Two weekends ago, I had an entrepreneur for dinner at my place. He has asked how to use employee equity effectively, especially regarding tax-related issues in Europe.
Stock options are essential for hiring, incentivizing, and retaining talent in startups. They offer employees the right to acquire part (of the shares) of the company that they are working for. This is the most effective way to make employees participate in the potentially huge valuation upside of tech companies. The company's success becomes their success. Everyone is on the team, everyone is sharing in the gains. Every company that we invest in has a stock option plan.
Stock options are core to our investment strategy. Think about it, our company Wix alone created more than 250 millionaires. This is one of the best ways to give back...
On a call with the Wix COO last week, he put it this way: 'Everyone in the team gets stock options, from the top executives to the agents in the call centers. It allows the CEO and myself to get on stage and talk about how everything we do affects all of us and all of our shares, with a straight face. And more than anything, it allows you to work with super strong talent for a very long time and reward everyone. My management team has been with us for up to almost a decade now...'.
Let's have a look at how founders can approach stock option plans, and the European tax challenge precisely.
Why a stock option plan and how to communicate it to employees?
Employee ownership is a key part of startup culture, and your best shot at hiring and incentivizing the best talent you possibly can.
As an early-stage investor, we usually aim for an unallocated stock option plan of around 10% when we invest (and, in some cases, this can go up to 20% at the pre-seed stage). This % is anchored in our belief that a great team and giving back is essential to build a rocketship.
First, stock options are an integral part of the employees' compensation packages. In most cases, these stock options are your only way to compete with big corporates such as Google, Salesforce, or Facebook, which are chasing the same talent. They will offer much higher cash compensation packages than you will be able to. Stock options are unique way startups can leverage to compete on compensation.
To illustrate the real value of stock options, startups need to be transparent with employees regarding the current and future value of their ESOP. First, in the hiring process, but, they should update their employees regularly, ideally once a year. The current value is the difference between the strike price (meaning the amount an employee has to pay to acquire a share) and the last price at which the company raised equity financing. The future value is based on the potential future valuations the company could get. If the company is doing well, everyone in the company is. Here a simple way to illustrate the compensation package:
The higher the valuation of the company, the higher the value of the ESOP. This is the startup game, and everyone in it should understand it. None of these values are, of course, guaranteed. But it is this belief in a company's mission and future success that incentivizes everyone on a team to work so hard, and this for less cash today.
This belief in future success is also what allows you to retain the best talent. In a stock option plan, options are usually vested (officially approved) in regular instances over a certain time period. Usually, this period is 4 years with options vesting quarterly (or monthly) on a pro-rata basis with a 1-year cliff (meaning the first vesting only happens after 12 months and not quarterly in the first year).
Stock option plans cannot be approached with a one-size-fits-all mindset. As my partner Michael points out in this great post, 'the key, as in all things employee-related, is to understand each individual employee's motivation and therefore to try to give them the remuneration package that is right for them (within the limits of your cash and ESOP budgets). Is the one who wants more ESOP (and is willing to take less cash) a bigger believer in the company? Possibly, but the decision by an employee here is much more likely to be rooted in the personal financial position of the employee than anything to do with their view of the company's prospects.' Again, being transparent in the hiring process will allow you to offer the best possible packages, and increase the likelihood of getting the best talent.
How to deal with European taxation rules?
This is a complicated topic as the taxation rules vary from one country to another. The key difference between the US/UK and Europe is that in Europe you are frequently taxed on the paper gains you make when exercising stock options. It means that you have to pay tax (income and/or capital gain tax) on the difference between the price you pay for the shares (meaning strike price when you exercise the options) and their current fair market value. This is mostly a problem for leavers whose right to exercise options is often limited in time, meaning that they need to exercise within a short period after leaving before they lose the options. Usually, they have to exercise their options with 60 to 90 days of leaving.
As a result, many people can just not afford to exercise their options and lose the ability to participate in the startup's past and future value creation. Let's have a look at this example where we assume that you have to pay 40% tax on your gains.
As you can see, to exercise your options you would have to pay EUR 40k in taxes on top of the strike price of EUR 10k. As a return, you receive shares of a startup, one of the riskiest assets out there, that are valued on paper at EUR 100k by some VCs. This is not exactly the trade-off you were looking for when you decided some years ago to join a startup and take a significant salary cut in return for stock options. But let's put tax aside for a moment. To begin with, most people will struggle to pay the 10k strike price.
In contrast to Europe, it is more common in the US/UK to be able to exercise your options on a cashless basis. As you don't have to pay tax on exercise, you can just forfeit some of your shares to finance the acquisition of the remaining shares. While you lose some of your shares, you essentially get the others for free.
So, how can entrepreneurs deal with this in Europe? Well, you have two possibilities, besides the traditional plan described above.
1) Extended Option Plan: You can defer the problem by allowing leavers to hang on to their vested options until an exit. This is different from traditional plans in which leavers are generally required to exercise their options within a short period of leaving.
2) Phantom Plan: You can replace the problem with another possibility, a cash bonus paid at exit based on a virtual number of shares held at the exit date. This award will be taxed as regular income.
Obviously, none of these possibilities is perfect. People typically just don’t like having to wait for a long time to cash options in. As a result, some prefer real money over options. Every CEO needs to decide which plan works best for his team. Some VCs, including ourselves, are helping European countries to improve these rules, because employee equity awards are a key component of building thriving tech ecosystems.
France implemented this year some interesting changes that go in the right direction. 'A restriction has been removed on people with French Tech visas that required companies to be headquartered in France. Someone can now receive stock options even if they are working for foreign businesses, and stock options are now priced at fair market value (FMV), rather than the price paid by investors'.
The levels of employee ownership vary quite a bit from company to company. There are a variety of reasons. Geography is one example. Employee ownership levels are higher in well-developed startup cultures like the US, Israel, or France. They are lower in emerging ones.
Here a great stock options calculator for European countries from our friends at Index. The variables for determining the right stock option plan are individual preferences of employees (see above), geography, valuation, expected additional funding rounds, exit valuation aspiration, and position.
The way to think about this is the following. To build a compelling compensation package based on a mix of cash and equity, you need to communicate the Euro value of equity and the underlying number of shares. For each employee level, you determine a salary multiplier. You multiply the base cash salary by the multiplier to get a Euro value of equity. Then, you need to determine the value of your company. Usually, this is the valuation of the last fundraising round, or the valuation of the last acquisition offer you turned down. To determine how many shares the value of equity in a compensation package represents, first, you need to determine the value of a share by dividing the value of the company by the number of fully diluted shares outstanding. Finally, you divide the euro value of equity in the comp package by the share value to get the number of shares. The important thing here is to communicate in Euro value of equity and not in % of the company.
Please note that these multiples are just examples. Please do reach out if you would like to have a better overview of a specific geo or use the stock option calculator mentioned above.
For the first hires, it is difficult to use such a formula though. The discussion is more about points of equity than the Euro value of equity. Convincing people to join your dream before you have anything is much more an art than a science. I have come across everything, from 1%, 2%, and sometimes up to 5%. Make sure you have a great story to get the best people. More on this here. Finally, co-founders are a different story again and each case is different.
This weekend I was in London for the first time in four months. It was good to be back, even if the weather was very English ;) (see pic below). What surprised me, though, were the number of friends leaving the city. Some go to the South of Europe or stay with their parents for the rest of the year. Many big companies have announced 100% work from home for 2020. London is not the same with so many international people out. One can only guess how our cities will look like in a year from now if this continues much longer...
What I know for sure though is that life is and will be awesome,
Other content I have found useful
The rise of Superpower Tech by Vedika Jain: 'The rise of no code is a sub-theme in an even larger movement: tools that give knowledge workers superpowers.' Vedika puts the products into 4 categories: (1) 'Open up access — do things you couldn’t before', (2) 'Create as a team - tighter feedback loops, fewer handoffs', (3) 'Automate workflows - work on what’s important', and (4) 'Cross-category superpower tools'.
(Partial) work from home is real. Even Siemens has decided to let employees work from wherever they want for 2 or 3 days a week, stating that 'This will also be associated with a different leadership style, one that focuses on outcomes rather than on time spent at the office...'.
Some thoughts on GPT-3. If you are in tech, you have most probably heard about GPT-3, a new and massive language model developed by OpenAI. Here a great post by Albert on its potential opportunities and challenges.
Garmin begins recovery from ransomware attack. 'Many of our online services were interrupted including website, customer support, customer-facing apps, and company communications.' The company expects all its systems to return to normal operation within a few days, but warned there might be a 'backlog' of user data to process. As my partner Mark put it: 'The silence from Garmin is deafening. Are we witnessing an existential moment?'
Podcast advertising is expected to grow by 30% this year. This is only the beginning of audio entertainment. I like to think of this as a similar evolution to what happened with radio and TV in the last century. It started with radio but TV was where the big money was made.
What is the most successful prosumer product out there? Most probably Excel with its 750M users. Satya Nadella (Microsoft's CEO) has called it the best consumer product Microsoft has ever made. This makes me wonder why not more people are building products on this platform.
Don't let stress ruin your decision making, a great article by Chris Schelling. Research shows that both short-term and chronic stress can negatively impact investment decisions. But there are ways to avoid making bad choices under duress.
Twitter is looking into the subscription business model for additional revenue streams as revenues from its core advertising business are declining sharply (20% decrease from the previous quarter), while the number of DAU grew 34% over the last year. Twitter is, in my opinion, one of the best sources of knowledge out there. A subscription model makes sense and would make the service even better.