KludgeCode

is Ben Rudgers

Option Stacks: Solving the Horowitz-Altman Conundrum

Abstract

Early stage investment constitutes greater risk and should offer commensurately larger rewards. Using the option stack an option accrues additional value in accordance with the degree to which it reflects a long term investment by the employee.

The problems with traditional practices surrounding employee options and the mechanics for exercising employee options are discussed by Ben Horowitz in How to Start a Startup: Lecture 15. There is also a transcript.

Altman: The idea is to grant options that are exercisable for 10 years from the grant date.

Horowitz: 10 years on a Startup stock, that’s a valuable thing. Remember the employee who stays doesn’t get that. The employee who stays just gets a stock. They don’t get the new job and the new stock. They get one thing but they don’t get both things. You have to weigh that in.

Goals

  • Provide ample time for former employees to exercise their options utilizing arms-length financing or other means.
  • Align company’s interests in retention with value of employee options by correlating the duration of an option to the duration of the employee’s tenure.

Mechanism

As options vest, they are pushed onto a stack. After an employee leaves, options periodically pop off the stack and expire. Vesting and expiration operate off the same master clock.

Formula

Let:
  c = a constant period of time that is the minimum amount of time
      former employees have to exercise their vested options.
  etd = employee's termination date
  ovd = option vesting date of a specific option.
  oed = option expiration date of a specific option.
In:
  For Each option
    oed  = etd + (etd - ovd) + c
 End.

Example

Terms:

  1. 100 share options.
  2. Four year vesting @ 25 share options per year.
  3. c = one year.

States:

  1. Employee start date = First day of year 1 = 0 vested share options.
  2. First day of year 2 => 25 vested share options.
  3. First day of year 3 => 50 vested share options.
  4. First day of year 4 => 75 vested share options.
  5. First day of year 5 => 100 vested share options.
  6. First day of year 6 => 100 vested share options.
  7. First day of year 6 => employee resigns with 100 vested share options,
  8. First day of year 7 => 100 vested share options.
  9. Second day of year 8 => the 25 options that vested at year end of year 4 expire => 75 vested share options remain.
  10. Second day of year 9 => the 25 options that vested at year end of year 3 expire => 50 vested share options remain.
  11. Second day of year 10 => the 25 options that vested at year end of year 2 expire => 25 vested share options remain.
  12. Second day of year 11 => the 25 options that vested at year end of year 1 expire => 0 vested share options remain.

Discussion

The one year constant for exercising options after leaving is symmetrical with the one year initial vesting cycle. This is probably easier for an employee to understand upfront and for a manager to clearly explain. A two year cycle might better smooth out variation in larger economic cycles. The example is intended to be illustrative rather than realistically nuanced.