Why Is Four The Magic Number?
No, this post isn’t about winning an NBA playoff series. It’s about a historical anomaly in start-up compensation that I’m struggling with. Although I know this risks being an unpopular post with entrepreneurs, I confess that I no longer get why we have four year vesting schedules for stock option grants at start-ups. Let me explain.
Vesting is known as the time period during which you unconditionally own the stock options that are issued to you by your company. Until you vest the stock options, you forfeit them if you were to leave the company. Typically, that time period is four years. There is typically a one year “cliff”, which means that you don’t vest for a year and then “catch up” by vesting 25% of the stock options on the one year anniversary. Subsequent vesting happens monthly or quarterly, depending on the stock option plan your company has put in place.
I was explaining to a friend the typical vesting at venture capital firms is 8-10 years. That is, if you leave a fund before 8-10 years from the start of the fund, you risk forfeiting some of your unvested profit interest in the fund, or carry. I explained to my friend that this vesting schedule made sense given venture capital funds take 8-10 years from managing initial investments through to exits.
Then I realized that vesting at start-ups should also logically match the time it takes from inception to exit. In looking at the data, it appears that the average time to exit in start-ups during the 1990s was 4-5 years, so the traditional 4 year vesting period made sense. But since then, the average time to exit has creeped up meaningfully from 4-5 years to 6-8 years. So why shouldn’t vesting schedules reflect this reality? Why shouldn’t the vesting schedule for stock options be 6 years? Boards are finding that they have to reissue options every 3-4 years because once an employee is fully vested, they naturally come back to the table with their hand outstretched asking for more incentive options to stick around.
In fact, why can’t vesting schedules be flexible and simply a part of the overall compensation negotiation? A CEO would benefit from having the tools at their disposal to adjust vesting dates alongside share amounts and other compensation levers. In the very early days, you might have six year vesting on stock options. After a few years, that date might be reduced to four or five, depending on the situation. Some form of accelerated vesting upon change of control (i.e., a sale) is often a part of the package for senior executives, so if a quick exit were navigated, there wouldn’t be a meaningful penalty.
So maybe you can explain it to me, but I just don’t get why our industry clings to a historical magic figure of four years.
Jeff is a partner with Boston-based VC firm Flybridge Capital Partners. Read his past peHUB posts, or follow him on Twitter at www.twitter.com/bussgang.
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Chris said on May 26, 2010
As always, good post.
Logically, your proposal makes sense. Why cling to 4 years when typical exit horizon is much longer than that. Venture guys already do this…
What’s missing in this argument is the fact that entrepreneur typically work for petty salary while venture guys make at least high 100k and more. The pitfall is that employees ask for the same vesting schedule as founders and executives. What’s the chance of a solid operating person joining a startup knowing that the vesting schedule is 8-10 years and salary is going to be much lower than big firms. The one and only upside for entrepreneurs is options and liquidity. On the other hand, VCs make a ton more money that they can use to build wealth. Exit means “meaningful” upside for VCs, but exit means the “only” upside for entrepreneurs. What would you say if your LPs say, “Jeff, I’ll give you 100M to run Flybridge for 20 years, and your vesting schedule is same as LP investment horizon: 20 years. Take low salary, and make your carry the ONLY upside”?
Also, VCs get committed capital for the next 10 years, startups don’t. Startups typically get enough to hit the next several milestones. When entrepreneurs know that the “sure” lifespan is much shorter than VCs, why should they have the same vesting schedule?
I don’t necessarily advocate the 4 year vesting schedule. It just seems that it’s unfair to ask for the same vesting schedule as investors when the risk and upside are clearly different.
Seasoned said on May 26, 2010
Good article. Makes one think and Chris has found some issues that I didn’t so here are mine to round them up.
a) Comparing venture firm partners to founders/execs/employees at a startup is simply misleading and unfair. The former are involved in a company; the latter are committed. The egg involved the chicken; the ham committed the pig in no uncertain ways. The venture partners are diversified and operate the equivalent of a mutual fund’s portfolio; they are hedged in many ways against swans-black or white–as they operate “multiple currencies” each involving the many companies they have invested in. The folks at the startup do NOT have that luxury as all they have is that one currency they acquire at that startup; if they aim to acquire another currency to hedge their odds for success, they have to jump ship to another startup (where the clock starts all over again)…
b) To add ammo to Chris’s point: remember, the startup employees earn little and their W-2 incomes are less than those of venture partners. Remember also the former pay regular income tax on those (smaller!) incomes whereas the latter, to their lasting shame, pay far less capital gains tax on their (much greater!) incomes. To top that you want to argue for longer vesting periods for the former?
Increasing vesting periods so that venture partners and startup employees are vesting on the same period makes sense…when the tables are normalized first so that both have equal guarantees of capital availability (10 years), earn approximately similar W-2 incomes, pay taxes from the same tax table, …
If things were as unfair as the article makes it one would see a migration from venture firms to startups; what we have on hand is exactly the opposite migration (when the opportunity presents itself) so that itself tells a tale at odds with the fundamental thesis of this article.
Dan Walter said on May 26, 2010
Interesting piece. Having worked in the equity compensation world since the mid-1990′s I think the reason behind the 4 year vesting period is more basic.
When options started become more popular in the late 80′s and early 90′s there were only a few companies giving them below the executive level. Their practices help set the “standard” (the “right of the early of the early adopter). Since options were seen as “long term incentives” they vesting really needed to be three or more years. Some law firms (the plan designers in those days) used 4 years, others used 5 years. Most used annual vesting, but there are many that used 20% at the end of the first year and then monthly vesting for the next three.
Restricted Stock has generally been set to a three vesting period for roughly the same reason (i.e. no good reasons).
There has generally been little thought, by most companies, into modifying these historical norms. There are obviously plenty of good reason to do so, including some that Chris has mentioned. It is time that companies who refuse to follow the herd in business matter stop following the herd in compensation matters.
Thanks for the posts Jeff and Chris.
Robert Hacker said on May 27, 2010
Probably no obvious logic to four year vesting. However, the notion of vesting periods matching the VC vesting schedule may not be a good idea. A lot of talent enjoys the early stage but move on when the company reaches the scaling stage. Such long vesting periods would not be an incentive to this critical group of people.
Dan Wilson said on May 27, 2010
In my opinion, comparing the compensation mechanics of a VC to a founder is ridiculous (and Ive been both).
Startup founders take a salary cut, self fund until a venture round and take large person risk. Equity grants are the only compensation for these risks and putting a long vesting schedule in front of their ownership isn’t fair. VC’s, on the other hand, assume very little personal risk, have their eggs spread across multiple baskets (deals) and get paid handsomely during the life cycle of the fund – seems fair to drag out the vesting schedule under those circumstances.
Daniel Haran said on May 27, 2010
“the average time to exit in start-ups during the 1990s was 4-5 years, so the traditional 4 year vesting period made sense. But since then, the average time to exit has creeped up meaningfully from 4-5 years to 6-8 years.”
That, rather than the vesting schedules, is what needs fixing.
westside.account said on May 27, 2010
Jeff,
Why are management fees for VCs between 2-2.5%? Seriously. The majority of funds have never experienced carry, yet for a $100MM fund, right off the top $15MM-$20MM goes to fees over the period of the fund. That doesnt make sense. Especially when coming to 10 year returns which show that the asset class for VC is below less risky and more liquid asset classes with similar correlations to public markets.
Note that the fees that you collect from management fees is very large when you compare to the total return on a fund you are providing investors. So if you provide a 2x-2.5x to your investors net of fees and expenses to your investors, your management fees are still a major portion of your overall compensation especially from a time and risk value analysis. The equivalent is if founders received a guaranteed salary for 5-10 years that was proportional to the expected exit of 2-3x of the company.
So your comparison to founders equity is either disingenuous or misguided.
This is egregious, especially in light of *your* point that exits for VCs take 8-10 years. If a VC is spending pension money of teachers and public servants, they shouldn’t be collecting such management fees over the 5 (invest)/10 year life of the fund.
For companies with strong management teams and VCs such as Sequoia, Accel, Matrix and others who can typically help their entrepreneurs raise successive up-rounds, the 4 year vesting typically isnt an issue, even in cases where the founders are fully vested far before an exit. The founders need to get the company to an exit whether its 4 or 10 years, to see their shares become worth something.
The logic for 4 year vests is that within the first four years of the company, the founders develop the platform and significant value that demonstrates that the startup is either #1 and #2 in their class. The best performing VCs attract the best founders enable this. If the board decides that they want to grow the company into an independent entity beyond the first 4 years then that can be a good point, but the founders were able to develop the company to the point where they have their choice.
Google, Facebook, Youtube, Cisco, NetApp, AdMob, Salesforce, Silver Springs and many, many others did exactly that. Some exited in a few years after founding. Google waited more than 6 years before exit.
The job of a good board member and VC is to build a relationship with founders and employees for a company culture that retains their team beyond their 4 year vest. If a founder is still contributing value beyond 4 years then they perhaps they should get some additional shares.
Nathan Beckord said on May 27, 2010
I agree with Daniel Haran’s comment above– with the exception of hardcore science startups (bugs & drugs, cleantech, etc.) the startup world, in my view, is shifting toward faster cycles and shorter times to fail-or-exit. It’s quicker and cheaper than ever to start and scale, and the Gen Y founders now coming up have significantly shorter attention spans. If anything, it could be argued that 4-year vesting schedules are too long as early exits become the norm in the startup world.
JJ said on May 27, 2010
Excellent article. One other point — management often comes back for additional option grants not because their existing option grants have vested, but because their existing option grants have been diluted by the financing rounds done by the company since those original option grants were made and the board wants to get management members back up to meaningful percentage interests in the company. As I’m sure you know, this is one of the reasons why an “options refresh” (i.e., increase in the options pool for “make whole” grants to existing management and grants to new hires) is built into the cap. table model for virtually all Series B and subsequent financing rounds.
Tony C said on May 27, 2010
Thanks @westside.account for pointing out the absurdity of a VC comparing their compensation to an entrepreneur and the early employees. In his defense however, at least he was a founder and worked at startups.
Jordan said on May 27, 2010
Good initial post, but I would agree with Robert — many of the important early-stage employees will not scale for various reasons and would lose out on much of their upside if the vesting were 6 years or more. Would a company be successful without them? In most cases, no.
Also, what about the folks that come in and provide a ton of value-add in years 3-5 and, when the company gets sold in year 5, could get no value from half of their options unless there are acceleration provisions in place? Many companies (and their VC’s) are opposed to acceleration for most employees other than the most senior execs, so this would require a whole revisiting of that thinking as well.
FG said on May 27, 2010
Jeff,
I agree with the above posts. It is offensive for you to compare VC compensation to entrepreneur compensation. I’m very surprised that you, a former entrepreneur, would do such a thing. I’d expect this from a career consultant/i-banker/VC, but not from someone with real entrepreneurial experience.
VC-funded companies typically go through multiple stages (here are some examples for a biomedical company) – the initial founding/proof-of-concept stage, the full proof stage (extensive preclinical testing and early clinical trials), product approval (Phase 3 or pivotal trial and then the NDA/PMA/BLA), then the Exit. Different skill sets are needed over time so a company’s personnel will expand and change. People that are very valuable in the proof of concept stage (and thus key if the company is to have a shot at an exit) may not be at the company during the late stage clinical trials. Why should they not get anything for their early work?
Lars said on May 27, 2010
Provocative piece, and I assume intended as such.
If not, I encourage Jeff to experiment: for the remainder of 2010, give it a try in your terms sheets – I doubt any talented entrepreneurs will sign.
Moreover,
“In fact, why can’t vesting schedules be flexible and simply a part of the overall compensation negotiation? A CEO would benefit from having the tools at their disposal to adjust vesting dates alongside share amounts and other compensation levers.”
True, but a guaranteed means of sowing discontent amongst employees.
Robert H. Heath said on May 27, 2010
The time-to-exit for the VC and the vesting period for the employee have very little to do with each other.
Only after the employee is fully vested does he enjoy the VC’s right to participate in an liquidity event or exit. So if an employee fully vests in his initial option grant after four years, but it takes another four before an exit, how exactly is the employee getting a better deal than the VC?
You could of course tailor 8-year vesting periods, but since stock options are simply a form of contingent, deferred compensation, you’d have to substantially increase the number of options granted as compared to a 4-year vesting schedule. At a minimum, you’d simply double the size of each option grant, but using VC-stage discount rates to calculate the present value of option grant, you would likely be tripling or quadrupling the size of the employee option pool.
Cornelius Diamond said on May 27, 2010
Ridiculous article, especially considering that most funds these days, especially in life sciences, are looking for late-stage, ie 2-3 years to exit, deals since most of their earlier work has not panned out. I would go one step further than Lars and say that if you agree it should be this way, why not try the reverse? Anybody can have money, most ideas worth funding will not take the money with such strings attached- they can find other ways to survive, after all, they have the patent and can sit on it with minimal investment to inch forward.
Jeff Bussgang said on May 28, 2010
Thanks to all for the great responses. I was trying to be provocative, obviously, so appreciate the folks that took the post in that context. The four year number just has struck me as very arbitary and worthy of more debate and dialog – particularly given how important vesting is to everyone around the table.
To the folks that criticized me for comparing VC compensation to founder/entrepreneur compensation – to be clear, I didn’t intend to do that. I was comparing founder/entrepreneur vesting schedules circa 1980s and 1990s to modern times. Sorry if my point about VC vesting was distracting but I meant it simply to provide a counter example to the rigid notion of four years as a magic number.
If anyone can provide historical data on why four vs. three or two or five for that matter (as Dan Walter did above), I’d appreciate it. Does anyone know of any examples where a number other than four was used??
Chris said on June 1, 2010
Jeff,
Since you’re the one with pushing out the terms to entrepreneurs, how about you give 2,3, 5, or 6 vesting schedule and share what you learn from that experience?
Perhaps too much risk involved with an “experiment”? If you are thinking, “I don’t think so”, that may be the reason VCs are sticking with 4-year vesting schedule.