Fixed Equity Grants Become Toxic

You win, the company wins. Equity for employees aligns incentives between employees, companies, and investors. There are enough details, though, for the devil to hide in. And those details change over time, so that a tasty decision at one point of a company’s life turns sour. Today I’m looking at an individual contributor’s view of equity compensation policies.

In what follows I talk about “working hard”. Extraordinary accomplishment is nourished by extraordinary effort but as a recovering workaholic burning yourself to nothing is not what I mean by extraordinary effort. Working hard is applying discretionary emotional energy to work. You can succeed without it but you can succeed more with it. Working hard comes with an opportunity cost, though. Do financial incentives align with working hard? It depends…

Standard disclaimer that the most important and safest incentives are non-financial. But money matters too…

We’ll start at the extremes.

Fixed Equity Grants/Early Stage

Employee number one receives a large grant to vest over, say, 4 years. 4 years is forever. The company likely won’t even last that long. The employee is incentivized to bust it. The employee’s every effort shows up in the company’s financials, financials that will justify a share price that rewards the employee’s efforts.

The potential upside of this stock price appreciation is substantial. The company’s market cap goes from $10m to $100m to $1b. Every year that the employee works hard they have more options vested & they also have more value in the options yet to vest.

Incentives are reasonably aligned in this scenario. Extra investment by the employee results in extra returns to the employee (also to the founders & investors).

Cash Only/Mature

Jump to the large, established company with a reasonably stable stock price. Hope of appreciation is no longer an incentive. Awareness of one’s own direct contribution to company financials is no longer an incentive (with rare exceptions). Equity is equivalent to cash. In this case the equity policy is not a strong incentives lever. You may as well, as Netflix has done, make all compensation cash.

Incentives are reasonably aligned in this scenario too. Employees get a fixed, known compensation for (likely) a fixed, known effort.

I’m interested in the cross-over between the two policies.

Late Growth

How about the pre-IPO stage? As a senior IC I receive a juicy-looking equity grant when I join (or I wouldn’t have joined). How hard should I work? The incentives compete:

• I’ll feel good about myself if I work hard, learn, grow, and succeed.

• Over time the amount I can contribute to a company wanes as the company gets bigger and less concentrated.

• Over time the amount I can contribute to a company waxes as my experience and social connections grow.

• In the early days I have much more to gain in vesting than what I have accumulated.

• Over time this balance tilts. The less there is left to gain compared with what has already accumulated the less incentive to bust it.

I can’t tell you how these headwinds and tailwinds add up for you. And the individual factors and the sum change constantly. I can say, as an investor/executive, that fixed equity grants lack the compounding incentive effects of early stage equity.

The standard response to the fading incentives of fixed equity grants are equity refreshers, further equity granted in response to outstanding performance. There’s a whole essay to be written about size & timing of refreshers, but that’s for another day. For now, size refreshers relative to both:

• The amount of equity yet to be vested &

• The market