A Different Approach to Refreshing Stock Option Grants

Stock Option Vending MachineEvery year in December and January I go through the same cycle for all the boards I’m on. It’s the annual bonus, next year bonus plan, option grant refresh cycle. For many management teams, especially in rapidly growing, or mature companies, it’s an important part of their existence as culturally we’ve oriented compensation, bonuses, and future compensation around an annual cycle.

I embrace this – my goal is to help these entrepreneurs and management teams win. I know compensation is an important part of the feedback / reward loop. While I’ve occasionally had conflict over compensation, and I’ve had a few CEOs I work with tell me they feel like it’s an uncomfortable discussion, my own perception of my behavior is that I’m a softy. If things are going well, I am supportive of anything that’s reasonable. And, having thousands of data points over the past 17 years, I’ve got a good calibration on reasonable.

One thing, however, has always baffled me. I’ve never really understood why the majority of stock option refresh grants are stacked grants mid-way through the granting process.

Let me give an example. Assume you hire someone and grant them 10,000 options with monthly vesting of four years with a one year cliff. That means that after one year, they get 25% of their options and then start vesting the remaining options monthly at a rate of 1/48 (208.3 options / month, or 2,500 / year.) On day 1 of year 3, the person has vested 50% of their options, or 5,000 of them and still has 5,000 left to vest. This person is doing great so management puts them in the annual option refresh cycle. Now, the company has increased in value, as has the option strike price, so the refresh grant is determined to be 25% of the original grant – or 2,500 options vesting monthly over four years, or 625 options per year.

Now, in year 3 the employee in question vests a total of 3,125 options, in year 4 they vest a total of 3,125 options, in year 5 they now vest 625 options, and in year 6 they vest 625 options. This makes no sense to me. You just changed their first four year vesting package from 10,000 options to 11,250 options (2,812.5 options per year) and then left them with 625 in years 5 and 6. This is a bonus in years 3 and 4 and a refresh in years 5 and 6.

Instead, why not grant them the new 2,500 options that vest in two years –  50% in year 5 and 50% in year 6. So now, they once again have 2,500 options per year for years 1 to 4 and 1,250 options vesting in years 5 and 6. This is a refresh in years 5 and 6.

The key difference is you are separating the “refresh grant” from a bonus, or retrading, of the hire grant. Now, I’m totally supportive of giving people bonus grants – if someone is doing an awesome job and they deserve more options in year 3 and year 4, do that. But that’s separate from a refresh, especially if your goal is to make sure there is always plenty of future options vesting.

The reason companies do the refresh in year 3 instead of year 5 is that – assuming success – the strike price of the option in year 3 will be lower. So the “value” of the option theoretically is higher if you grant it earlier since you get to lock in a lower strike price, especially against the uncertainty of where the strike price will be in two years. So that’s perfectly rational, but the idea of stacking the refresh grant on the old grant is not.

I’m not pushing to implement this in 2013 since I’m at the tail end of the refresh cycle with many of the companies I’m an investor in and just recently realized why the way refresh grants historically have been done didn’t make sense to me. And it shouldn’t make sense to the management team either – their goal and my goal is aligned – get plenty of future option value locked via vesting as a reward and retention tool.

I’m open to hearing why this doesn’t make sense. I just read it again and realize it’s confusing, as is almost every conversation I have with a management team around what, how, and why they are refreshing options. So – tell me what you do – and why – as I try to make this explanation / approach simpler.