I think that the way that employees are getting compensated at startups is starting to break. The old model of relatively low salary and “high” equity only works when there’s a healthy public market for that equity in the not too distant future. If IPOs are getting significantly delayed and are potentially at risk of not happening at all,[1] we need to change how compensation is structured.

Options only make sense as compensation when you can draw a clear line from the point at which you get the options to the point at which those options are equivalent to cash. This happens when two conditions are met: 1) the stock price is enough above the strike price on the options to make exercising worthwhile to the employee and 2) there is someone willing to quickly buy the stock. This tends to happen with access to liquid markets, which traditionally means public ones. That’s the only place where an employee can sell whenever she wants and can know the price she’ll get with a high degree of certainty. It’s also the only place where an employee can really hedge out some or all of the risk of her options.[2] That hedging is important if the value of the options rise significantly and lead to an employee having 99% of her net worth in a single illiquid asset.

When shares can only be sold in private transactions on secondary markets, and, increasingly can only be sold with the consent of the company, the options are actually worth less. This is true for three reasons.

The first reason is that control is an important factor in asset pricing. Think about this in a situation where an employee would like to sell stock to fund the purchase of a home. In a public company, that employee could exercise the options, sell the stock quickly and use the cash to buy that home. If that employee instead wants to sell stock in a private company, and the company does not let the employee do so, the employee cannot get the cash to buy the house. Because that employee cannot do what they want with the equity, that employee should discount the value of the options they hold.

The second reason that options are worth less in the absence of robust public markets is that the terms of sale of stock in the future are unclear. An employee being granted options has no idea under what conditions he will be allowed to sell stock in the future. The future sale might be subject to board approval, there might be a heavily restricted set of buyers, the employee could be told that no sales are allowed whatsoever for a variety of reasons. Each of these possibilities adds uncertainty which makes the options harder to value and worth less.

Founders need to account for this change in the value of options when giving them, and employees need to account for the change when evaluating their offers and negotiating. This is, however, hard to do in the absence of information. Without a liquid public market to value stock, it’s hard to say what the options are worth. The best guess an employee has in this scenario is to go by the most recent valuation given to the company during a fundraise. The further from that fundraise an employee is, the less relevant the price. Furthermore, without the ability to compare how different employers control and handle the sale of private stock, it’s nearly impossible for an employee to know what is standard.

The third reason for why individual options are probably worth less now than they used to be is that both employer and employee need to account for the fact that the time until IPO or liquidity is longer than it used to be. This is a big issue. To get the true value of offered comp, employees need to add their offered salary to the present value of the options offered. When calculating that, the further out the payout, the less it is worth today.[3]

This is an especially important calculation when trying to hire employees away from larger companies who are already public or can offer larger cash packages to employees. Those offers also tend to include options or stock grants which have known price and sale terms. Because of their easy to understand high dollar value, these offers are hard to compete with. Options in early stage startups are much harder to value even without all these new factors. Given uncertainty around the final value of those options, the time until they can be exercised and sold is hugely important. As you move further out on the curve, not only does the discount factor become a larger lever, uncertainty over the final value gets more extreme. You can be pretty sure that a company currently worth $10mm won’t be worth $1b in 3 months, so you have a reasonable band of expectation. Once that value calculation moves to years out, nearly anything is possible and needs to be factored into the calculation.

I’m not the only one thinking about this, and, indeed, there are instruments available that let employees take immediate advantage of long term options. Some banks or private investors will provide loans collateralized by options. This can be good, but debt is very different than having cash. Taking advantage of this kind of strategy could also lead to potentially tricky situations where, if the option value as determined by secondary transactions falls (which could happen quickly and dramatically given the lack of liquidity in the system), the creditor could claim the assets before the term is up. Even if the price then recovers, the employee is out of luck and money.

Founders need to deal with these issues, and given how fierce the competition for good employees is, I think someone will do so soon. One response would be to increase overall options packages to account for the fact that they are now less valuable.

Another path would be to create an internal liquidity pool capable of buying shares from employees at predetermined trigger points. Maybe this could be funded by existing investors, or maybe by other employees or existing shareholders. Because the sale points are predetermined and don’t provide an open market, the value of options would still be discounted, but not as much as a scenario with no guaranteed access to liquidity.

It may make sense for some companies to start creating revenue share programs as standard practice – especially for companies that never plan to going public (of which there appears to be a rising number). This could be a powerful means of retention, though would only work with companies throwing off enough cash.

I think that something even more basic needs to happen first: companies need to standardize their secondary sale and options repurchase practices. We’re living in the wild west right now – each company and each employee is doing things on their own. An employee that wants to sell shares on the secondary market generally starts asking friends if they know anyone who wants to buy those options. Generally, they’ll find a broker who offers to matchmake and who then gets a cut of the overall sale in exchange for their work. The price that gets set isn’t shared from one deal to another, and the rules around whether or not the company can block the sale aren’t standardized. This isn’t fair to employees, and will lead to confusion and bad outcomes.

Maybe what we need is two things. The first is a founder pledge that they will do everything in their power to let common holders sell into secondary markets above a certain valuation, say, $500mm. The second is that founders of highly valued private companies need to participate in a robust, standardized, secondary market to allow for the clearance of those shares.

My guess, though, is that there will be a number of different solutions with the market choosing the best one as evidenced by the quality of talent hired and retained by the company using them. Founders should be watching for that and be willing to adopt best practices as soon as they arise.

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[1] There have been a lot of articles and blog posts about this recently, but Andreessen Horowitz’s recent “US Tech Funding – What’s Going On” is the best analysis I’ve seen. They note that the average time to IPO is now 11 years vs. 4 in 99, and that the overall number of tech IPOs is plummeting as privately funded companies raise huge late stage private rounds instead.

[2] You can do this a number of different ways and hedge out either your exposure to the company itself or do the overall market. Hedging out this risk probably deserves an entire post as it can get complicated. And, while nearly impossible to do it perfectly, is important to significantly reduce risk.

[3] We’d do this as a lump sum calculation for simplicity. You can play with that calculation here: http://www.calculatorsoup.com/calculators/financial/present-value-investment-calculator.php