What goes through the minds of most founders when they think about how they will finance the next big thing? Debt? Equity? Bootstrapping? Either way, cash is likely to be tight, runway will have to be protected. This need for cash efficiency factors into all decisions, especially hiring plans and remuneration strategies.
If you’ve been in business planning meetings, you’ll know the script. “We can’t compete with the big players on salary!”, “Those market rate benchmarking surveys are a bit punchy these days!”, “Do we really need that variable compensation element on top?” You’ll likely know the suggested answer to these problems as well…Equity! The CEO or CFO will chime in, “that’s the point of the EMI scheme we created a while back. We might not be able to compete in cash terms at this point but we’ve sold the vision. We’re the next big thing. When the vision becomes reality, no one will care about a below average starting salary.”
So maybe there’s another form of financing at play. How much is financed by the belief of the team? The belief to go on this mad startup journey, forsaking potentially higher monetary rewards elsewhere for doing something more meaningful, creating something special.
All good so far, right? Startups need to protect cash. Employees are excited to take that leap of faith. Share options provide that bridge, a way of financing that belief. Recruit or retain an employee, that’s the purpose according to HMRC. Interests are now aligned. So what’s the problem?
We need to talk about secondary sales.
Let’s say we embark on the equity funding alphabetical roadshow. At Seed, A, B, C etc. primary investment will be raised, cash into the business, new shares created and issued to those investors in return. But at some point on the journey secondary investment can become an option and existing shares can be sold instead of issuing new.
So this is the moment we’ve been waiting for. Those long tenured employees can cash in some of those vested options and their belief financing can start to be repaid. Wrong. So many boards are against it and therefore the share option scheme rules are designed as Exit Only, making the participation in secondary sales impossible.
Why is this the case? I’m sure there are some Exit Only schemes because template scheme rules were downloaded at some point and implemented without consideration as to how the scheme should operate. But I’m always so disappointed at the number of conscious decisions made, usually resulting from Investor Director pressure.
I hear concerns that founders will be less motivated if they are financially secure, less pressured to make the business a success. That’s naive to me. A founder who has paid off their mortgage is more likely to make sound business decisions and not burn cash chasing risky growth strategies. And let’s face it, once that first mortgage is paid off, it will likely be replaced by a bigger one shortly, so there’s always personal financial motivations to chase!
I hear concerns that those key, long tenured employees are more likely to jump ship if they are not held prisoner by that future value. But allowing employees to realise value in their share options is hugely valuable to the business. It shows to those employees that their belief was invested wisely and there is more to come. It sends a strong signal to other employees that their options are worth something too and not just a bit of paper to be forgotten about. Businesses are too concerned with what they view as a negative signalling risk, when in reality it should be reframed as a hugely positive signalling opportunity. Surely your key employees are far less likely to have their heads turned by others offering the big bucks if they are more financially secure?
There are governance risk concerns around secondaries but really these are all controllable through the investment round documentation. But at this point I feel we’re just trying to pick holes. Let’s put to bed the argument that share options are just Monopoly money and let’s start using them as the powerful tool they are designed to be. Startups are run on cash and belief. Let’s allow share options to truly finance that belief.