The race for accelerated growth, larger rounds, and shortened periods between them, are bringing to the fore the need for a review or an update of the CEO/Founder/Founders option plan (will be referred to in this post as: the CEO Option Plan*).
This practice, usually kept for much later stages in a company’s life, is even further accelerated when the round includes a secondary offering.
The best and most common way to address the CEO Option Plan is through a Compensation Committee (CC), comprised of members of the company’s Board of Directors.
Every company has different needs and sensitivities around the Compensation Committee’s responsibilities. In this post, I have mainly addressed the frequently asked questions concerning the creation and approval of the CEO Option Plan as well as suggestions on how to avoid potential difficulties.
Of course, not all cases are the same, so please keep in mind that this blog is based on my own experience.
1. Who are the members of the Compensation Committee and who should appoint them?
The CC is comprised of two or three members of the company’s Board of Directors, and they usually serve in this role voluntarily. The CC is often initiated by the company’s management or by the chairperson of the Board of Directors if s/he is appointed, but the members are officially appointed by the board. The CC does not have to include the chairperson and normally would not include members of the management.
2. What are the roles of the Compensation Committee?
There may be various roles, but in this post, I focus on one of the main purposes of the CC which is to create and approve the CEO Option Plan. The first step should be to consult with the CEO to decide which tasks and key responsibilities the CC will oversee.
3. Should the CC also initiate and/or approve incentive plans for other members of management?
This could be a delicate issue as the final decision on what to bring to the approval of the company’s Board of Directors regarding the incentive plan of the management team lies, in practice, in the hands of the CEO. Of course, the CC can voice its opinion regarding the percentage of shares it recommends be given to a certain executive, however, my suggestion is for the CC to share its opinion with the CEO as a recommendation, and let the CEO make the final decision on what to bring to the approval of the Board.
4. When is the right time to create a CEO Option Plan?
In the past, a CEO Option Plan became necessary either in the lead-up to an IPO or when there was a big deficiency in the founder’s percentage of shares.
These days, as explained below, the need to work on incentive plans comes earlier – both due to the ever-increasing amounts raised (and dilutions thereafter) but also in order to keep the company’s CEO/founder incentivized enough to continue to the longer road and higher valuations, which have now become more achievable. In addition, as exit valuations increase, every single decimal percentage point can mean a great deal of money.
5. CEO Option Plan – Relevant topics:
a. How to build an incentive plan
The CEO Option Plan can be developed in different ways. While I have chosen not to discuss tax considerations and instead focus on other aspects, I will emphasize that they should also play a role in the method of building the incentive plan.
The plan can be determined according to milestone achievements such as reaching a certain valuation during a financing round or exit or hitting a fixed-size round, or all three.
In my opinion, this method can be counterproductive in cases where the valuation achieved in a round is only temporary — unfortunately, there is always a possibility that the company will deteriorate after a high-priced round, making the round’s valuation a slim reed.
A better option, in my opinion, is to build an Annual Incentive Plan that is triggered upon achieving yearly milestones – be they budgeted revenues or margins or other KPIs, depending on which milestones are most important for a company to achieve.
Non-numerical achievements could also be a milestone the CC may like to encourage – such as certain re-organization or recruitment roles.
I added below an example of an Annual Incentive Plan, where the incentive plan includes a certain company share percentage** comprised of the following:
– 1/3 of the % to be granted yearly for no particular milestone (i.e. in any case)
– 1/3 of the % to be granted yearly for achieving budgeted revenues/ARR/GM/profit if it exists/any other chosen KPI. This scenario can include up to 2x the grant in case of over-achieving and zero or decreased % in case of missing the target
– 1/3 of the % to be granted yearly for achieving certain MBOs (Management By Objectives), as determined by the CC (ie – recruitment of certain roles, move to a different pricing model, etc)
Not all parts of the plan need to be weighted equally and the CC should have a say which parts of the plan are more important to incentivize the CEO.
A grant which is based on a specific target, may create a disproportional incentive for the CEO to achieve that particular target, even if a change in circumstances arose. Creating a blend, inclusive of several targets, is a nice solution to this concern.
b. How long should the incentive plan last?
Many recent incentive plans last for a multi-year performance period (2 to 3 years), while in some cases the board chooses to re-consider the plan each year. In my opinion, multi-year programs are better both in terms of time-consuming process and in terms of creating better visibility and alignment of interests for the future.
c. Which data should be considered when creating the plan?
Where possible, the CC should use comparables of incentive plans created in companies at similar stages/categories/ geographies to support its recommendation. This brings the question of whether the current percentage of shares held by the CEO should be taken into consideration when deciding on the Option Plan. One could argue that it should. If we take the example of a CEO who holds 5%, and the comparable shows s/he needs to reach an IPO scenario with 10%, the plan should implement an increase of 5%. However, I am not in favor of this argument. In my opinion, the 5% can be an outcome relating to a large secondary transaction the CEO has fulfilled in the past, or to large amounts raised by the company, or due to a previous down round. As such, I think decision-making based on definite numbers is less reasonable and misses the point.
I believe the plan should refer only to the current granted percentages without reference to the existing holdings. Of course, in cases where the CEO holds a smaller percentage, the option plan is more critical for the CEO’s continued efforts to run the business, while in cases where the CEO holds a large percentage, the option plan serves mostly as an incentive to reach certain goals.
d. How to approve the plan?
As a matter of law, the Option Plan is subject to the full approval of the company’s Board of Directors, and in some cases also by the shareholders. The CEO Option Plan is a relevant matter for all of a company’s directors and as such a unanimous decision is required, even if the legal requirement is for a majority only.
Another important tip is to present the plan in a call/ video conference/meeting (vs. in an email) to avoid any misunderstanding. During the meeting, there should be a dialogue that allows answering all questions as well as the ability to make changes, if necessary, based on feedback. Obviously, the CEO should not participate in the board discussion on this matter.
e. How and when to involve the founder/CEO in the process?
As I noted above, the Compensation Committee is sometimes initiated by the CEO, but not always. Whether it is or not – I strongly suggest asking the CEO to refrain from offering a plan of their own. Let the CC finish its work and present its suggested plan to the CEO. In some cases, the CEO may decide to negotiate on the suggested plan. Limiting the negotiations to improvements on the suggested plan, rather than a comparison with his/her own plan, may make life easier.
Once the CC and CEO agree on the CEO Option Plan, it should be presented to the rest of the board members for approval. As mentioned above, I highly recommend a face-to-face meeting, or video conference/call. Try to avoid confirmation by text.
f. There are additional issues that often come to the table and most of them are economic issues, such as terms of acceleration upon M&A, IPO, termination, death, and disability (no simple answer here, and each grant has its own dynamics and sensitivities); exercise price (I recommend that the exercise price remain the same for all employees to ensure that the incentive is indeed based on the creation of real upside value) and I am sure there are many more that I have not mentioned.
Once the CEO Option Plan is approved and granted, there’s only one hope for outcome: that one day these percentages will be worth lots of money to compensate the CEO/founders for his/her/their tremendously hard work!! Given the recent successes of the high-tech industry, this day may arrive much sooner than expected for many founders…
* This post refers to “CEO Option Plan”, however in cases where the company has several founders, the plan would apply to them as well, with the necessary adaptions.
** Note: This post does not include precise numbers for a reason — it is not based on specific research but rather on personal experience.