An alternative to employee options/equity grants

I think its a creative solution in response to the employee ask, but it doesn't seem to actually resolve the issue does it?<p>One of the reasons that equity grants work is that people are incented to grow the company as the bigger/more valuable the company becomes they participate in that valuation growth. As equity, there is also the notion that if circumstances dictate that you move on you will still be rewarded for your hard work 'later'.<p>The 'units for time served' system effectively simplifies to this if you allow the employees to 'keep' units after they leave the company.<p>Its disingenuous to say 'we have no intention of selling or going public' since I can assure you that you also have 'no intention of doing this for the rest of our lives'.<p>And no, I cannot read Jason's thoughts, but I can reason to this statement logically. Jason (and other co-owners) of the company have interests outside of 37signals. Working there may be the awesomest thing in the world now, but at some point when the realization comes that you're time on the planet is finite, it occurs to one that perhaps they should take some time to do some of these other things. The notion that if you had enough savings you could live off the returns from that capital, and do the things you love, and not worry about specific deadlines, becomes more and more appealing. At some point the owners reach the 'tipping' point where they would rather work 'free form' where the cash flow for basic lifestyle was disassociated from the work product they're doing (the word 'retired' really doesn't cut it, more like 'base expenses covered before work income is considered') If the combination of owners wanting to change their lifestyle, and some entity is willing to offer you enough money for 37signals to make that change possible cross, the environment is ripe for a sale. The only other statistically probable 'exit' for LLCs is for the founder to die unexpectedly. The outlier case is the founder runs the company until senility and degeneration results in them dying leaving behind what was once a thriving business/practice/partnership and is now simply an obligation to file a tax return once a year.<p>By that reasoning I know that the principals of 37signals are going to either 'sell the company' or 'go public' at some point in the future, regardless of their protestations to the contrary. And when that happens, you've carved out 5% of the sales price / market value for the employees who have stuck with you to that point and are currently there. Which is admirable.<p>But Jason's point number 3:<p><i>It should reward current employees. This was about who was at the company at the time of a sale/IPO, not people who worked here years ago.</i><p>Does not sound like the system would provide anything for the folks who were instrumental in you getting there but for one reason or another had left the company. This system might leave them with a bad taste.<p>A variation on this system would be to reserve a larger chunk (say 25%) of the transaction price or fair market value (FMV), and accumulate your units on a monthly basis (so 1 unit per non-owner employee / month) which fill the whole pool over the lifetime of the company ( prior to sale / IPO ). Allowing employees to retain their unit-shares even after people leave, so basically the employee-month units slowly grow over time (while the value of the company grows over time) and the payout is proportionate to the time of service, and is retained for employees who have left, and requires only that you compute the integral number of months any employee has worked. (no admin overhead). Finally, it gives a better signal of recognition to your employees that you value them with a more meaningful percentage than 5%.<p>A sample worked problem where each employee-month-unit (EMU) accumuates 1 per non-owner employee per month.<p>3 founders, $500K seed round<p>+1 year 5 employees (2 non-owners) (24 EMU accumulate if sold each EMU worth slightly more than 1% of the company)<p>+2 year 15 employees (12 non-owners) (+144 EMU, 168 total, at sale each EMU worth .14% of the company, 2 yr vet worth 3.6%)<p>+3 year 20 employees (17 non-owners) (+ 204 EMU, 372 total, each unit worth .07% of the sale price)<p>People who stick around get a bigger payout, leaving isn't a penalty (you may not have a choice), and everyone gets rewarded the same.<p>Unfortunately given that some employees are going to have a much bigger impact on the success and 'value' of the company than others, I doubt they would go for that scheme either. That doing compensation is hard isn't really a very surprising result I guess.

Mature LLCs do have tricky issues when it comes to option grants for employees. Among other things:<p>1. LLCs are partnership-like entities governed by an operating agreement and every owner (member) has to sign and agree to the terms of such agreement, meaning also that every owner (employee) gets to see in intimate detail who owns what within the company, who has what management authority, who has invested what, and the like. Bad for the company.<p>2. LLCs have no counterpart to ISO-like grants, meaning that everyone who exercises options can (normally) effectively do so only at the time of a liquidity event because he would otherwise have to pay an immediate tax on the "spread" (difference between exercise price and fair value of equity interest acquired) as of the date of exercise and would thereafter hold an illiquid investment for what could be many years. Bad for the employee.<p>3. Apart from the limitations of LLCs themselves, it becomes difficult to administer an option plan when the value of a company is already high because it costs too much for employees to buy into it. For example, if a company is already worth $10M, the exercise price of options needed to buy .001% of it would be $10K. How many employees want to part with real dollars for the hope of a speculative return way down the road, especially if the company itself says it has no plans to move toward a liquidity event any time soon?<p>Hence, the alternative plan adopted here makes sense. It does <i>not</i> represent any form of true equity interest but is an employee bonus plan. This means you lose the benefits if you leave employment. It also means you get, at best, employee compensation that is subject to tax at ordinary income tax rates as well as to all employment taxes (though no tax is due until the bonus is paid). It also means that the interest is not transferable. It is basically a special reward granted to those who stick it out over the years until the company gets to a liquidity event. It is not perfect but, given the problems noted above, it is actually a pretty good solution to the problem of how to afford special incentives to key employees whom you want to add value to a growing but mature company operating in LLC form.

This plan conjures an image of accountant given a copy of the PHP manual and the instruction to write a login form. He may do it the right way... but I'd be a wee bit scared.<p>Prior to implementing something like this at your own company, I'd ring your friendly neighborhood tax accountant and make sure you didn't just create a taxable event for all employees. Much like writing a login form, I think there are a lot of very subtle infelicities in implementations which have very serious consequences.

The classic alternative to options/equity is a partner track. That's how huge law firms and the big 4 accounting firms do it. There are multiple levels in the partnerships, and the upper levels are often pretty spectacular.<p>Partner tracks address some of the concerns Fried brings up here. For instance, they reward current employees and don't create a class of former employees with a painful claim on forward revenues. They're simpler than options (you're gunning to "make partner"; you don't need an Excel spreadsheet to figure out what a win is).<p>They also have downsides; for instance, the biggest partner tracks are also all up-or-out systems where competent employees who are assets to the team but not ambitious enough to make partner are incented to leave.<p>So the question I have is, why didn't 37signals do that? It's a proven model. I ask because I'm sure there's a reason, and I'd love to hear it.

To clarify: * Employees working now will get nothing if they leave. * The amount you get is not tied to performance. * Chances of this happening are slim. * In many cases employees get new stock-option/bonuses at M&#38;A anyway (to keep them on board).<p>Sounds like the only good thing from this is: You have something to tell loyal employees asking you why you won't share with them some of the proceeds they created you by hard work.

It's like anti-profit sharing. The employees own part of the company, but only for acquisitions and not for profits.

You're giving away 5% of the pre-tax value, but that only translates to 2.5% net for those at the receiving end here.<p>One key distinction with options is that they can be more tax advantageous if the employee exercises and holds their stock for more than one year, triggering long term capital gains (LT cap gains may or may not exist in the future, though).

I don't know... What are some realistic numbers here? Suppose a mere $10m acquisition, 5% is a mere $500k. Suppose 10 employees, 5 are maxed out, the other 5 have 4,3,2,1,0 units respectively. The payout range then is $14k to $71k. Working there for 5+ years, taking home only $71k, which is definitely nice, while the boss gets at least a few million... I think employees should be made as happy as possible at acquisition time. I'm not sure this scheme would accomplish that, but I don't know what realistic numbers would be nor what competitive options/equity figures would look like.

They're trading the 'unfair' uneven distribution of equity based on position for one in which people are compensated equally regardless of position. This twist on the distribution seems like a great way to attract people to fill those positions that generally come with a less-than-average equity expectation. However, I'd be willing to guess that there is a negative correlation between ease of filling a position with a high-quality hire and the average expected equity amount for that position.<p>It seems to be a disincentive for those with higher-than-average equity expectation in that it implies that their contribution to the company is valued at the same amount proportionally as the lowest-contributing employee of the company, salary notwithstanding. If you are looking to hire a new CEO and inform him/her that, in the case of an IPO or acquisition, the new secretary hired last week will get the same cut of the bonus pool as the prospective CEO, they might be less inclined to work for you vs a company that, all else being equal, might offer them a proportionally higher payout.<p>Edit: Response to reply by jarin:<p>1) Right, I meant to encompass salary with 'all else being equal' in the last sentence.<p>2) The fact that something is currently unlikely doesn't mean that it won't ever become more likely. I think ChuckMcM's reply addresses this pretty well: <a href="http://news.ycombinator.com/item?id=2888740" rel="nofollow">http://news.ycombinator.com/item?id=2888740</a>

Personally, I would be more interested in a profit-sharing system. I understand that actual equity is difficult to do in some situations, but the 1-5 units system could be adapted to offer profit sharing. When the company makes a profit, the portion designated as a distribution gets divided into the total units as employee bonuses. I'm not sure how these units are handled once an employee leaves, but as a guarantee against missing out on a windfall profit or exit I could see this system being useful.

This just seems like the owners are being menschen in trying to ensure everyone gets a taste if they ever IPO.<p>Given that this "isn't [used as] an incentive to work at 37signals" I don't see how it's an <i>alternative</i> to options which exist entirely to incentivize employees &#38; management.

I really like the simplicity and overall fairness of the plan.<p>The only thing I wouldn't like (and it could very well be that way for technical reasons[1]) is the part where only current employees get a part of it. I understand the idea behind that but if someone were to do fantastic work for them for over 5 years and leave 6 months before Jason Fried and DHH change their mind about selling, that employee might feel stiffed.<p>Instead, I could see a system where you earn units while you work there and lose them for the time you don't work with them, at the same or different rate. Say you earn 1 unit per year worked but lose 2+ per year non-worked.<p>But, you know what? It's their company, they do it however they want to :) and considering they have no obligations to put that in place, it's hard to argue.<p>[1] e.g. maybe it's a pain to pay somebody anything once they're not on the payroll…

I think this is a really smart, fair program that every startup should read, especially since most companies (even those that want to) don't get sold/IPO at a huge price that makes tiny options worthwhile.

They say: <i>"I wouldn't be surprised if many employees have forgotten about it or don"t even know about it at all."</i><p>Which means it's not by any means <i>"An alternative to employee options/equity grants"</i>.

This seems more like an attempt at rationalizing "equity" (in the social sense) rather than motivating performance, which is fine. I would love to hear what the document is that guarantees execution of their promise at a sale. And why not put 5% of shares into a trust for employees per the allocation stated so they don't face the significantly higher tax rate of ordinary income? Thanks for sharing your idea.

I don't know...<p>I like that you're trying to address the problem, but I think this points to another problem, which is the core issue of whether you actually care about your employees' success as much as you do about the company.<p>On a grand level, no, of course not, but at the micro level, you should.<p>You want people to stay, even though they're considering moving on to form something of their own. You want them to feel like they are 37 lifers.<p>Obviously, you want some to graduate and move on to bigger things too. These types are also valuable.<p>All in all, it doesn't feel to me like you care about your employees, especially when one founder is busy in LA and/or racing around in expensive cars, and the other is writing posts like this.<p>If I were an employee and presented with a plan like this, I wouldn't feel the need to invest in anything more than a paycheck, and while that's great for many companies, that doesn't seem right for one, like 37 Signals, that once was cutting edge.<p>I want something I can sink my teeth into, and feel like I'm going somewhere. I have a feeling many other HN'ers feel the same. This won't attract people like that, or get them to stay, but maybe those aren't the type of people you want?

I don't understand how this is any kind of incentive at all. They've declared they have absolutely no intention of ever making good on it (will never sell out or go public). They don't even tell new employees about it.<p>Other than making themselves feel like good benevolent managers, this utterly fails as an incentive. What's the point?

I can vouch for the agreeableness of this system. I received a bonus from a similar pool when the company I was working at was sold. It came across to me and everyone else who received it as a genuine and thoughtful act.<p>That may have been ameliorated by the fact that there was no expectation ordinary employees would get anything -- we just found out about this bonus at the same time we got our "Welcome to [Acquiring Company]" letters. The founders also had a very generous profit-sharing-equivalent project bonus plan as well, but as has been mentioned, this is in an industry where bonuses are more prevalent than equity.

It seems broken. While the guiding principles are interesting, there's a reason why stock-option plans have evolved to where they are today: all cases have been tried, and they are well understood.<p>One example of problem in Jason's plan: if you go IPO, you immediately owe 5% payments on the full valuation of your company, to your employees. Where is this money coming from? The money raised during the IPO? Fine, but how many shares did you float?

"We treat this entire idea purely as a bonus in the unlikely even of a future sale/IPO."<p>At far too many companies, equity is seen by the employer and employee as a form of cash-equivalent compensation, even though it isn't unless that equity has an income stream attached to it (as would be the case in, say, a grant of restricted stock in a company that pays dividends). So it's somewhat refreshing to see a high-profile tech company eschewing this.<p>The problem here is that 37signals' "plan" lacks all substance. The company doesn't intend to go public or seek acquisition, and its "bonus pool" is potentially limited to just 5% of any acquisition price.<p>As such, this "plan" doesn't promote retention the way equity does, and for all intents and purposes, it doesn't promote much of anything as the savvy employee will never expect it to bear any fruit.<p>Put differently, this "plan" feels sort of like an equity version of a poorly-made Louis V. knock-off. While, to its credit, 37signals' isn't pitching this as a justification for a less-than-market salary, there's a strong argument to be made that offering an equity substitute like this is <i>worse</i> than not offering equity at all.<p>The better approach for a company like 37signals? Make sure salaries are highly-competitive, offer an attractive benefits package and, if you want employees to feel like they have a direct "stake" in the company's success, implement a profit sharing plan. The benefit of this approach is that you attract the type of employee who wants to work at a company like yours without creating any confusion on trying to pretend that you're offering something that you're not willing to offer.

"And since we have no intention of selling 37signals or going public"<p>It seems to me to be unfair to create incentives like this without intending on ever paying them out. I'm glad that they are creating this now instead of if and or when they are acquired, but I still think equity grants are a more fair way of handling incentives.

I always thought something like this would be the more fair:<p><pre><code> Employee X share = (Max(0, Business Days Worked Before Sale - Business Days After Leaving Employment) / (Business Days Open Before Sale * Total Number of Employees)) * Total Employee Equity Percentage * Total Equity Amount</code></pre>

We have this at my company at well. However, I treat it as a piece of paper, no more no less because the owner of my company has no intention to sale at all.

Doesn't that miss the point of giving your employees incentive to work "above and beyond", to the benefit of the company and all? It's a good thing they don't tell the employees, cuz what would an employee want with worthless "BIG IF" points?

Why max at 5?

Wow, gives employees all the impression of co-ownership but none of the real co-ownership.<p>Much like the Skype-SilverLake plan.<p>37signals sure has some good lawyers!