Angel Insights Blog

Thursday, July 26, 2018 

Pure Upside: Understanding Stock Options and Restricted Stock for Angels

By: Ham Lord, Managing Director of Launchpad Venture Group and Co-Founder of Seraf-investor.com and Christopher Mirabile, ACA Chair Emeritus, Managing Director at Launchpad Venture Group and Co-Founder of Seraf-investor.com. 

This post originally appeared on Seraf-investor.com

Note: This article is the thirteenth in an ongoing series on valuation and capitalization. To learn more about the financial mechanics of early stage investing, download this free eBook today Angel Investing by the Numbers: Valuation, Capitalization, Portfolio Construction and Startup Economics or purchase our books at Amazon.com.

The first time you receive stock options as an employee is a magical moment. You feel suddenly part of something bigger than just earning a paycheck. You daydream about how various financial scenarios might play out. You take a sudden interest in the wellbeing of your company and the factors which affect its stock price.

Early in my career I worked with, wrote, and interpreted many stock option programs and thought I understood them very well. Intellectually I did, but that did nothing to prepare me emotionally for being on the receiving end of my first grant of options as I transitioned to becoming a young tech company employee. The sensation of recognition, reward, even worth, has a powerful impact on a young professional.  

It is no surprise therefore that startups are nearly universal in their adoption of stock options as a tool for attracting, motivating and retaining new hires. And with all these start up stock option pools everywhere, it is natural for an angel to wonder if they are a relevant part of an angel’s overall investing strategy.

The short answer is yes, in two important ways. First, in connection with setting the valuation of a company, and second as a direct recipient of stock options (or their cousins the restricted stock grant or stock warrant). We have talked quite a bit elsewhere about the impact of option pools on valuation, so here I want to focus on the direct use of these derivative securities on the strategies and returns of angel investors. Let’s see if we can tackle a few of the key questions about options and restricted stock for angels.

Christopher, occasionally, angel investors end up taking board seats or becoming advisors in companies when they make an investment. Should they expect to be paid? What is the rationale for paying them?

There is a long-standing tradition by established companies of paying the independent directors for their board service with equity, typically options or restricted stock. It is viewed as essential for attracting the best talent and compensating them for their time and value-add. And it is believed that using stock that vests over time is a good way to align directors with shareholder interests. If the directors want their compensation to be worth anything, they will focus on mid-to-long term share price appreciation.

With less established startup companies, some of this tradition applies, but with some important caveats. In an established company, much of the board will consist of independent directors who are compensated by the company using some combination of stock and cash. With a startup, the board typically consists of roughly equal parts management and investors, with maybe one independent director mixed in.

How does this affect compensation?

For the management and independent directors, compensation practice is roughly the same: salary, bonus and stock for management and some stock for the independent director. However, the investor component of the board is a bit different for a few reasons:

• First, they appointed themselves by contractual right,
• Second, they are already major shareholders, and
• Third, in the case of VCs, they are already being paid a management fee, and some carry for things like board service. It is their day job.

What difference do those three factors make in compensation?

It tends to weaken the argument that generous compensation is required. For VCs it is hard to force yourself onto a board and then demand that you be compensated with stock. Especially when you are already a major shareholder and your LPs are paying you to do the board work.

However, board compensation tends to be a little more generous for angels investors relative to VCs in recognition of several key differences between angels and VCs:

• The angel is representing and doing the work on behalf of many individual investors;
• The angel is volunteering her time and not being paid a management fee or carry by any LPs;
• The angel is likely a much smaller shareholder for whom a few options would make a real economic difference; and
• The angel is typically helping the company with valuable skills, connections and expertise at a very early stage when help from the board is sorely needed.

How much, and in what form, will this compensation be paid out to the director or advisor?

Payment is almost invariably in the form of equity rather than cash. Paying directors cash would be a terrible use of that scarce resource early on, and also a lost opportunity for alignment with shareholders. The form of equity paid is usually either stock options vesting over time, or increasingly, restricted stock where the restrictions lapse over time. The typical approach is to give an initial grant at the time of joining the board, and then do supplementary grants annually or once every couple of years.  

In our experience, early-stage directors are typically given an initial grant in an amount equal to somewhere between 0.25% and 1.0% of the company’s total shares outstanding on a fully diluted basis. Board chairs or extremely active directors with specific industry contacts and introductions may be at the higher end of the prevailing range. Executive directors and special advisors are special cases and may fall outside of the range. It is the responsibility of the board to ensure the appropriateness of all compensation paid by the company. Assuming a grant is appropriate, it may have a very big impact; for an angel investing their own money in order to buy a likely similar or lower percentage of the company, a grant like that can be a huge multiplier on your returns – doubling or even tripling a good outcome.

Subsequent supplementary grants would be at the lowest end of that spectrum.  Based on market studies, our experience of how angel directors are paid would appear to be fairly consistent with prevailing market norms for non-investor directors; Pitchbook has done a study and come up with pretty similar findings: