Feature: Keeping Employees Motivated When Their Stock Hits Zero –

WhiteLight Systems Inc. hit a speed bump in August when a highly-dilutive bridge financing crushed the company’s valuation, putting the squeeze on all the equity, including the employees’ option pool. When the analytic software company sent a flurry of pink slips around the office in September, morale hit an all-time low. Some remaining employees wondered if their departed peers with severance packages were better off than they were.

Employees are the wildcard in all of these startups, and equity was the carrot that many VCs dangled in front of them. Unfortunately, common stock is losing its luster, as employees find out that their shares are worth nothing when a company is sold.

In some cases, VCs have been creatively changing employee incentive packages, such as reworking employee equity packages, piling cash incentives on top of them or carving out a piece of the VCs’ stake for them. Whatever the method, VCs, like those involved in WhiteLight, need to keep entrepreneurs motivated to reach the finish line.

“With the tremendous liquidation preferences being piled on these companies by new investors, the pool of money that will be left over for management teams is probably going to be small,” says Doug Chertok, managing director of Hudson Venture Partners (not a WhiteLight investor). “If your returns are 10x or 20x, no problem. But, if your returns are 1x, 2x or 3x, then there’s an issue.”

Even when the employees hold large equity stakes, the forces of the market have divorced any connection between their efforts and the value of their common stock. They’ve done the math, and they know where they stand.

“Clearly we’re worth a ton less than 24 months ago when we did our Series C round at a post-money valuation of $75 million,” says Greg Smith, WhiteLight’s chief financial officer. Smith wouldn’t disclose WhiteLight’s current valuation, but Venture Economics shows the company had a post-money valuation of $50 million following the first of two bridge financings.

“We’ve got a ton of liquidation preferences ahead of us,” Smith says. Even though WhiteLight employees still have a 15% stake in the company’s common stock, that stake will be worthless if the company is sold for less than the value of the VCs’ liquidation preferences, a sum that Smith won’t disclose.

However, since September, the turnover has stabilized and the board reworked the employees’ compensation packages to give them a reason to keep cranking away.

Tom Simpson, managing partner at Northwest Venture Associates, prefers to reset the capital structure to keep employees motivated. “I’m a big fan of, You know what, let’s just revalue the whole thing,'” he says.

Recapitalizations start the capital structure all over, resetting the options and removing the previous layers of equity stacked on a company. However, the stakeholders in the company in those different layers of equity all have to agree to that reset, and that can be a difficult sell when it’s going to wash somebody out of the deal.

Other VCs have taken an abbreviated approach and converted individual layers of preferred equity to common stock, which shortens the line ahead of the employees’ payout. However, a majority of the stockholders in that series must also consent to the reset in most cases, but the maneuver succeeds when the investors in the reset series have all participated in a later inside round.

Taking the simplest approach to appeasing employees, VCs could just throw more common stock options at them and hope they don’t notice that they’re standing behind the preferred stock. But, savvy employees, like Smith have already figured out that trick.

Some VCs talk in theory about granting some sort of incentive vehicle based on preferred stock to put the employees on even footing with the VCs, but those grants may not comply with federal standards for favorable tax treatment. Instead of being taxable at their exercise, they may be taxable at the time of their grant, and they may not even offer any of the capital gains benefits that make options attractive.

Gavin McElroy, head of the executive compensation practice at Frankfurt, Garbus, Kurnit, Klein & Selz PC, says he has been involved in negotiations where puts or similar agreements were added to the common stock option. Puts give the owner the right to sell a security cut out at a fixed-price, and in this case they give the option a floor. Puts also give the executives a way to cash in if they leave the company before a liquidation event.

All these conversations and what-if scenarios are all relatively new in the venture market.

Dangling Conversations

“Before, it was, assuming you do well, you go public, and you get the IPO,” says Adam Zoia, managing partner of executive search firm Glocap Search LLC. Now, that that outcome is not a given, conversations about the terms of equity and other incentives have become more technical. “[Concerns over exit opportunities have] increased the emphasis on cash-bonus compensation tied to performance.”

However, in a cash-starved market, VCs are reluctant to dole it out.

“In the start-up environment as long as there is a clear line of sight [to the payoff], you pretty much want to stick with equity,” says Sven Jacobson, senior associate with Carrot Capital. “Once the company is profitable, if there’s no exit seen for a long time, I wouldn’t have a problem with some kind of [cash] incentive scheme.”

Jacobson previously put together a unique cash incentive scheme (described in the chart EVA below) that attempted to align the bonuses with the shareholders’ interests.

But since cash is tight, VCs tie the bonus systems to cash-generating activities: growing net revenue, cutting operating expenses and reaching the break-even point.

In the past, VCs have paid executives bonuses for taking a company public, and some VCs have suggested offering a bonus for closing a financing round. Well, both events raise capital for the company, but the bonus from the financing round ultimately comes from the company’s coffers in other words out of the new investors’ pockets.

“If I were a new investor, I wouldn’t be that happy,” says Ravi Chiruvolu, general partner of Charter Venture Capital.

Hidden Cash

McElroy offers a word of warning to cash-wary VCs. “Sometimes, the agreements are so complicated, they give someone benefits without giving someone an obvious cash position.” Previous term sheets and contracts with the management team might hide additional stock grants coupled with buy / sell agreements that give the net result of covertly giving executives cash.

These pitfalls and gimmicks aside, legitimate cash incentive plans may be a means to keep employees motivated and contributing to shareholder equity. The trick is to tailor a plan that aligns the employees’ interests with shareholders’ interests when the employees no longer see themselves as shareholders.

“Different employees have different responsibilities,” Chertok says. “Maybe carve the cash bonuses among the group that does the most work but not the executives. They can make their money later on.”

Chertok suggests that executives with their proportionally large equity positions have the ability to influence the value of their equity incentive by their performance. However, VCs still have to figure out how to give beaten-up common stock some perceived value.

VCs, like Chiruvolu, have promised their employees that they will carve a piece of their proceeds out and give that to the employees.

“I’d hate to see great work and hard work go completely unrewarded from a financial perspective, because it’s a down market,” he says. “You want to give them 20% normally, but you tell them, The least you will get is 10%’ – recognizing we’re in tough times and everybody is in it together.”

Out of Pocket

If VCs move around the whole equity structure, they need wholesale approvals, but if they just take the money out of their own pockets, it’s not as much of a production. Of course, the employees have to trust that they will follow through on their agreement.

“I tell them, If we’re successful, we’ll help you. If not, it doesn’t matter,” says Chiruvolu, a WhiteLight investor. For example, WhiteLight employees currently own 15% of the company on paper. If the company goes public, they’re in luck, but if it sells below the undisclosed point under the liquidation preferences, they are entitled to nothing. The VCs agreed to cut them in.

WhiteLight CFO Smith declined to give the specific numbers behind the agreement, but he says that the VCs created five tranches on a sliding scale for giving the employees a piece of the deal. As the sale price of the company increases, the employees get an increasing percentage of the proceeds – up to 15%, he says.

Additionally, Smith says the board has kept the employees’ ownership in the company at 15% through the dilutive bridges and promised to continue as the company looks to close a Series D round below the Series C valuation.

To calm uneasy employees after the September layoffs, the board promised the remaining employees the same severance packages that were handed out in September if they lose their jobs down the road.

Smith says these concessions from the VCs and a feeling that the worst is behind them have helped the employees at WhiteLight regain a positive attitude. “People are believing that the common [stock] will really be worth something,” he says. That’s the key. VCs can’t control the economic realities of the market, but they can adjust their compensation strategies as the market shifts.

Economic Value Added Incentive Systems
Before Jacobson got into VC, he worked with 22 companies owned by a diversified South African conglomerate, Rennies Group, implementing incentive schemes based on Stern Stewart & Co.’s Economic Value Added model or EVA.EVA is a performance measure like earnings that also considers the balance sheet.EVA = net operating profit after tax – opportunity cost for capitalStern Stewart recommends several applications for EVA, including a unique bonus system.”We recommend a few things conventional compensation consultants say you should never do,” says Al Ehrbar, partner at Stern Stewart. Key features of the cash incentive system include:* Uncapped on the upside – Most companies stop adding to bonuses after an employee hits 120% of their operating goals, which Jacobson calls the go-golfing point.EVA motivates employees to continue producing.* Uncapped on the downside – Conventional bonuses also usually disappear when performance drops below 80% of the operating goals. EVA gives employees a reason to minimize losses.* Creating a Bonus Bank – Part of the bonus carries forward to the next quarter so that employees won’t sandbag a particularly bad quarter or front-load sales.* Divorce Bonus Calculations from the Annual Budget – Base the bonus on improvement over the previous quarter’s EVA numbers, rather than projected improvements.* Transparency – “Identify the value-levers to the management teams,” Jacobson says. Employees should understand the variables that affect their bonus and be able to monitor them.”Incentives are probably the hardest thing there is to get right,” Ehrbar says.Jacobson says, “There is a big difference between a bonus payout and an incentive scheme.”

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