The Tokenized Stock Option
Updated: Mar 4, 2020
Making employee stock options more liquid with Ethereum
By Chris Walker, TokenSoft Developer
The following is a simplified illustration of how the technical features of ERC-1404 could facilitate token transfers and affect employee incentives. The examples provided showcase early opportunities for industry collaboration with the acknowledgement that several key technical and legal components remain open questions. The article is not intended to provide legal, tax, or other advice about employee stock option plan administration or serve as a recommendation to move stock option administration to the blockchain at this time. If you are considering employee stock option tokenization or other plan changes, consult your legal counsel, employee compensation specialists, tax specialists, and related third-party service providers.
The (Bad) Deal
Today, stock options are a bad deal for many startup employees. Steve Blank recently wrote a great article describing the problem. In short, modern startups stay private longer due to huge “growth capital” financing rounds. As Matt Levine likes to say, “private markets are the new public markets.” Back in 1997, Amazon went public at just three years old and raised $48M in its IPO. Contrast that with WeWork, the nine-year-old unicorn that recently raised $2B from SoftBank in a private offering.
This shift creates two big problems for early employees:
By IPO, employee equity is more diluted and subordinated
Startups take a decade to IPO, making stock options extremely illiquid
As new financing rounds occur, each series of investor typically demands more preferential treatment than previous investors, resulting in a capital structure with layers like an onion. In a liquidity event, such as a company sale or IPO, the funds flow to the outer layers first, so the onion needs to grow very large for the inner layers of the equity held by early employees to be worth much.
Even if the success of the startup was guaranteed (which is almost never the case), employees face liquidity challenges because it is difficult to sell shares in a private company. Most company plans prevent the sale or transfer of options (there are definite risk-reward considerations that justify this choice), and even if the company technically allows it, selling private equity is really complex from a legal and tax perspective. Unfortunately, employees with illiquid stock options have a challenge putting their capital to work, for example to pay taxes or buy a house.
Because the status quo does not work well, especially for early-stage employees, some folks are betting it will change.
Let’s look at how technology could simplify the management of employee stock options and improve the liquidity of employee-held private stock. Of course, any firm looking at changes to their stock option plans must seek guidance from their own legal, tax and financial advisors.
If stock options were easier to exercise and sell once vested, the decade-long path to IPO would be less of a problem for employees.
Companies like Carta are building capitalization table management tools intended to simplify the process of managing private equity. Think of cap table management tools as glorified Excel spreadsheets tracking company equity (past, present, and future based on option pools, vesting schedules, and new investors) with company role-based permissions. Companies such as Carta that are registered transfer agents may also have the legal authority to manage shares on behalf of the company.
Even if these tools improve equity management processes, we also need private equity markets with more clarity and liquidity. Companies like SharesPost and Forge create special purpose vehicles for privately placing startup equity or use alternative trading systems (ATS) to connect employees selling their private equity with qualified buyers, including institutions and high-net-worth individuals.
But are centralized third parties like Carta or Forge necessary to manage cap tables and improve liquidity? In the blockchain economy, we look for opportunities to eliminate middlemen and unnecessary trusted third parties from private transactions.
Several smart contract standards on Ethereum were designed specifically to facilitate transactions in private company stock.
At TokenSoft, we designed the open ERC-1404 simple restricted token standard to support a broad variety of securities like restricted company shares. Let’s look at how a company (call it ABC Inc.) could use the ERC-1404 standard to create tokenized stock options.
Stock Option Issuance
DISCLAIMER: this is a rough, simplified illustration of how the technical features of ERC1404 tokens could facilitate token transfers and affect basic stock option game theory.
Nothing presented here should be construed as legal, tax, or any other form of advice. Consult your legal counsel, employee compensation specialists, tax specialists, and related third-party service providers about any contemplated employee stock option tokenization.
ERC-1404 enables private companies to restrict stock and option transfers to specific whitelists of approved parties (e.g. accredited investors only) at a designated time (e.g. after a vesting period or holding period), ensuring that all transactions and token holders are approved by the issuer and, if required by law, a transfer agent. The issuer may delegate some compliance procedures such as whitelist management to third parties like TokenSoft that assist with compliance checks, including KYC (know-your-customer), AML (anti-money-laundering), and investor accreditation verification.
Consider the example ERC-1404 token representing ABC shares illustrated in the figure below. The boxes represent whitelists holding different categories of authorized or issued common stock, while the arrows represent typical stock transfers between specific whitelists. The company or third party compliance partners add participants to one or more whitelists as appropriate.
Two aspects of this ERC-1404 token are important to highlight:
First, the token whitelists serve several distinct purposes. The first four whitelists are intended to provide clarity to the employee and company on the status of their stock option plan. The point of an option plan is, after all, to incentivize employee performance. Only the company may authorize transfer of tokens held in these whitelists, as illustrated by the “Company Tx” dashed arrows. The final two whitelists are intended to facilitate token transactions between employees and the broader private equity market without relying on a third party like DTC to settle transfers of tokens between owners and third parties. Tokens held in these whitelists may be transferred (subject to restrictions) by their current owner as indicated by the “Market Tx” solid arrows.
Second, there are complex legal restrictions on stock option or stock transfers, e.g. ISO plans may not permit employees to sell their stock options. The ER-1404 token illustrated above enforces this restriction by only permitting employees to transfer tokens that represent shares they own outright, e.g. shares acquired by exercising vested stock options, but it ignores other relevant transfer restrictions. Transfer restrictions for stock option plans can be implemented by ERC-1404 whitelists.
Tokenized Stock Option Whitelists
Company Option Pool
The board of ABC Inc. authorizes 1,500,000 shares of ABC common stock, representing 15% of its equity, for an incentive stock option (ISO) employee stock program. Each authorized but unissued share reserved for the option pool is represented by one ABC token. These tokens are initially placed in the Company Option Pool whitelist, and then moved to the appropriate whitelist in order to track the status and ownership of these shares.
Suppose ABC Inc. hires a new employee, and their compensation package includes 100,000 stock options vesting over a four-year vesting schedule with a strike price of $0.21 per share based on the company’s 409(a) valuation.
Employee Unvested Options
Upon hiring this new employee, ABC Inc. adds a new Ethereum account controlled by the employee to the Employee Unvested Options whitelist and moves 100,000 ABC tokens to this account. Tokens in the Unvested Options whitelist represent authorized stock reserved for this employee corresponding to the employee’s unvested, unexercised stock options. The employee can view their token balance on any compatible Ethereum wallet but the employee does not not own any ABC common stock until these stock options are both vested and exercised. Thus, unvested option tokens are not transferrable from this whitelist by employees and ABC Inc. still controls the tokens. If the employee leaves the company prior to shares vesting, ABC Inc. may transfer these tokens back to the Company Option Pool whitelist. Note: some companies do not recycle canceled options back into their employee option plan and these shares just return to the authorized but not issued shares rather than the option pool.
Employee Vested Options
Each new employee also has an Ethereum account added to the Employee Vested Options whitelist. Vesting in this context means unconditional ownership of the option to purchase shares regardless of employment at ABC Inc. Each token in this Vested Options whitelist represents authorized stock reserved for an employee that the employee may purchase by exercising their stock options. Because this option plan is implemented using a smart contract, vesting is performed automatically: 25,000 ABC tokens are transferred from the employee’s Unvested Options account to the employee’s Vested Options account at the one year of employment mark, and 2,083 ABC tokens (1/36th) are transferred every month for the following three years thereafter until all of the employee’s 100,000 ABC tokens are transferred to the Vested Options whitelist.
Just like the Employee Unvested Options whitelist, the employee can view but not transfer these tokens. If the employee leaves the company, they will still own these stock options, but the options themselves may expire (e.g. 90 days after termination of employment or 10 years after grant date, as required by law). If the employee leaves the company or otherwise allows these options to expire instead of exercising them, ABC Inc. may elect to transfer these tokens back to the Company Option Pool whitelist.
Employee Unvested Stock
For some employees, there may be significant tax benefits to exercising stock options before they are granted. For example, exercising options prior to selling shares allows for the employee to start the holding period for long term capital gains rather than immediately selling upon exercising for short term capital gains. If the employee chose to early exercise their stock options, ABC Inc. could add an Ethereum account controlled by the employee to this whitelist and transfer tokens to this account. Tokens in this account would represent restricted stock units (RSUs) owned by the employee but subject to repurchase by ABC Inc. during the vesting period. As the employee's RSUs vest, tokens are automatically transferred to the Employee Liquid Stock whitelist.
Employee Liquid Stock
Once stock options are both vested and exercised, the corresponding ABC tokens represent issued common stock, so these tokens are transferred to an Ethereum account controlled by the employee in the Employee Liquid Stock whitelist. If this employee has worked at the company for three years and immediately exercises their options when they exit, they control 75,000 ABC tokens representing the same number of shares of common stock. Now the employee has the ability to view their balance and sell these tokens to other whitelisted parties without the direct involvement of the company. In this simplified example, the ERC1404 token contract allows the employee to sell their stock to other whitelisted employees or private buyers approved and whitelisted by the company.
Private Equity Markets
In practice, private stock sales are highly restricted by securities law and contract law: private company stock is simply not as liquid as public company stock. In this simplified example, ABC Inc. decides that employees may sell shares to a small number of accredited investors residing in the U.S. Rather than managing these token sales itself, ABC Inc. partners with several third parties who perform KYC/AML compliance, manage the Private Equity Markets whitelist, and facilitate token sales via private placement or ATS listing.
We glossed over a couple of important details in the narrative above. Let’s consider those now.
The ABC tokens in the Employee Vested Options and Employee Unvested Options whitelists above correspond to options to purchase shares of ABC Inc. common stock at a $0.21 strike price. Any two tokens held by the same account in the same whitelist can be considered fungible. But in the real world, different stock option issues have different exercise prices, making stock option issues non-fungible. Creating a separate token contract to represent each option strike price might be unwieldy, so the best solution might be incorporating these non-fungible attributes into the tokens themselves.
Business Confidentiality Concerns
There are good business and legal reasons to keep the details of employee stock option plans and private stock sales confidential. Could a company issue stock options on Ethereum privately?
ABC Inc. could take several simple steps to obfuscate sensitive information about their stock option plan, such as granting or transferring ABC tokens only once per month in many identically sized transactions to fresh Ethereum accounts.
But better solutions, which would allow putting sensitive company data on the Ethereum blockchain, may be just around the corner. For instance, several projects including Aztec and EY’s Nightfall seek to integrate traditional Ethereum smart contracts with zero-knowledge proofs for a much higher level of privacy.
The landscape of corporate finance has shifted away from public markets and toward large private transactions. This makes employee stock options less liquid, reducing their value as an employee incentive. Companies like Carta and Forge recognize this shift, so they are building centralized solutions for managing company stock and finding private buyers for employee-held stock.
But these manually administered, closed ecosystem products are not the only solution. Company equity, including employee stock option plans, can be recorded on the Ethereum blockchain using the open ERC-1404 standard and administered via software.
Companies considering equity tokenization must choose their technology providers carefully: a conservative approach to legal compliance, an excellent track record, and forward-thinking technical leadership are all critical. So far much of the work in the security token space has focused on token issuers and investors, but at TokenSoft we see an opportunity to benefit employees as well with the tokenized stock option.