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'.
The 'units for time served' system effectively simplifies to this if you allow the employees to 'keep' units after they leave the company.
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'.
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.
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.
But Jason's point number 3:
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.
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.
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%.
A sample worked problem where each employee-month-unit (EMU) accumuates 1 per non-owner employee per month.
3 founders, $500K seed round
+1 year 5 employees (2 non-owners) (24 EMU accumulate if sold each EMU worth slightly more than 1% of the company)
+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%)
+3 year 20 employees (17 non-owners) (+ 204 EMU, 372 total, each unit worth .07% of the sale price)
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.
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.
37signals is older than any YC company. In its current incarnation, I believe it's older than Facebook. It is clearly not on the same trajectory as the typical company we talk about on HN. It is not a flavor-of-the-month, or even of-the-year, for Fried and DHH.
Supply and demand probably does give them an edge on employee comp, but from friends I know who've worked there, they're making market wages. People aren't taking jobs there on the promise of hockey-stick upside. It's a pretty amazing work environment. You should see the offices. Place is nuts.
You don't have to take them up on their comp plan, but it's naive to write comments as if there was something wrong with it. Most YC companies would be very poorly served indeed by the comp plan 37signals laid out here; those companies are all on VC shoot-the-moon trajectories, and a stake in a liquidity event is a big chunk of the reason you'd work at any of them. In 37signals case, you have to start by defining what a liquidity event even looks like.
As I mentioned the desire on his part and that of the other owners to respond to that request was admirable. And certainly for non S-Corp type businesses it can be very difficult to respond to this sort of request in any way.
My comment on compensation was targeted to exactly this:
"People aren't taking jobs there on the promise of hockey-stick upside. It's a pretty amazing work environment. You should see the offices. Place is nuts."
Compensation is such a rich confluence of things, from wages to benefits to corporate culture to 'lifestyle perks' to profit sharing. My mother-in-law ran a CPA practice for 30 years and did various things over those years as forms of compensation. So its a rich, complicated, highly nuanced, and rarely replicatable space where companies have to operate. I get that.
The disparity for me is that Jason makes this claim, "And since we have no intention of selling 37signals or going public – the two scenarios where options/equity really make sense – the complexity became too hard to justify."
My claim is that that statement is disingenuous because it posits the following argument; The company will never be sold, thus options or equity would never be liquidated, so providing equity or options doesn't make sense. The implicit claim on which this argument rests is that they will never sell the company, and that claim is neither supported by a structural contingency on the company, nor supported by a statistical comparison with the ways in which LLCs are dissolved (granted medical practices and law practices seem to dominate in this area, and can skew the results). In my opinion, it deceptively leaves that impression rather than being 'up front' about what are the real constraints.
I would completely believe him if he said instead "The Articles of Organization for the LLC specify exactly how any proceeds from the sale or dissolution of this company are to be distributed, and we are loathe to change them. Thus we don't really have an option here." (no pun intended)
And again, I think its really impressive that they came up with a way to share 5% of the proceeds when the company is sold. I merely suggested some ways they could make it 'look more' like what other people get in terms of equity and options by both allowing people to keep accumulated time after leaving the company and by having those 'units' represent a similarly sized chunk of the company.
Whereas with 37Signals, you are getting a 'regular' job - where you can do everything to excel and become better at what you do and earn a nice living.
If you want to save your own money and invest in companies, then that's up to you. But it's not the same type of math.
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.
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.
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?
Hence, the alternative plan adopted here makes sense. It does not 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.
If early-stage LLCs want to adopt equity incentives, they can mimic what a corporation does with a little custom drafting to the operating agreement. Instead of defining ownership in terms of percentage ownership as set forth in a schedule (the typical LLC pattern), LLC owners who want to issue equity to employees can define the ownership in terms of "units" of ownership. They define a number of authorized units in an operating agreement (e.g., 10M units) and then reserve a grouping of them for an equity incentive pool. These can then be used to support unit option grants (like stock options, albeit always NQO and never ISO) or restricted unit grants (akin to restricted stock grants in a corporation). If this is all done in the early stage, the units can be priced at nominal pricing so as to avoid adverse tax consequences to the employees. There is still the problem of option holders being taxed on the spread on the date of exercise (as with NQO options in a corporation) but, otherwise, such grants may be made very much as they would be in a corporation (made subject to vesting, etc.).
The key to an effective plan is to do this early in the LLC's existence and, if done in that way, this is pretty comparable to what happens with a corporation (except for the absence of ISO-like options). As long as this is all done right, there are no special restrictions on issuing equity incentives to employees in an LLC.
LLCs are state-specific and it might be that there are special restrictions in Illinois or other states that don't exist in California where I practice. But the above sums up the essence of how it is done here.
The obligation to be 1099 is the default case for single-proprietor LLCs but can be overcome as I described above. It is not necessarily the case for multiple-member LLCs.
I am not a lawyer, but I have done all this before.
Right, that's what an 8832 election I referred to in the original comment is.
Generally speaking, LLCs are not appropriate entities for a highly fluid, ever-changing shareholder picture. If you want to be able to easily add or drop employees--and for that matter, institutional investors--as partners, don't choose a pass-through entity. Choose something that is structured as an appropriate vehicle for that kind of thing, i.e. a C-corp with a share pool.
There are ways to get around this, of course. The simplest idea I can think of if you are an LLC is to create a separate C-corp as a holding company, and have it own some (presumably non-trivial) percentage of the LLC. You can then issue shares in the Inc. holding company to your senior employees. The Inc. would of course be entitled to the highest liquidation preference, be dilution-proof to whatever extent desired, etc.
Edit: You can also do what grellas said above and make some sort of accommodation for an equity pool in an operating agreement. But if you want to actually write any employees in as partners, you'll have to amend your articles of organisation every time you do it. So, it's still by far not the most flexible entity type for that.
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.
Equity compensation schemes are like programming language manuals and spellbooks of eldritch power: every word in here can kill you.
In a max-tax scenario (high-tax state like California, expiration of the Bush tax cuts in 2013), the bulk of a large exit would be taxed at about 53% if ordinary income, but only about 33% if long-term capital gains treatment can be obtained. So they'd be netting about 30% less due to the 'bonus' approach rather than equity.
(I'm counting medicare tax, which no longer phases out any income, but not social security, which isn't collected on income over ~$107K.)
Since RSUs are generally treated as shares, employees have a slight idea of what kind of piece they're getting. With this setup, "At least 5% of the ultimate sale price" could be anywhere from 5% to 100%.
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).
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.
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.
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.
37sigs has implemented essentially a non-performance based bonus (which is also what they call it), which kind of defeats the point of equity/options at all in my opinion. An interesting question would be, if 37sigs does take any more investment in the future, and this pool stays the same, it does seem to have the advantage of not being diluted?
Mainly this is an argument against ever using an LLC for a long-lived business. LLCs should be reserved for personal shell companies and companies that will be wound down at a fixed time. If this had been an S corp or C corp, they could have simply adapted an off the shelf stock option agreement.
If you compare to an industry like fast food where the goods created by labour are not capital in nature you'll see mature operations and new operations paying roughly the same. It doesn't matter whether you work at Bob's Burgers or Mc Donald's you're making min wage.
Second: never mind, what's your point? If most of the value in the company comes from employees and not the execution of the owners, the company pays more salary. If they don't, the employees leave. So, in what way is this responsive?
The employees do not own part of the company. They're promised a bonus in the (unlikely) instance of a major liquidity event.
Granting them that bonus in no way injures any other element of their comp. This is so much the case that Fried says most of his employees have probably forgotten they even have this bonus. That's not what you say when you're using a comp scheme as leverage with your employees.
You have no idea what 37signals people make, how profit sharing and incentive comp work, or why people choose to work there. But you feel just fine snarking about them because they don't fit into the "first engineering hire gets 5%" shoot-the-moon mold we normally talk about on HN.
Lamborghini Murcielago, 2010, premiered at $400,000 to $600,000.
However, when people are talking about a million dollar car they're most likely remembering the McLaren F1 which sold for $970,000 back in 1998.
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).
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.
Edit: Response to reply by jarin:
1) Right, I meant to encompass salary with 'all else being equal' in the last sentence.
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: http://news.ycombinator.com/item?id=2888740
1) They pay good salaries.
2) They are not seeking an exit strategy, and this is merely a "just in case" scenario.
I would guess that most technical and executive hires come to the company with full knowledge that an IPO or sale is against their core values.
Given that this "isn't [used as] an incentive to work at 37signals" I don't see how it's an alternative to options which exist entirely to incentivize employees & management.
The only thing I wouldn't like (and it could very well be that way for technical reasons) 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.
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.
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.
 e.g. maybe it's a pain to pay somebody anything once they're not on the payroll…
Which means it's not by any means "An alternative to employee options/equity grants".
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.
On a grand level, no, of course not, but at the micro level, you should.
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.
Obviously, you want some to graduate and move on to bigger things too. These types are also valuable.
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.
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.
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?
Other than making themselves feel like good benevolent managers, this utterly fails as an incentive. What's the point?
The thing that makes these completely worthless is, should the company ever actually have an equity event they are void, as the new owner may do whatever they please which probably won't include honoring "these spreadsheet scribbles we put together with no legal weight whatsoever"
"Because we’re making the point that this payout should not be expected. You should not be banking on this. It’s not an incentive to work at 37signals. It’s purely a bonus."
The whole idea is doubletalk; that's my point. Its a non-incentive incentive. Its a non-paying insurance policy.
Incentive to work better is not the only motivation that an employer may have to share money with an employee. Generosity is another motivation, for example.
Only Jason knows his true motivations, but if he says it's not an incentive, there is nothing inconsistent or logically wrong with that.
Instead they have a promise of a bonus they're never going to get (by his own declaration), and have to start wondering what he's playing around at. Its the opposite of generosity - "its all mine, but maybe some indefinite share might go to you if somebody else later feels like it, but I'm going to try hard so that never happens"
This non-bonus bonus plan seems to be lazy, ineffective and insincere.
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.
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?
Believe it or not, most companies don't sell or go public.
PwC and E&Y seem to incent employees just fine.
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.
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.
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.
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 worse than not offering equity at all.
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.
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.
This is more like the founders making provisions to guarantee a gift to current employees in the event of a sudden windfall. Maybe even a form of severance pay in case an acquiring company starts laying people off.
I think it's a pretty pointless program, but I don't see anything unfair about it.
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
Much like the Skype-SilverLake plan.
37signals sure has some good lawyers!