EMI options are belief contracts

I have written and spoken before about EMI options as a form of belief contract. The equity compensation platform, Optio, recently picked up on the phrase following a podcast conversation I had with them about what makes employee equity work in practice. You can read and listen more here.

I know the phrase comes across as gimmicky, but I think it is actually a useful shorthand for something quite important: an option only really works as an incentive if the employee believes there is a credible path from what they do today to value they might one day realise.

Strictly speaking, the idea is wider than EMI. Almost every form of long-term equity asks an employee to believe something about the future. What differs is how much belief the incentive requires.

A listed-company share award may already carry observable value and a reasonably clear route to liquidity. But a growth share above a substantial hurdle or an option in an early-stage company, may depend much more heavily on a future state of the business which does not yet exist.

EMI often brings several of those uncertainties together. It is commonly used in growth companies where value is difficult to observe, liquidity may be years away and subsequent financing can materially change the eventual economics.

The option itself is a financial instrument. It can have value whether or not the employee believes in the company and it may also perform a retention function simply because leaving means giving something up. But its ability to motivate future behaviour depends much more heavily on belief.

The employee has to believe that value can be created, that they can participate meaningfully in it and that there will eventually be a credible route to turn paper value into cash.

That is what I mean by a belief contract. It is not a legal promise that those economics will remain unchanged. It describes the expectations on which the incentive relationship depends. The company is asking the employee to commit time, effort and part of their career to building a business whose future value is uncertain. Investors put financial capital at risk but employees, of course, have a different risk exposure: company-specific career investment, forgone alternatives and a contingent element of reward. 

And you can read about my thoughts on that here.

The interesting question, though, is what happens when the belief survives but the economics supporting it change.

The percentage is not the economics

An employee may be told that their options represent 1% of the company. That percentage can be psychologically powerful, but it tells them surprisingly little about what they may eventually receive. Their return may depend on the exercise price, subsequent dilution, investor preferences, further funding, the timing and value of an exit and the rights attached to other securities in the capital structure.

Much of the economics of the belief contract is therefore written outside the option agreement. That becomes particularly important when the company raises capital. Suppose a funding round dilutes an employee from 1% to 0.7% and introduces new preference rights. Looking only at the cap table, the employee's position appears to have weakened.

But that comparison may be misleading. The new capital may enable the company to survive, accelerate growth, enter new markets, make acquisitions or reach an exit that would otherwise have been unattainable. A smaller percentage of a much more valuable business may leave the employee substantially better off. Equally, additional capital can alter the distribution of value without creating enough additional value to offset the dilution. The effect is ultimately economic, not mathematical.

The important point is not whether the employee has been helped or harmed by the funding. It is that the proposition they are being asked to believe in has changed. The expected path to value creation may be different. The likely route to liquidity may be different. The way in which exit proceeds are shared may be different. The economics may have improved or deteriorated, but they are unlikely to be identical.

Dilution is therefore not the story. The story is that financing changes the economic architecture within which the option operates. Sometimes it weakens the employee's opportunity. Sometimes it strengthens it. Almost always, however, it changes the bargain the employee thinks they are helping to build.

When belief and economics diverge

That leads to what I think is the more interesting problem. The company normally knows when the economics have changed. By contrast, the employee is likely to still be thinking about their option granted three years earlier. They may remember the percentage quoted at grant or an illustration showing what their award could be worth at a particular exit value. Meanwhile, more capital has been raised, the distribution of proceeds may have changed and the likely route to liquidity may look quite different.

The employee has not necessarily become worse off. Indeed, they may have a much better opportunity. The problem is that they may be making decisions using an obsolete understanding of that opportunity.

And that matters because, objectively, valuable equity and effective incentives are not the same thing. An award can be worth a great deal and still have limited motivational effect if the employee regards the value as remote or cannot understand how it might be realised. Equally, an uncertain option can be a powerful incentive where the employee sees a credible connection between their contribution and an outcome in which they will participate.

Employees do not need access to every investor term or a detailed liquidation model. But they should understand the broad shape of the proposition: what drives their value, what could dilute or rank ahead of them, how uncertain the outcome is and what has to happen before liquidity becomes possible.

In an ideal world, there shouldn't be a material gap between the economic opportunity the company understands and the one employee's think they have been given.

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