Pitfalls of Equity for Employees In Startups

http://blog.upcounsel.com/pitfalls-of-equity-for-employees-in-startups/

by mfaustman • 13 years ago

30 45 13 years ago

blog.upcounsel.com

Wanted to start a discussion on this topic and see what advice people can provide for employees when it comes to equity. We have noticed a large amount of equity agreements come across our service lately for review, so wanted to start a discussion to provide guidance and get some of the larger questions out in the open.

adotify• 13 years ago

We are just sorting out equity/option scheme for our first employee, so this was a good read, and completely agree with the first statement about owning 100% of a company where staff are not invested!!

tptacek9• 13 years ago

Joel Spolsky's Stack Overflow answer to this question is to date the best single explanation of this issue I've read:

http://answers.onstartups.com/questions/6949/forming-a-new-s...

Also: keep your eye on the ball. When a software company gives equity to an investor in exchange for money, most of that money is going to employees anyways; salaries dominate the expenses of tech companies.

michaelochurch10• 13 years ago

I don't agree that founders deserve as much as Spolsky thinks. 3-5 times more than early employees, sure; 20 times more, no.

Most often, "took more risk" means "comes from a rich background and had a softer landing". The VC-funded startup CEOs (and hedge fund CEOs; that was even bigger than VC startups in NYC for a while) I know didn't take any real risk, because they're all trust-fund kids and, half the time, their families pulled connections to expedite pre-packaged outcomes.

Sure, more risk should mean more reward, but not the order of magnitude Spolsky suggests, especially given that most of this "risk" people claim to have taken is fabricated; they're really rent-seeking off the connections that made their forays not risky.

Making the system fair (and I recognize that this is impossible) would require taking into account the socioeconomic status of the players. I'm not actually suggesting it should be done that way, because it would be a total clusterfuck and no startup would ever be founded for all the nasty arguments that would ensue, but it would at least be closer to fairness.

beat2• 13 years ago

What about those of us who aren't "trust fund kids"?

imagnitude3• 13 years ago

I know you're just trolling, but I'll comment anyway, because it's important to set the record straight.

The vast majority of founders are not spoiled rich kids playing with daddy's money. The vast majority of founders take a massive risk when they go all in on a startup. Before getting funding, most bootstrap for years, neglecting family, friends, vacation, working 14 hour days, all for a business idea they believe in. The equity a founder gets is small compensation for giving up years of his life. Even after raising money, a founder will continue to live on subsistence wages, giving up the opportunity cost of a cushy 6 figure job. In pretty much every venture backed startup, the founders are some of the lowest paid employees at the company. Most of the funded startup founders I know make less than $50K, which is a big improvement from the minimum wage salary they paid themselves in the first two years of the startup.

When your startup falls, there's not some kind of cushy EIR gig waiting for you at the friendly VC. Unless you're a tech celebrity, you're lucky to get an entry level PM job at a Google or Facebook. Source: Dozens of founders I know who raised money and failed.

Your portrayal of all founders and investors as some kind of scheming robber barons is insulting and incredibly demeaning to every single entrepreneur on this forum.

Guess what: founders are regular programmers, just like you. And they deserve every last bit of equity they get.

pdog• 13 years ago

The absolute value of the startup when the founders and investors get involved (literally, founding the startup and investing in it) is often 1-2 orders of magnitude less than the value of the startup when the first employee is hired. So an employee may get 1/100th the equity of a founder, but still get more on an absolute basis.

jt2190• 13 years ago

  > I don't agree that founders deserve as much as 
  > Spolsky thinks...

I've always read Spolsky's advice like this: "If you literally can't build the business without the other person, make them an equal partner." I agree that founders should think long and hard about this, because there are very few scenarios that require a fifty-fifty partner, and many that require high-skilled, but not unique, people.

gfodor2• 13 years ago

Even rich kids have to deal with opportunity cost. (Besides, claiming VC funded founders are all rich kids requires evidence, and you haven't provided any.)

Besides, why do you get to say what a founder "deserves" of their own company? If I bake a cake, and agree to give people small slices of it in exchange for things, you still think I don't deserve the rest of it even though I made it myself?

josh2600• 13 years ago

This is a good blog post with lots of helpful information and some good numbers to start making some educated guesses.

That being said: Please take your super slow loading popup of doom off of your blog. I don't want to have you spam me for my info the second I hit your page, and, no, I don't care how many more people sign up.

Yes it's effective, but it's also rude.

Edit: Capitalization removed.

michaelochurch10• 13 years ago

I don't think equity is a good way of paying employees. There, I said it. I know this is contrary to Silicon Valley wisdom, but I've studied the alternatives and I think I'm right on this one.

Profit sharing (a larger percentage, but annually dispersed rather than permanent) is a much better method of upside compensation. I actually think that typical equity allocations in VC-istan fall into the uncanny valley and become demotivators. A nickel (0.05%) of a 50-person company isn't ownership. It's a consolation prize (severance) if your job is sold away in an acquisition.

Also, I think startup equity exacerbates the inequalities. Let's say that a software engineer (someone who does actual work) makes $120k while some politics-playing non-technical VP (who doesn't show up half the time, but the CEO likes him) makes $150k. That's unfair, but it's not going to stop people who are otherwise enthusiastic about their jobs. They'll find it mildly annoying but get back to work and forget about it in a couple of days. Replace those numbers with 0.05% and 1.0%, however, and you get a different story.

You could release all the salaries at a VC-funded startup and it wouldn't stop work. If the equity table came out, the engineers would all leave on the same day and it would be chaos. That's why the cap table is hidden (a disgusting practice when one considers that equity is billed as ownership; by the way, someone should totally Wikileaks a bunch of startup cap tables.)

I don't even think it's meaningful to consider yourself an owner-- at all-- of something if you don't get to see the capitalization table or interact directly with investors. I'd rather have a market-level salary, to be blunt. There are levels of equity that justify the typical startup's pay cut, but no (non-founding) engineer in Silicon Valley gets anything close to that.

I worked out how to make profit-sharing more fair: http://michaelochurch.wordpress.com/2013/03/26/gervais-macle... . It can be done, but it requires a dramatically different style (one less vampiric) than a typical organization.

hga• 13 years ago

In your short essay above you left out the perverse incentive that equity presents if the company becomes worth something: getting fired before the IPO or other cashing out event. To rag on your favorite target (http://en.wikipedia.org/wiki/Brian_Reid_(computer_scientist)...):

"In June 2002, [Brian] Reid became Director of Operations at Google. He was fired in February 2004, nine days before the company's IPO was announced, allegedly costing him 119,000 stock options with a strike price of $0.30, which would have been worth approximately $10 million at the $85 IPO price."

Still being litigated....

comatose_kid• 13 years ago

You should consider hiring an editor.

mahyarm• 13 years ago

After working for a start up for a while, a couple of other things that would make equity far more attractive compared to Google paying $80k/yr more in total compensation:

1. Non-expiring options on leaving the company. Many SV companies have options expire in a couple of months after leaving. Some have them expire immediately upon firing.

This does remove some of the Schrödinger's golden handcuffs effects of equity, but start up equity is not liquid. It can be tough to expect someone to put a significant chunk of their savings into a company and deal with the tax BS just to purchase equity so they can move on. Much of the stress of start up equity I've realized comes from the non-liquid nature of the stock and the fact you don't have control over the company. Many companies want to completely control second market behavior when private, which removes even more liquidity. Much of the stress will just go away if I could keep the options.

2. A consistent pattern in working for various companies is giving the stock & employment contracts after hiring. From now on I'm making it a condition of accepting an offer to receive all contracts, stock contracts, proxy agreements, etc that I would be asked to sign. If you have a surprise call option on purchased stock, no way I will work for that company.

VladRussian2• 13 years ago

basically it is a great filter - people who have good employment aren't going into startups because numbers just don't work for them as well as being handcuffed for a number of years and a risk of losing a lot, basically all of your sweat equity, just on the whim. This works though for youngsters just out or a few years after college where they need to gather experience and corporate salary is smaller.

7Figures2Commas• 13 years ago

There's a big pitfall that isn't mentioned: the equity doesn't grow in value, perceived or real.

Savvy and experienced employees will consider equity at an early-stage startup to be a lottery ticket. Most startups will never experience a liquidity event, and, on average, the windfall from liquidity events is relatively small. There are a number of things that most employees can't effectively protect themselves against (dilution, liquidity preferences, etc.). None of this means that these employees won't negotiate the equity package, but they won't trade salary and benefits for equity either.

Many if not most employees, however, are not savvy or experienced. They hope and expect that their equity will grow significantly in value, and consider it a big part of their compensation package. Some employees are so confident in the future value of the equity that they are willing to negotiate their salary down to "maximize" their equity, almost as if it was a cash equivalent.

As a result, equity has become an attractive retention tool for early-stage startups, and one that is seemingly cheaper than alternatives that require cash. And equity can be very effective so long as employees believe their equity has value, is growing enough in value and that the odds the equity will be liquid in a reasonable timeframe are good.

If and when that belief starts to fade, however, equity can become a significant source of low morale and employee attrition.

happened2me• 13 years ago

So this happened to me...

I am 3rd layer share holder, and also the 3rd employee. I got 4%. There was a 4th and 5th layer employees added, each about 1.5 years apart. 4th got 30%, 5th also I think got 4%.

Now when the economy really crashed in 2009 we had a couple of months of temporary 20% pay cuts (not getting contracts trying to bootstrap, IOU when we get $ again). Since then we have had more pay cuts sometimes as much as 40% for a month or 2, and once we had a 100% cut for 1 pay period.

We are an s-corp, when there is profit we get payments (and subsequent tax bills for our share of profit), so these aren't stock options. However, is it right that everyone shares the pain on the same level (x% across the board temp pay cut) but has a very great difference of reward possible? Is this normal?

Pitfalls of Equity for Employees In Startups

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