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Pitfalls of Equity for Employees In Startups

30 points by mfaustman 13y ago

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 13y 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!!
tptacek 13y 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-software-startup-how-do-i-allocate-ownership-fairly 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.
- michaelochurch 13y 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.
  - beat 13y ago
    What about those of us who aren't "trust fund kids"?
    - michaelochurch 13y ago
      VC-funded founders? Not rich? I have no problem with you four.
      - tptacek 13y ago
        This new trope of yours is extremely irritating. I come from a solidly middle class background. My parents didn't even pay for college --- I didn't go. Two of my siblings are in the arts, and one is a lawyer at a domestic violence clinic. I'm on startup #5 (year 8), with no VC funding at all. 2 of the previous startups I was at (one of which I cofounded) were VC funded. Not only am I not a trust-fund type, but nobody I ever worked with was. The founders of startup #2 for me just sold their third company. Both were middle-class Canadians with no "connections", just a solid professional track record. My 2 cofounders at startup #3 were well-off; both were working professionals, like me. Startup #4 was a spinoff of the University of Michigan started by a professor and his postdoc. At each of the 5 startups I've worked for, I worked with 2-3 founder/cofounders. That's ~12 (I just counted them out) people I've worked with that had founding roles at startups; none of them recurring from previous companies. Not a single one of them fits this inane description you keep using. Am I just extremely lucky, or are you a little bit full of it?
        bokonist 13y ago
        "Am I just extremely lucky, or are you a little bit full of it?" My own observations corroborate your data. I've personally known about a dozen founders who have built a seven or more figure net worth from startups. About ~6 were upper middle class. That is they had parents wealthy enough to pay for a "good" school. But the parents did not have enough money to fund their kids startup or pull on VC connections. Around ~3 people came from well off parents, who might have had enough money for a small trust fund (I do not know whether they actually had a trust fund). One had parents with VC connections. Overall, the career arcs of the well-to-do founders were indistinguishable from the upper middle class kids. The founders from upper class backgrounds were just as smart and hard working as any other founders. The other three founders in my personal dataset were immigrants with very little family support and had to hustle their whole way up. In my observations, getting VC funding requires at least one of five paths: a) building a product via bootstrapping and/or seed money, and then either getting significant traction or have a prototype of genuinely novel tech. b) developing a proven track record as an employee at a company. Maybe you joined a startup early that became big. Maybe you joined a big company and worked your way up to VP of Sales. c) Having some specialized and valuable knowledge. Maybe you consulted for a particular industry, and thus have inside knowledge about a valuable product that industry could use. Maybe you a professor that just developed some new technology that can be commercialized. d) going to business school, getting a job as VC associate, and then launching a company with some funding from that firm. e) having started and exited a previous company Getting VC funding requires connections. But building these connections is a trivial problem compared to the problem of establishing a track record via either bootstrapping or working your way up at a company. If you cannot establish those connections, you probably do not have the hustle it takes to found a company. If you have VC connections, but no product with traction nor track record of success, then you are not getting funding. The world michaelochurch describes, "the VC-funded startup CEOs ... I know didn't take any real risk, because they're all trust-fund kids " is a very different world than the one I have experienced.
josh2600 13y 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.
michaelochurch 13y 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-macleod-17-building-the-future-and-financing-lifestyle-businesses/ 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 13y 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)#Working_at_Google 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....
mahyarm 13y 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 13y 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 13y 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 13y 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?

30 points by mfaustman 13y ago

adotify 13y 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!!

tptacek 13y 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-software-startup-how-do-i-allocate-ownership-fairly 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.

michaelochurch 13y 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.
- beat 13y ago
  What about those of us who aren't "trust fund kids"?
  - michaelochurch 13y ago
    VC-funded founders? Not rich? I have no problem with you four.
    - tptacek 13y ago
      This new trope of yours is extremely irritating. I come from a solidly middle class background. My parents didn't even pay for college --- I didn't go. Two of my siblings are in the arts, and one is a lawyer at a domestic violence clinic. I'm on startup #5 (year 8), with no VC funding at all. 2 of the previous startups I was at (one of which I cofounded) were VC funded. Not only am I not a trust-fund type, but nobody I ever worked with was. The founders of startup #2 for me just sold their third company. Both were middle-class Canadians with no "connections", just a solid professional track record. My 2 cofounders at startup #3 were well-off; both were working professionals, like me. Startup #4 was a spinoff of the University of Michigan started by a professor and his postdoc. At each of the 5 startups I've worked for, I worked with 2-3 founder/cofounders. That's ~12 (I just counted them out) people I've worked with that had founding roles at startups; none of them recurring from previous companies. Not a single one of them fits this inane description you keep using. Am I just extremely lucky, or are you a little bit full of it?
      - bokonist 13y ago
        "Am I just extremely lucky, or are you a little bit full of it?" My own observations corroborate your data. I've personally known about a dozen founders who have built a seven or more figure net worth from startups. About ~6 were upper middle class. That is they had parents wealthy enough to pay for a "good" school. But the parents did not have enough money to fund their kids startup or pull on VC connections. Around ~3 people came from well off parents, who might have had enough money for a small trust fund (I do not know whether they actually had a trust fund). One had parents with VC connections. Overall, the career arcs of the well-to-do founders were indistinguishable from the upper middle class kids. The founders from upper class backgrounds were just as smart and hard working as any other founders. The other three founders in my personal dataset were immigrants with very little family support and had to hustle their whole way up. In my observations, getting VC funding requires at least one of five paths: a) building a product via bootstrapping and/or seed money, and then either getting significant traction or have a prototype of genuinely novel tech. b) developing a proven track record as an employee at a company. Maybe you joined a startup early that became big. Maybe you joined a big company and worked your way up to VP of Sales. c) Having some specialized and valuable knowledge. Maybe you consulted for a particular industry, and thus have inside knowledge about a valuable product that industry could use. Maybe you a professor that just developed some new technology that can be commercialized. d) going to business school, getting a job as VC associate, and then launching a company with some funding from that firm. e) having started and exited a previous company Getting VC funding requires connections. But building these connections is a trivial problem compared to the problem of establishing a track record via either bootstrapping or working your way up at a company. If you cannot establish those connections, you probably do not have the hustle it takes to found a company. If you have VC connections, but no product with traction nor track record of success, then you are not getting funding. The world michaelochurch describes, "the VC-funded startup CEOs ... I know didn't take any real risk, because they're all trust-fund kids " is a very different world than the one I have experienced.

josh2600 13y 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.

michaelochurch 13y 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-macleod-17-building-the-future-and-financing-lifestyle-businesses/ 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 13y 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)#Working_at_Google 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....

mahyarm 13y 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 13y 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 13y 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 13y 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?