Pitfalls of Equity for Employees In Startups

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

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

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.

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.

imagnitude 4728 days 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.

This EIR thing† is one of the weirder beliefs he has about the startup market. I know hundreds of people involved with startups and many tens of founders, and I have never even heard of someone in my social network getting an EIR position.

The reality of EIR positions seems to be that they're places that VC firms park executives that they're almost willing to fund "on spec". That is: people who have already made them a shitload of money. I cannot find a way to give a shit about some VC firm paying a 50 year old former CEO to wait around for the next social cat picture startup to helm.

† He didn't say it here, but use the search box below to look for the phase "EIR sinecure"

That is: people who have already made them a shitload of money.

Also: people they owe favors, kids of Senators whose votes they need to sway, and people they did embarrassing stuff with in MBA school who are now getting the EIR job as a form of hush fee.

The whole world runs on extortion, influence peddling, and favor trading. That's thousands of years old and hasn't changed much. But technology was supposed to be different and maybe, at some point a long-ass time ago, it was.

You write comments like this and I worry about your mental health.

Not because I think EIR positions are fairly allocated among deserving people, but because you've clearly fixated on something as petty and irrelevant as EIR positions at venture capital firms.

What in the world could possibly matter less to young entrepreneurs than EIR positions?

And yet here you are with stories about EIRs used to hush up things that happened at business school or bribing Senators. You've taken the time to actually tell yourself stories about them. About EIRs. The most boring feature of a VC firm. The guy they bring into the room to screen you when you're not compelling enough to get a meeting with an associate.

If I'd been offered an EIR position at a VC firm, I'd worry about what I'd done wrong, shortly after checking my hairline and hair color to make sure I hadn't suddenly gone grey and bald.

mjn 4728 days ago

The vast majority of founders are not spoiled rich kids playing with daddy's money.

I can believe most aren't rich, in the grew-up-in-a-mansion sense. But it'd be interesting if there were some hard numbers on it. What is the distribution of socioeconomic backgrounds of founders who raise VC? I've got some anecdotes myself (mostly suggesting solidly upper-middle-class), but data would be more enlightening.

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.

"The vast majority of founders" never take VC and aren't even working in a space that VCs will fund. I'm not talking about lifestyle businesses, which actually involve a lot of risk and sweat, I agree with you.

When your startup falls, there's not some kind of cushy EIR gig waiting for you at the friendly VC.

If you're VC-funded, there is. If you never get funding in the first place, then what you say is correct, there's no guarantee of anything.

By the way, the fact that it's unfair I don't believe to be worth complaint. My problem is that we've ended up supporting a game that actually increases and perpetuates inequality by making pre-selected rich kids look like they earned it.

In fact, the real respect goes to the risk-taking, unfundable, silent majority founders you described.

I was funded in 1999, at 2013 A-round levels. No EIR position awaited the failure of that company. Again: I don't even know anyone who's ever been offered an EIR position, and I know a fair number of people, many of whom have been funded, some of them by huge name VCs.

So, why don't we do it this way: why don't you name a couple people who've been recipients of "EIR sinecures"?

U32LnJfiYoiLQP 4728 days ago

I know of a company where the parent of one of the founders made a ton of money for the VC. Twice. In exchange, one of the partners has put some seed money into the kid's startup. The seed money is a pittance compared to how much money the VCs got.

What's sad about it is that there's no entrepreneurial spark in the founders. They're not hungry for success. They're paying themselves way too much and working with no effect. The company will fail, and they'll go on to whatever nice lifestyle awaits them.

(edit: Note that I'm not saying that this is typical, just that there are examples of this "insider" activity.)

yuhong 4728 days ago

Note the "in 1999". michaelochurch can you comment on when it started?

imagnitude 4728 days ago

My comment is specifically about founders of VC funded startups. It might be different outside Silicon Valley. But in my experience in SV, I know the founders of about 20 venture funded startups socially. One of them is what you would call a "rich kid". The rest bootstrapped for many months, paying themselves virtually nothing, getting deep in debt, before their Series A. Even after raising an A round, they pay themselves subsistence wages, just enough to eat so that they can pay market rate six figure salaries to the engineers on their team.

This might be unique to the West Coast. But around here, social/country club connections mean nothing for raising money. Anyone can get a meeting with a top tier VC pretty easily, even if you are a complete nobody. Having a well connected family might help with other things, but it has absolutely zero effect on fundraising.

The rest bootstrapped for many months, paying themselves virtually nothing, getting deep in debt, before their Series A. Even after raising an A round, they pay themselves subsistence wages, just enough to eat so that they can pay market rate six figure salaries to the engineers on their team.

I actually agree with you that, if they're truly suffering financial hardship (but I'm never impressed by a rich guy taking a $1 salary) they deserve a lot more than the engineers taking full salary.

What about those horrible executive implants installed by investors, though? They also get an order of magnitude more equity and full salary, and that's wrong.

gfodor 4728 days 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?

pcwalton 4728 days ago

I don't agree with michaelochurch here at all, but I don't think I agree with your cake analogy either: early employees of startups often work very hard. Of course founders do an exceptional amount of work and take an exceptional amount of risk, and, having not been in the founder position, I won't take the position that they don't deserve the equity they receive, but they aren't baking the whole cake.

gfodor 4728 days ago

The cake isn't assets or liabilities, products or customers, it is the equity of the company, and equity is created when the founders decide to incorporate the business and it belongs to them. As such it's theirs to do with as they please, from the time it is worth nothing to the time when everyone wants some of it, if they are so lucky.

It's kind of lame to say what they do with it is or isn't "fair" since the exchange of equity for something else is always done between two agreeing parties. It's extremely over-simplifying things to look at a liquidity event and then at the equity division to say if it was "fair" based upon who contributed what to the company. The equity and its distribution happens on a separate plane from the actual operating activities of the company itself, and the individual efforts or contributions of employees. There is no particular reason to believe that someone who provided huge amounts of value to a company "deserves" equity based upon this fact alone, though often founders will give up their equity to these people in exchange for their good work.

Any equity in the hands of a non-founder can be traced back to the founders giving up the equity they had up to another party in a mutual agreement, so it's quite bizarre to try to apply some external notion of fairness since nobody is forced to take such an offer.

jt2190 4728 days 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.

http://www.yesatyale.org/files/lecture_06.pdf

danielweber 4728 days ago

Back in 1996 it was recognized as one of the classic start-up mistakes. It's so old I could only find a PDF:

I think vesting might avoid the problem, but I tend to think one person is probably more invested in the start-up and should take charge. I've seen too many times where "everyone is responsible" leads to "no one is responsible."

You need to designate someone as the tie-breaking authority for disputes, but it doesn't follow from that that you need to give that person more compensation.

Two things that would keep me from joining any founding team at this point in my career:

* Not having everyone on a 4-year vesting schedule, founders included

* Not giving equal shares to the partners

I'm with Spolsky: if you think it doesn't make sense to give a "founder" the same share as yourself, that person isn't really a founder.

pdog 4728 days 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.

beat 4728 days ago

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

VC-funded founders? Not rich?

I have no problem with you four.

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 4728 days 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.

fearless 4728 days ago

You're making a very bold claim that being born into wealth and connections is a prerequisite for VC funding. Do you have any hard evidence to back this up?

Please don't take this the wrong way: Your comments seem to reflect your own track record of professional failure rather than some legitimate trends or observations about the industry as a whole.

If every founder, investor, executive you have met has seemed malicious or incompetent, please consider this: the only common denominator is you.

Your comments seem to reflect your own track record of professional failure rather than some legitimate trends or observations about the industry as a whole.

You know nothing about about me, what I have seen, or where I have been. It's true that I've picked some terrible startups, but hundreds of people have had similar experiences to corroborate. If I were the only one who held these opinions or had that category of experience, I'd think differently about the whole thing.

I'm pretty good at picking out genuine problems (i.e. the persistent low status, mistreatment, and mediocre compensation of software engineers in this industry) from noise (transient bad luck that happens to all of us).

If every founder, investor, executive you have met has seemed malicious or incompetent, please consider this: the only common denominator is you.

That is far from what I said. Not even close. Not every one is bad. However, I do think that the social class distance between VCs and petitioners is vast and is already at, if not beyond, the point of being the most important factor in the interaction.

This game has already been worked out, and we should leave it to the people who won it and go build something new. They don't have much without us, so what are we waiting for?

beat 4728 days ago

I'm not VC-funded, either (hopefully I can avoid that entirely, but at the moment I've barely started working on angel funding).

I was born into a poor family, with no connections to speak of. I simply did not know anyone who was wealthy or successful when I was a kid. I've made a comfortable middle-class life for myself through lots of hard work. Starting a software company is something I'm doing because I see a valuable problem to solve, and something I believe I can do because I'm smart and determined - not because I was born into privilege.

mahyarm 4728 days 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 4728 days 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.

happened2me 4728 days 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?

josh2600 4728 days 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.

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 4728 days 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 4728 days ago

You should consider hiring an editor.

adotify 4728 days 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!!

7Figures2Commas 4728 days 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.