

A fair, mathematical approach to equity programs for pre-IPO companies - maxcan
https://medium.com/p/12ddebcc63ef

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rdl
I'm not a lawyer; this is not legal advice.

I like the fundamental idea. However:

1) This risks pricing the common, which is bad. It certainly isn't the same as
preferred, due to superior rights (liquidation preference most seriously)

2) In general, you should discount equity vs. cash because equity, even
granted today, is illiquid. Even if you claim you're willing to buy it back at
any given time for the then-current market price, you're better off motivating
employees by giving them equity than cash, all things being equal -- the
employee can improve the value of the equity through work, but can only in the
most absurdly indirect way increase the value of cash itself (by tearing up
other cash...)

In practice, I love what Palantir does (or did; I know about this from Ari
Geller on Quora, not directly). You basically get 3 discrete offers e.g. --
$130k/500 shares, $100k/1k shares, $85k/3k shares. It's essentially a way to
reveal your preference and beliefs about the company (although, Palantir is
now so big that an individual's contributions don't materially move the
price.) (I'd personally be WTF at someone who picked the $100k/1k; either
extreme would be defensible, but I'd generally prefer to hire the 85k/3k
person, unless I knew he had high cash expenses like kids in school).

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samstave
> __ _unless I knew he had high cash expenses like kids in school)._ __

Thats the rub for us older startup joiners... I had two options at my current
company, and while the spread was very small as compared to your Palantir
example - because I have high kid expenses I chose less stock but higher
wage...

Although, I'd prefer if they looked at the discussion going on over employee
equity, with only 20 employees thus far, their option package are nowhere near
even what people have been throwing out for discussion :(

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rdl
I actually think investors put enough of a premium on equity vs many employees
that a reasonable case can be made for very tight equity distribution, using
something like this proposed model, and periodic cash bonuses.

I actually have an even weirder idea for equity in big companies -- each class
of incoming employees gets founder shares in a company comprised of hires.
(Per month, per team, not sure); essentially like a PEO. Company buys that
entity giving employees a capital gain related to their group's contribution
at purchase time. Standard 4/1 repurchase on the founder shares within that
group.

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samstave
That is an incredibly interesting idea... It would be really interesting to
attempt to model and see how it could play out in various forms.

You could grant some sets of options to the older employee-groups too....

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gibybo
This is probably the best equity compensation plan for pre-IPO companies I've
seen so far. Vesting schedules for a fixed quantity of equity have always
irked me for the same reason Max explains: they assume a constant value over
the life of the vesting, which is almost never the case in a pre-IPO startup.

If I was choosing between multiple offers from startups, the ones using this
model would have a huge advantage in my book.

The one (big) issue I can think of is that it does not provide a way to value
the common stock. The valuation events in a startup will very often be
investors purchasing preferred shares. Preferred shares tend to be worth quite
a lot more than common shares (and the gap tends to be larger the younger the
company is), so assuming a 1:1 value between them will severely undervalue the
common stock grants.

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bjterry
Using the pre-money valuation of a venture capital round to price common stock
is a bad idea that is not supported by economics. The rights granted to the
VC's preferred shares are REALLY, REALLY valuable, but the pre-money valuation
values all shares as if they have the same package of rights. With things like
participating preferred, dividend rights, not to mention the base liquidation
preference, the value of common stock bears no relationship to the value of
the preferred shares. They are only remotely similar in the event of a billion
dollar IPO, when all the downside protection gets lost in the wash. This is a
fundamentally low-probability scenario.

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mifeng
While prefs and commons certainly differ in value, I don't think it's matters
much given that the goal here is to give employees a fairer, more transparent
way to allocate between cash and equity compensation.

The valuation differences are more stark in mid- and late-stage startups; at
the same time, only a small amount of the overall equity is being granted to
employees.

Where I think this model has a real impact are to help the first few employees
figure out compensation, which is a complete unknown right now. Pref vs common
valuation matters much less at that point.

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bcbrown
I like this approach, but this sentence gives me pause: "Interpolated Equity
requires just one assumption about pre-IPO startups: the value of the equity
grows at a constant rate between valuation events."

What about cases where the value drops between valuation events? If I was
considering an offer, and the equity portion of the offer was valued based on
a model that didn't consider the possibility of a drop in valuation, I would
discount that equity severely.

Furthermore, how realistic is it to have a constant rate of growth? Perhaps
I'm misreading it, but I think it is likely that the rate of growth between
Event n and Event n+1 won't be well correlated with the rate of growth between
Event n+1 and Event n+2.

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maxcan
You're absolutely right. The problem is that there are no market mechanisms at
play in between valuations.

The goal of IE is to base equity pricing on market mechanisms as much as
possible. In the absence of market signals, we essentially choose the
simplest, most economically justifiable assumption. The alternative is to
simply let the board or management massage the intraperiod valuations as they
see fit which is less transparent and yields values that don't necessarily
have a market basis.

I guess the "real" assumption of IE is that market mechanisms are the fairest,
most efficient pricing system.

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apercu
What I liked about the article was simply the maxim: "Companies should
minimize the impact of the inevitable information asymmetry between
prospective hires and founders and management."

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maxcan
Many people have raised preferred/common pricing issues and it is a valid
criticism. I don't have a complete answer but have added a partial answer to
the original document and have reposted it here:
[https://news.ycombinator.com/item?id=7625099](https://news.ycombinator.com/item?id=7625099)

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zabbyz
Mad brings up a lot of interesting points. I esp agree with having more
transparency around equity.

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zabbyz
*Max

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rhizome
"edit" link is right up there ^^

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arb123
thanks but super weird, i dont have an "edit" anywhere

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rhizome
It's only there for a couple hours after the comment is posted. Not sure if
green accounts behave differently, I don't create new accounts willy nilly.

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thatthatis
This model doesn't seem to handle down rounds well, unless I missed something.

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maxcan
It "handles" them in the sense that the math doesn't call apart. What happens
is that the implied rate of return is negative and purchases towards the end
of the period get more shares than those at the beginning.

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dmk23
The only problem with such "justified" models is that it always comes down to
what everyone thinks of everyone else's value to the company. For example -

1) A first employee might feel he should have been a founder

2) Two co-founders who might feel the 3rd one has not contributed enough to
justify their share

3) Employee/contractor #20 (or whatever it is) at Facebook who painted
graffiti on the walls ended up with a package worth $100M while it is hard for
anyone to say with a straight face they actually created that much value (i.e.
what is the reason for granting equity by job role)

4) Sizing of equity grants to engineers vs. sales staff, given that
salesforce's primary motivation should be based on hitting their quotas with
all incentives built around that

5) Someone fired a few months before the vesting cliff might think they are
being cheated, while the company might believe they have been toxic to the
culture (I won't name any examples here)

6) Employees "resting-and-vesting" at pretty much every level of the equity
grant cohort

7) Later employees who end up carrying the weight of the earlier ones without
comparable rewards

In every deal it all comes down to a willing buyer meeting a willing seller.
Compensation packages are no exception.

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gibybo
I think you misunderstood the article. It's not about choosing how much to
compensate someone. It's about how to allocate equity given a known
compensation total.

