

Pitfalls of Equity for Employees In Startups - mfaustman
http://blog.upcounsel.com/pitfalls-of-equity-for-employees-in-startups/
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.
======
tptacek
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...](http://answers.onstartups.com/questions/6949/forming-a-new-software-
startup-how-do-i-allocate-ownership-fairly)

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
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
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.

~~~
michaelochurch
_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.

~~~
tptacek
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"?

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

~~~
danielweber
Over the past decade I've had the, um, interesting experience of watching a
number of start-ups fail, VC-funded or not, sometimes competitors to
'tptacek's companies. I've never seen an EIR landing. I'm not even sure there
are enough EIR spots available.

Maybe lightning will strike and your name becomes recognizable on the front-
page of the business section and then people throw results and funding at you
in a self-fulfilling prophecy because they want to be on your good side. But
I've also seen a lot of people team up with these famous folks only to
massively regret it.

It's definitely not the most efficient graft-free super-meritocracy ever, and
there's a lot of luck even once you get past that, but I just don't see it.

------
mahyarm
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
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
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
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
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...](http://michaelochurch.wordpress.com/2013/03/26/gervais-
macleod-17-building-the-future-and-financing-lifestyle-businesses/) . It can
be done, but it requires a dramatically different style (one less vampiric)
than a typical organization.

~~~
hga
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)...](http://en.wikipedia.org/wiki/Brian_Reid_\(computer_scientist\)#Working_at_Google)):

" _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....

------
adotify
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
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.

