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Startup Equity

November 23rd, 2017
startups, money  [html]

The standard way to compensate startup employees is to pay a below market salary, and then make up for it with stock options. If the company succeeds the employee can exercise the options, turning them into liquid stock, while if the company fails they're not worth anything.

Consider a different model: companies sell the stock they would have been granting options for, raising more cash, and then use that to pay employees market rates. It seems to me that either I'm missing something (quite possible; leave comments!) this is a much better model and employees should push for it.

Possible reasons for the current system:

  • Startups are weird and hard to fund, so they need to resort to getting funding from their employees. This may have been true at one point, but there's huge demand for venture capital as an asset class, and the past decade has been an amazingly good time for raising money.

  • Startup equity is more valuable to employees than to outside investors. I would expect the opposite: if I'm working at a company I already have lots of exposure to company-related risk and reward, so company stock (or options) isn't the kind of additional exposure I want. [1]

  • Employees want risk more than VCs do. Since VCs can diversify and employees can't this doesn't seem likely.

  • Incentives are better aligned with stock options, and employees are more motivated. I think this is right at very small scales, like five people, but even at 50 people your own contribution starts to be a pretty small component of how the company does. And companies use this model at much larger scales than that!

  • Employees are unsophisticated investors and so effectively give companies more for their equity than VCs would. Companies are hard to value, the company has much more information than you do, and `liquidation preferences and other generally private terms can mean that estimating the value of your shares from the last price the company raised at gives overly rosy numbers.

Overall it seems like employees should be less willing to trade money for equity than VCs should be, so how did we get into this situation? It looks like it made more sense in the past (when companies had more trouble raising money) and in the early days of each startup (when a person's extra effort really would come through to stock returns), but now it persists because employees don't know better. [2] This is a pretty cynical explanation, however, so I'm curious if people see other explanations?


[1] This also applies to big companies that give stock grants vesting over several years. I'd much rather they sold the stock, put that in index funds, and then vested the index fund shares. Selling my employer short would be somewhat similar, except I think I might not be allowed to do that and it's much riskier (I could lose my job before my stock vests, for example).

[2] You could say "because employees don't have much negotiating leverage" but these employees have the option to work elsewhere at what looks like a higher wage even in risk-neutral expected value terms.

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