Sunday, June 26, 2011

Startup Pay and Equity

Having worked at a couple of startups in my time, and currently looking at an opportunity to join another or start my own, I've been thinking about compensation. I'm gonna try to lay out those thoughts.

First off let's figure out what your rate should be. That is, how many dollars per year you are worth. I'll haul out that old economists' maxim, "The value of something is how much someone is willing to pay for it." So let's take your most recent job. How much did you make last year in total? Count salary, bonus, and equity (more on that in a minute).

That total number is your rate. I'm going to use it to figure out what your compensation should be at that startup you're thinking of joining.

But let's tackle that equity thing first.

If you were at a publicly traded company then your equity compensation is easy to value since the shares or options have a well defined value. But what if you were at a private company or another startup? In that case, if you have equity you need to see the capitalization sheet (shorthand for a listing of all of the outstanding shares, who is holding them, when they got them, and what they paid for them) to determine what your equity stake is worth.

You ask why?

Well, suppose your rate is $100k/year and I offer you $50k/year plus options on 100,000 shares. Is that a good deal? What about $50k/year and options on 1,000,000 shares? Look good now?

What if I tell you that in the most recent funding round the company sold an investor 5 million shares for $50k? That million shares of your represents $10k of value. A million shares sounds like a lot, but without seeing the cap sheet you have no way of knowing.

The formula is this; take the value of the total compensation being offered (salary + bonus + equity value determined from cap sheet) and compare it to your rate. They should be about the same.

There are reasons other than pay to go work at a startup. The fun, the excitement, the team, the lack of rules prohibiting bringing your dog to the office, the awesome late night jam sessions, the overwhelming stress of not knowing if the boss is really going to manage to close this next round of funding because he started the company to design software not spend all of his time fundraising and if he doesn't then all that equity you're holding is completely worthless and you need to start freshening up that resume and looking for another bland gray corporate job again. But I digress...

Now, here are some things to look for:
  1. Equity is "a large part of your compensation" but they won't show you the cap table.
    This almost always means that equity is not a large part of your compensation. They are telling you this to get you to swallow the small salary. They may think it is a large part of your compensation, but they may also overvalue their own company.
  2. You don't really trust the founders but they are offering you what looks like a great deal.
    There are innumerable ways for shady founders to screw the employees at a liquidity event. Everything from extreme dilution, to a very low sale price and an employment contract with the acquiring company for the founders that is "very generous." At the end of the day, you really need to be able to trust the founders to look out for you.
There's an interesting thing that just occurred to me. I have often heard people say that they want to keep their burn rate low (e.g. pay low salaries) in order to keep from having to give more of the company away by raising more funding. This only makes sense if you are under compensating the employees with equity. After all, if you say that we want to give you equity in lieu of pay then that equity must be worth at least as much as the salary you're trading for it.

If that were true then it wouldn't matter whether the equity was used to pay the employees directly or exchanged for cash to pay the employees' salaries. Either way, the equity is being traded away. The fact that some people are so loath to share the cap table info, thereby making the value of the transaction transparent, at the same time they want to push equity in lieu of pay makes one wonder.

I honestly don't think that most founders even think this through. I think most of them are trying really hard to do right by their employees. But it is one of those situations where the transactions are so convoluted that it is really easy to lose sight of the final outcome.

Bottom line, if equity is part of your compensation you need to see the cap table. You have a right to see the cap table. After all, you are an investor too. You are investing days of your life and that is more valuable than some angel investor's money.

Update 6/25/2011: I gave a talk on this at BarCamp Seattle and the notes & deck for that talk can be found on my Equitable Equity: Fairness and Transparency in Equity Compensation post.

7 comments:

sechrest said...

You are right... The person taking equity is an investor. And they should act like an investor. You should see the cap table, but you should go much further into due diligence. Do you trust the guys? If not, you should bail. Do you see the path to a market? Do you see the path to how the equity becomes money?... Lots of questions.

But when you say:

The formula is this; take the value of the total compensation being offered (salary + bonus + equity value determined from cap sheet) and compare it to your rate. They should be about the same.


I think you miss something important. Because you are an investor, you are taking a risk. A substantial risk. And so your compensation should represent a substantial upside. Your equity portion of your salary should be structured in a way that gives you a substantial upside. Specifically that you have warrants or other methods to put in more money later to get more money out when there is an opportunity. Find a way to make the financial reward match the risk being taken.

Bruce said...

@sechrest Good point!

You certainly want there to be an upside. In theory (and I want to stress that theory part) that risk and potential for upside should already be baked into any valuation.

Note that in the case where the financial reward precisely matches the risk being taken there is no upside on average. That is, if you play the game many times, the expectation value of the payout goes to 1:1. Investors (buyers) of any type are doing so on the theory that they know more about the value of the thing they are investing in (buying) than the founder (seller) does. This is rarely the case and helps explain why, on average, angel investors lose money.

sechrest said...

You say:

.... on average Angel Investors loose money...

I don't think that is correct. If you look at the work of Rob Wiltbank, who is a professor at Willamette University, he has some interesting data about Angel investors. He is doing a comparision of Angels vs Venture investing.

We see things coming out of his research such as:

* On average, Angel investors are seeing a 27% annualized return on overall investments

* on Average, Angel investors are out performing Venture investors


this assumes several things about the Angel investors:

* They are investing in many small deals

* They are actively involved in the businesses they are supporting

* They are getting in early

* They are getting into businesses that they understand


And while it is true that 1 out of 10 investments its it big, 3 out of 10 make some postive cash flow and 6 out of ten loose money, this does not mean that on average the Angel investors are loosing money. In fact, just the opposite.

And the reason they loose money on some investments does not usually have anything to do with the valuation between the buyer and the seller, but has to do with the market place and the success of the company.

Brad Hefta-Gaub said...

Bruce,

Good post... lots of food for thought. Although I agree with your point about being an investor, I'll admit I'm not convinced that it makes sense for executive management to disclose the cap table as broadly as you're suggesting, and I don't think it means the management team is being dishonest or shady.

That being said, I agree that management should have candid/frank discussions with their team members about their entire compensation package.

But... what's even more interesting to me, is the implication that the current economic environment might have on "equity as a part of compensation". If the predictions I've seen from many investors and entrepreneurs is true: that "exits" as we know it might be a thing of the past... or at least not part of the near term future... then we will need to rethink this aspect of compensation.

I've started pondering the idea of focusing on other aspects of compensation. Is it time for us to start emphasizing such "boring" concepts as 401Ks, Profit Sharing, equity that pays dividends, etc.

Bruce said...

@brad

So what should the management team tell employees who are being compensated with equity? How do the employees know what "fair" is? Simply trust the management team? Blindly?

I think that there should be no reason whatsoever not to share the cap table with the shareholders. As a member of that management team, if it makes you uneasy to share that information then that should be an indication that you need to take a close look at the source of that unease.

vmahillon said...

This ia great post. Far too often, people are bedazzled by a large number of shares when, in truth, they're not even sure what that means. It's almost like dealing in a foreign currency. Are you going to be impressed with 10 million Rupees or are you going to ask first what 1 rupee is worth?

It's great advice to ask for a glance at the capitalization documents - it's the least bit of due diligence you can perform as a candidate accepting an offer. You make another great point though that at the end of the day, you have to place a certain level of trust in the founder(s). You may get screwed as Mark Saverin did with Facebook (and his diluted shares) but at least you're making the effort.

I found your content extremely helpful and will be sharing it with the start-ups that we've invested in at OpenView!

Best,
Vic Mahillon
OpenView Recruiter

searchquant said...

Very under-discussed topic, thanks for writing this post. I'm interested in quantifying the extent of information asymmetry between non-founding startup employees and founders/VC's, and so put together the below survey. So far with 15 responses, it's clear that the majority of startup employees are far less than informed when it comes to startup equity and how to maximize it:

http://www.surveymonkey.com/s/CTL3V93