Startup Equity Explained: What Employees need to know.
Employee Equity Compensation Ranges, Factors that Determine Equity Value and Liquidation Preferences.
Welcome to Part 3 of the series discussing startup equity dilution decisions.
In Part 1, we discussed some of the basics of equity and shares and dove into some considerations for hiring a co-founder, early employees or advisors. This was followed with an appendix discussing SAFEs and Convertible Notes.
In Part 2, we discussed the type of investors you might encounter, how they view the value of your equity and why everybody is afraid of the dreaded down round.
This post covers how an employee should think about the value of their equity and why any person involved in a startup should understand Liquidation Preferences.
Equity for employees:
The previous posts focused on equity from the perspective of a Founder or Investor. After the Founders of a company, employees personal networths are most influenced by their company’s equity value. In the context of sports, if the Founders are the Coach/General Manager, then Employees are the players. Just like in Professional Sports, you need a good GM, Coach and Players if you hope to be a Dynasty. Since startups do not get to draft or trade for employees, they need a great Founding team that are capable of recruiting strong employees to forgo other offers, often for much more money, to join them. If as an employee you are deciding between joining a startup instead of a larger, more established company, you are almost certainly going to have to accept a pay cut. In the early days of a startup, capital is much more constrained, and the founders are likely trying to maximize the output from each dollar, so even the difference of a few thousand dollars can be consequential. To compensate for the lower salaries, and overall riskiness of the business, employees will be offered stock options, which permit them to earn theoretically unlimited upside, if the business does very well1. There are many positives to joining a startup/early stage company but for the purpose of this article, let’s just focus on the financial considerations.
In Part One, I presented a scenario where a founder was contacted by a recruiter who on top of a competitive salary, said the offer came with 50,000 stock options, that sounds like a lot but how can you figure out what those are worth? Based on the way the recruiter presented you the information, there is no way you could come remotely close to figuring that out. To get a better picture of what your shares are worth, you would need to ask the following questions2:
What does 50,000 shares represent as a total percentage of total outstanding fully diluted shares? The company might not be willing to give you an exact number, but they should be willing to let you know if the total share count is in the millions, tens of millions or hundreds of millions. Even if they tell you that the total share count is between 10-50 million, that would tell you that these 50,000 shares would present somewhere between 0.01-0.5% of total outstanding shares. Based on this, you might be wondering if this recruiter’s offer is insulting. Do they really expect you to leave your startup where you own 100% of the equity, for a measly fraction of 1%? Before deciding that they are rude, stupid or a combination of the two, you should ask the next question.
What was the last round's valuation? Assuming that the last round was raised somewhat recently (within 12-18 months for a fast growing company), this number combined with the ownership range calculated above, can you give a rough estimate of what the value of your options would be at the time of the last financing round. Assuming that market conditions have not deteriorated and the company is growing quickly, this assumed share value might already be conservative. They likely won’t give you specific details around the valuation multiple that they raised at but you can probably get some idea of the revenue when the last round closed. With last round’s valuation, you can get a rough idea of how big the multiple was at the time of the raise, and how likely the company can justify this valuation.
What is the current option strike price? They will need to provide you with this information in your offer letter. The strike price is simply the price you will need to pay to exercise your options to convert them into common shares. This is generally when the company is acquired, goes public or when you depart the organization. The strike price is determined by a 409A valuation, which is conducted by a 3rd party company that tries to value a common share at the time the exercise is conducted, based on the performance of the company, the company's capital structure and market multiples. The higher the strike price, the higher your company needs to sell for, in order for you to earn money on your options (since you only profit by taking the difference between the price per share you receive at exit and your strike price). Once granted, your strike price will not change, therefore you need to believe that there is significant upside from the moment you join for you to earn anything from your shares. Generally, the equity value of the company and the strike price move in the same direction, but the strike price is a lagging indicator. In the investor section, we discussed why a company’s valuation can drop between investment rounds and why this is bad for investors. As an employee, this could be potentially disastrous if you join at the wrong time3. An ideal situation is a large gap between the strike price you are granted and the price per share at the latest funding round. Assuming no down rounds, generally the later you join, the higher your strike price, which can make it unfavorable to join companies that are already very highly valued.
How much money have they raised to date? While generally funds raised and high valuations are positive signals, if the company cannot sustain high growth and capital efficiency, it will actually work against your equity value when it’s time to exit. The reason being, that your investors always get paid their money back first. If your company cannot exit above the amount of capital that has been raised, there will be none left for the Founders or Employees. This is because of something called a Liquidation Preference.
When investors put money into a startup, they earn something called a liquidation preference. A liquidation preference means their money must first be returned before anybody else gets paid. There are different mechanisms but the general principle is Last-In-First-Out (LIFO for the accounting folks). The later investors generally have to pay the highest price for their ownership, therefore they are entitled to receiving their capital back first. This goes all the way down the line, until all investors are re-paid. Common shares, held by Founders and Employees, are unfortunately at the end. This is why, if your company has raised a lot of money, it might be difficult to realize what you expect your equity to be worth. If your company raised $250M, but then gets acquired for $900M, everybody will be happy. The proceeds from the sale easily cover the invested capital, so everybody will share in this $900M. If the company sells for less than $250M… people are going to be very disappointed (see Liquidation Preferences examples below). As an early stage employee, you are likely not going to know what type of terms your VCs have but in general, be wary if your company has raised big money, at huge valuations, followed by a down round at a time when capital is scarce. If so, even in the event of an exit, the value of your equity will be far less than what you would expect.
The short of it is, if you want to see a good financial return on your stock options, you need to believe that your company will become much more valuable in the future. Whether your liquidation event comes through an acquisition, a public listing or a secondary sale, your hope is that the “fair value” price of your company’s shares deviates far above your strike price.
Liquidation Preferences:
Liquidation Preferences are generally 1X (investors get 1X their original invested capital), however if your company is trying to raise at an especially difficult time in the market, Liquidation Preferences can go as high as 3X (higher than that is mean). If your investors have a 3X liquidation preference, it means they get 3X their money back, before the next investor gets theirs. Shockingly, Founders and existing investors don’t like this. Your company is only accepting this because there are no other offers. To further complicate things, Liquidation Preferences can also carry participation rights. This means on top of receiving their money back first, they get to double dip by first getting their initial investment back and then get their share of the remaining proceeds. Liquidation Preferences without participation rights cap forces the investor to decide between earning their share of the proceeds or just receiving their initial investment back (which they would only do if their equity value at exit would be less than the capital they contributed).
2 Quick Examples:
A company sells for $10M. The last investor put in $5M, owns 30% of the company and their shares carry a 1X liquidation preference with participation rights. The early stage investor invested $2M, owns 20% of the company and has a 1X liquidation preference with no participation rights. The founder owns the remaining 50% of the shares. The $10M would be allocated as such:
$5M to Last Investor
$2M to Early Investor
The remaining $3M split between Founder and Last Investor (since the early stage investor invoked their non-participating liquidation preference).
Since the early investor cannot participate if they invoke their Liquidation Preference, their 20% ownership is not factored into the remaining funds. Investor 1s share increases from 30% to 37.5% ( 30%/ 80%) and the Founders Shares Increase to 62.5% ( 50%/ 80%). The founder will get $1.875M ($3M * 62.5%), while the Last Investor gets an additional $1.125M on top of the original $5M. If the Early Investor chose not to invoke their Liquidation Preference, they would have only earned 20% of $5M, and gotten $1M.
A company sells for $10M. The last investor put in $5M, owns 30% of the company and their shares carry a 2X liquidation preference with participation rights. The early stage investor invested $2M, owns 20% of the company and has a 2X liquidation preference with no participation rights. The founder owns the remaining 50% of the shares. The $10M would be allocated as such:
$10M to Last Investor
$0M to Early Investor
$0M to the Founder
The Founder and the Early Investor angrily egg the Last Investors house, the Last Investor does not notice because they are in a different home that they just bought with the $10M they got back from the exit.
This concludes the series on startup equity. If you enjoyed this or found it helpful, please comment or subscribe to let me know. Otherwise share with friends, colleagues or anybody else you think might benefit from the ~10,000+ words split over 4 posts.
Publicly traded companies will sometimes offer employees restricted stock units (RSUs), but unlike stock options, RSUs are considered taxable income as soon as they begin vesting whereas stock options are tax deferred.
Companies won’t normally share all of this information, but you can often figure out some of the information by reading public funding announcements as well as the offer letter.
Employees at WeWork who joined after the big funding rounds, had worthless equity, since the company went public via SPAC, at a much lower valuation. Fintech startup BOLT convinced employees to take out loans to buy their options at a peak valuation above $1 Billion dollars at the height of the Fintech boom, about a year later, it was evident that the company would not be able to raise near that valuation for some time.