Why do startups have an exponential drop-off in equity for employees?
I've never heard a reasonable explanation of why there should be exponential drop-off in equity compensation based on joining time in a startup (vs. linear, for example). Obviously you need some time function to push prospective employees to make the jump when they are earning below-market salary, but is there a good reason why the drop-off is often exponential?
3 Answers
Mary Russell, Attorney, Stock Option Counsel to ind... (more) Attorney, Stock Option Counsel to individual employees and founders in maximizing and monetizing startup stock and options5 upvotes by Mike Townsend, Lexie Kier, Dan Walter, Jordi Valls, (more)Loading...
The Gray Area -- Revealed!
This is a great question because it reveals a truth: The difference between a founder and an early employee is gray, not black and white. There is not a true difference that would allow an exponential difference to be appropriate.
A Thinking Trick
It is very useful for an employee to reverse the exponential drop logic the company may use -- how much more than zero should this "employee" receive -- to acknowledge the gray area by thinking along the lines of "How much less than a founder should I receive?" While it is unlikely for an employee to come in at close to founder level, that should be ideal starting point to work from in your mental calculation of what is appropriate and will inspire you to perform at a founder level.
Founder Delusions
And remember that founders are notoriously delusional about how soon they will be funded, so don't drink the Kool-Aid. I see companies try to grant employee-level equity before a funding on the promise that they are "just about to be funded." They promise salaries that will be "deferred" until funding and try to bring on "first employees." If you're not getting paid today, you are not at an employee's level of risk. Be sure you are granted founder-level equity if you have founder-level risk.
Stick to Percentage in Negotiations
On a geekier note, the emphasis in this conversation should be on % ownership in the company, not the form of equity. Founders usually receive "restricted stock," and employees receive "stock options," but don't get caught up in those distinctions. The % is what's important.
This is a great question because it reveals a truth: The difference between a founder and an early employee is gray, not black and white. There is not a true difference that would allow an exponential difference to be appropriate.
A Thinking Trick
It is very useful for an employee to reverse the exponential drop logic the company may use -- how much more than zero should this "employee" receive -- to acknowledge the gray area by thinking along the lines of "How much less than a founder should I receive?" While it is unlikely for an employee to come in at close to founder level, that should be ideal starting point to work from in your mental calculation of what is appropriate and will inspire you to perform at a founder level.
Founder Delusions
And remember that founders are notoriously delusional about how soon they will be funded, so don't drink the Kool-Aid. I see companies try to grant employee-level equity before a funding on the promise that they are "just about to be funded." They promise salaries that will be "deferred" until funding and try to bring on "first employees." If you're not getting paid today, you are not at an employee's level of risk. Be sure you are granted founder-level equity if you have founder-level risk.
Stick to Percentage in Negotiations
On a geekier note, the emphasis in this conversation should be on % ownership in the company, not the form of equity. Founders usually receive "restricted stock," and employees receive "stock options," but don't get caught up in those distinctions. The % is what's important.
Dan Walter, I have worked with start-ups since th... (more) I have worked with start-ups since the mid-90's. I provide assistance in compensation philosophy, design, implementation and communication. If you need to fix your compensation or create compensation for your long-term success I can help. You can also follow my compensation-related blog postings 3-4 times a month at www.compensationcafe.com.2 upvotes by Mary Russell and Brian Dominick
There is another component to this issue.
What type of key initial employees are needed to ensure success?
It may take 7-8 "stars" to get a company to a point where VCs or other funding sources are ready to provide real financing. These stars are often expensive when it comes to equity. You may see 15% of the company dedicated to the first 10 employees, when only 20% of the company can ever be given away. (20% is not a hard fast rule, it is just used here as an example).
It is also a simple fact that many companies put their equity plans in place as a result of there first dealings with big Angels or VCs. These investors often have a basic formula that they feel has worked before. The founders might not have had any experience in this area so they follow the lead of the investors. The investors show market data (usually from their own client pool) that shows similar numbers. It can be a self-fulfilling prophesy. The laws of averages and desire for simplicity push companies to adopt equity distribution slopes that may not be in their specific best interests. If you are company that may require 500 employees to get to an exit, your equity slope should look different than that of a company that may only require 85 employees to get to an exit.
There are many good reasons to avoid the steep drop, but it can be hard for companies to get the right advice when they are getting direction only from those who will benefit from the legacy approach.
What type of key initial employees are needed to ensure success?
It may take 7-8 "stars" to get a company to a point where VCs or other funding sources are ready to provide real financing. These stars are often expensive when it comes to equity. You may see 15% of the company dedicated to the first 10 employees, when only 20% of the company can ever be given away. (20% is not a hard fast rule, it is just used here as an example).
It is also a simple fact that many companies put their equity plans in place as a result of there first dealings with big Angels or VCs. These investors often have a basic formula that they feel has worked before. The founders might not have had any experience in this area so they follow the lead of the investors. The investors show market data (usually from their own client pool) that shows similar numbers. It can be a self-fulfilling prophesy. The laws of averages and desire for simplicity push companies to adopt equity distribution slopes that may not be in their specific best interests. If you are company that may require 500 employees to get to an exit, your equity slope should look different than that of a company that may only require 85 employees to get to an exit.
There are many good reasons to avoid the steep drop, but it can be hard for companies to get the right advice when they are getting direction only from those who will benefit from the legacy approach.
Equity compensation is a form of reward that's associated with a clear risk - the risk of company failure. That risk declines over time non-linearly. I would argue that it's actually more of a step function -- at various stages of a startup's timeline the business gets more and more validated at clear milestones, and the risk associated with the business declines steeply at each milestone. The founders and early employees at a startup carry tremendous risk compared to those joining after a product has been developed and there's been a funding round, and they in turn carry much more risk than someone joining after there's revenue traction. The differences in equity compensation are often orders of magnitude between founders and employees, and between very early employees and those who join later.
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