A Better Startup Equity Plan
If you’ve ever negotiated a job offer at a startup, you’ve likely encountered the inevitable discussion about equity. Essentially, prospective employees are offered ownership interest in the nascent venture in exchange for a lesser salary than they might otherwise receive.
At this point, ubiquitous examples are called to mind, wherein a similar early-stage employee of Facebook or Google is now luxuriating upon the deck of some yacht off the coast of Monte Carlo. This, of course, is little more than availability bias run amok, as for every FAANG company, there are tens of thousands of others for whom the equity held by employees lost all value.
This is why a little back-of-the-envelope math is required to calculate what your equity is worth.
Distorting an old adage, “if a company fails in the digital age, and no one is there to write an article about it, does anyone notice?”1
The old startup equity model
Recently, startup employees have begun to lament the fact that, in most cases, the equity they received is valueless, and the salary they might have received instead would have served them far better. This leads to the perception that, to some extent, equity can feel like a scam.
Jane Q Saeio founds a startup focused on underutilization of greek letters for specifying angles in high school geometry classrooms. She names her outfit HypoThetacal Corp. A venture capital firm offers her $10M in exchange for 10%. At this moment, back-of-envelope math suggests that HypoThetacal is worth:
Then, Jane Q Saeio finds a sarcastic data scientist and offers him a $100K salary and 0.2% equity. John Q geek is acutely aware of what the VC has invested, so he calculates the value of his equity as:
Of course, Jane Q doesn’t just cut John a check for $200K, this equity contains a four-year vesting period. So if dear John writes a Dear Jane letter and departs to work for John Deere, he loses his equity. To imitate famous salesmen2, “but wait, there’s more!”
What “equity” actually means
Jane doesn’t actually hand John equity in most cases. She’s actually handing John some options, which grants him the right to buy at the fair market value when the contract is struck.3 As an example, let’s write a contract that says, “you may purchase one share of HypoThetacal, for $100, at any point in the next year.”4
Right now, exercising that option achieves nothing - you’d buy one share for $100, which theoretically could be sold (if you could sell it) for $100. You bought a $100 item for $100. Woohoo. However, if, a few months from now, HypoThetacal’s stock is trading for $110, your option now allows you to buy a share for $100, then turn around and sell it for $110, netting you $10 excess with no risk. If, at that time, the stock is trading for $90, that option is worthless. You could buy a share for $90 on the open market, so what good is a contract that lets you buy one for $100?
But HypoThetacal is not publicly traded, so even after four years, John could exercise his options (and buy shares at $100), but to sell the resulting shares he would still need to await an IPO5, a sale, or some other “liquidity event.” Jane will tell John that $200K in options over four years is like an additional $50K of salary (200/4) with considerably greater upside because the equivalent salaried professional earning $150K lacks the opportunity to become unspeakably wealthy. But those options aren’t equity. On paper, the day the contract is signed, they’re worth $0.
What actually happens
Let’s say John, on day 1, received 20,000 options, when the fair market price was deemed to be $10. The strike price was set to $10 to avoid taxation. That’s “$200K of options.” (that the IRS values at $0) Now, the years have passed, an IPO occurred (bells were rung on various exchanges on CNBC, etc), and the stock now trades at $30 per share. Sure, John would love to buy 20,000 shares for $10 a piece, then turn around and sell ‘em for $30 a piece, netting $400K for his efforts. Ah, but in some rather grotesque cases, he’d better be able to come up with $200K first6...and many such employees cannot, and their options expire. That’s right, he might not be rich enough to become rich, however incongruent that sounds.
On top of that, John has all of his eggs in one basket. And most of the time, that basket is dropped. A circumspect John doesn’t like his odds.
Our Agency Increasing Alternative
AE has developed a unique model, putting its faith in its clients, its employees, and the skunkworks projects it incubates. We expect our employees to treat skunkworks and client work alike as if they are founders, hustling and taking pride in every element of the process - and our new model aligns compensation with that expectation!
What does AE offer? Rather than equity in AE itself, we take equity from the clients whose MVPs we help assemble, who we help raise their next round, and for whom we augment enterprise-grade software. Also, the skunkworks projects, mostly startups we incubate internally ourselves (same upside, less ramen and air-mattress life) provide AE another orchard of equity whose fruit we await and already led to a successful exit! Those chunks of equity are then conferred to our employees as “profits interests.” Let’s walk through an example of those too.
The new, AE model
To illustrate just how cool this could be, let’s start with another quick example from basic finance:
Imagine a company helping weightlifters return to normal proportions after retirement. We’ll name it ExAmple LLC. ExAmple is worth $10M (like HypoThetacal). We hand you $200K in profits interests (0.2%). Now, when ExAmple LLC distributes profits in excess of the threshold value (fair market value when the employee receives the profits interests), you’ll receive 0.2% thereof. If ExAmple balloons, you’ll get fat in the best possible way. If ExAmple goes belly-up, those profits interests are worthless, but so what? You don’t lose anything because you’ve never purchased a share.
If an exit is delayed (the founders don’t want to sell or take on new shareholders), but the company generates increasing profits, you get paid. With options, no exit means no money.
AE’s employees receive their equity, not as illiquid options, but rather profits interests at the current price. Functionally, it’s not “equity in the future” it’s “equity today.” If the company generates profits from a liquidity event tomorrow, above the current allocations to owners, you get paid. Simple.
Comparing the old and new models
Let’s play a game. How much is $200K in options in HypoThetacal worth, given that they do not vest for four years, and cannot be sold even then without some liquidity event over which the shareholder has minimal control and some serious up-front expense? The correct answer is “I don’t know, but clearly much less than $200K.”7
But when you sign your name on the offer sheet, you can bet your bottom line, your bottom dollar, and your bottom that the options offered will be used to offset a non-trivial quantity of potential salary (and probably discussed with candidates as if they’re somewhat interchangeable). Founders are necessarily optimistic about their idea, which unfortunately, gives them incentives to delude prospective hires about the value of the equity offered as they are deluding themselves. VCs are optimistic about startups in general. The IRS is, if and only if it doesn’t favor you. And as a final fork-in-the-eye, when you exercise those options, the profits you obtain will probably8 be taxed as ordinary income.9
How much is $200K worth of profits interests in ExAmple’s worth? The correct answer is “I don’t know, but clearly more than $0.”10
And to be clear, AE’s employees aren’t holding one-year’s worth of profits interests, but rather, profits interests with infinite horizons11. So they can hold their $0 cost-basis asset12 indefinitely, until either it withers or blossoms into riches. Moreover, if there are payouts, since the asset has been held for a while, it’s probably capital gains13, which probably means better tax treatment.
The value of diversification - why VCs make fortunes and startup employees usually don’t
AE’s employees, unlike equity-holding startup employees, own stakes in many startups, both internally and externally, all with options and infinite horizons. In other words, AE’s employees have all become VCs, diversifying their portfolios. It is worth noting that 80% of the average VC fund’s returns emerge from 20% of its ventures.14
This is of no concern to a venture capitalist, enjoying returns that historically have outpaced the broader equity market by leaps and bonds. Of course, an employee of one of those less-fortunate startups (or one that never finds VC funding at all) never benefits at all from those returns. AE’s employees can enjoy the optimism, aspiration, and dynamism of working at a tech startup, but also access the returns of VC (e.g. they get paid if any of several startups succeed, not just their own). Investing in venture capital is off-limits to most of us, but not AE employees. All the while, they receive competitive salaries. Sure, most startups fail, but our eggs live in multiple baskets, a few of which will likely gestate spectacularly.15
Why most companies don’t do this
Why doesn’t everyone do this? It’s harder to explain and required hundreds of billable hours of conversation with lawyers and accountants to figure out and implement. Moreover, most startups are conceived as Delaware C Corps. Why? Because that’s what potential investors want to see.16 AE was not founded as a mechanism to attract investors. It was founded as a mechanism to increase human agency and retain extraordinarily talented individuals. It works on both counts and several others.17
Some of you may recall the Stanford marshmallow experiment. Summarizing the psychological conclusions, researchers discovered that perhaps the most predictive trait in determining a child’s future academic and economic success is the ability to delay gratification. In this specific case, eschewing the consumption of a single marshmallow for the promise of receiving a second for their patience.
Would you rather receive a $100 marshmallow today (that is certainly not worth $100, cannot be eaten for several years anyway if ever, and requires some upfront marshmallow purchases before the first bite) or numerous $0 cost-based marshmallow profits interests, some of which might become a Ghostbusters-esque, Stay Puft marshmallow man?
Why we do
At AE we put our money (and our marshmallows) where our mouths are. We believe in our clients’ ventures. We believe in the work our employees deliver on a daily basis. And most importantly, we believe that even when those employees are buried under an avalanche of lucrative marshmallows, they’ll continue to show up to deliver upon AE’s mission.
Perhaps this is the most challenging, daunting, “disruptive” paradigm shift of all. No matter how many marshmallows one consumes, we all want s’more. The material pleasures of financial success lack any mechanism to confer meaning. Meaning is derived from work that serves a broader purpose. An “exit” in silicon valley offers no escape from the human condition.
Successful founders amass luxury vehicles, only to recognize this offers little in pursuit of meaning, often finding their way to nonprofits, space exploration, and other random eccentricities. We believe human agency and its pursuit offers a path to purpose and meaning. And that purpose is worth pursuing even if an employee is already laden with equity-driven-marshmallow-wealth.
We believe that our employees’ campfires will cook the finest marshmallows, in quantities that would dwarf any pre-Halloween CostCo run.18 But even if their daily exertions on AE’s behalf are wholly unnecessary to fill their pantries (perhaps the capitalist idealization of human agency?), delivering that agency to others will inspire their next great idea and inspire them to continue finding meaning in their work. Finding such meaning seeds the next orchard of equity. It is the circle of life, or at least, of marshmallows.
Chances are you have questions about what your equity is worth, and how this might compare to alternative offerings of traditional startups. For more entertaining equations and witty discussion, we encourage you to read this essay!
1
Incidentally, this is why your humble blogger endures a visceral, anguished reaction to the entire genre of honored, graduation-day speakers and award-acceptance monologues wherein some affluent, well-dressed person regales the fawning audience with tales of how they dropped out of school or quit their job impulsively en route to this illustrious occasion. Common sense would suggest that these actions are ill-advised, and most folks who undertake these actions never achieve the status required to deliver a speech offering the counterpoint. But of course, Bob Dylan and Bill Gates dropped out of Harvard, Steve Jobs never learned how to code, and so on...availability bias gets me all riled up. Ever heard a graduation speech from a college drop-out who now flips burgers? Yeah, me neither.
2
Ron Popeil and others of his ilk
3
This is crucial, because if the options could be exercised at a value higher than fair market value, the IRS would (correctly) consider contracts to have value above $0, which would then make them subject to tax. So even if there is some exit event in four years and John can exercise his options, he’s only walking away with money in his pocket if the market price of HypoThetacal on that day exceeds the market price when he signed on. Otherwise, he gets $0.
4
More precisely, this would be an “American” (can exercise the option at any time before expiration) “call” (the contract lets you buy, not sell) option with a strike price of $100.
5
Initial Public Offering. The moment when a privately-held company offers shares to the general public, investment bankers make a truckload of money for facilitation thereof, or a SPAC finds its desired target of acquisition and spawns wholly new acronyms no one understands.
6
It is worth noting that many companies will allow a “net exercise,” in which the difference between the value of shares received and their value at the strike price is conferred to the employee, avoiding the need to make the purchase upfront. Some, but not all.
7
The logic is simple. A $200K set of options of a publicly-traded company is worth $200K. Anything that makes that “$200K” less attractive to own must necessarily decrease the share’s value. And to be clear, an option you cannot exercise for four years (and probably not ever) is definitely less attractive. Moreover, the IRS already believes it’s worth $0, hence you're not paying taxes.
8
You could, theoretically, exercise the options, then hold the stock for a while, at which point, the profits are capital gains...but almost no employee would do this. There are additional nuances between Incentive Stock Options (ISOs) and Non-qualified options...but you’d still need to hold the stock for at least one year, and again, in the real-world, employees are exercising their options, takin’ the cash, and purchasing the finest muffins and bagels in all the land.
9
Your marginal rate is almost assuredly much higher than the capital gains rate.
10
If the company folds, you lose nothing. If it produces profits above a threshold, is sold off, or spun off, you make money. That’s worth something. Given the large, glass buildings in which venture capitalists ply their trades (or the large homes in which they operate in the post-pandemic universe), the something is substantial.
11
If they remain at AE (so take off your coat, which you don’t need in LA, and stay awhile!), though they retain some upon departure (see note below).
12
This turns out to be relevant because an asset conferred with a current value of $0 requires no taxes to be paid. It’s not income...yet.
13
Again, there are some relevant nuances, timing, and commentary reserved for Boardrooms and economics lectures, but who doesn’t want s’mores?
14
Venture capital economics reference
15
Full disclosure, like other startups, if an employee leaves, AE reclaims some of their equity to ensure that new employees can partake. Unlike other startups, the employee retains 20% regardless, and if, perchance, they depart for one of the many companies in which AE owns equity (including one they themselves founded whilst at AE), they keep all the goodies. Moreover, if an internal startup is acquired, and the employee departs to work for the acquirer, they also keep the goodies. Extra incentive to found a startup of your own while you’re here!
16
Making complex accounting simpler, this allows investors to avoid taxation on up to $10M of “qualified small business stock” (QSBS) if certain criteria are met...and most startups are dying to raise money for investors (or dying because they cannot to be precise). Profits interests are only available to LLCs and other partnerships.
17
As an LLC, AE can spin out skunkworks as new companies (taxable in a C-Corp, no taxes in an LLC). AE can sell a venture (like, say, this one), and while the sale of assets is taxable, there’s no double taxation wherein first the IRS taxes the seller for the sale, and then the payouts to the individuals involved for the income.
18
No legal promises are made regarding future wealth of employees, expressed in either monetary or culinary currencies.