One things I’ve noticed over the years is that equity grants given to new employees soon after Series A financings are generally a bad deal for those employees on a risk/reward basis. (By a Series A financing I’m referring the first round of funding by VCs, where the amount raised is roughly $2M or more).
Here’s how equity is often granted from the very beginning of a company’s formation:
1. Founders decide on mostly equal split over beers. It’s all just scribbles on a napkin at this point so equity flows freely.
2. In the cold light of day, founders renegotiate, with some founders possibly getting (significantly) more than others.
3. Employees who join pre-funding get reasonably big equity grants.
4. Series A financing occurs.
5. Suddenly equity grants to new employees are sliced an order of magnitude or more from what they were prior to Series A.
(Also, toss in there along the way one founder gets disgruntled and leaves – see founder vesting).
The problem is a Series A financing usually de-risks the company far less than the equity grants drop. If I had to graph this in a totally unscientific way it would be like this (for successful companies – as represented by the green line going straight up):
Why do the equity grants drop so much after initial VC financings?
1) There are well established norms for post VC equity grants. Going against them generates a lot of resistence from VCs. By way of example, here are directionally accurate although probably 2x what I have typically seen post Series A.
2) Compounding this, after a financing the founders probably just got finished arguing for a smaller option pool to reduce their dilution, and it’s seems very hypocritical after that to argue for greater-than-standard equity grants.
3) The company now has an arms length valuation, probably in the multi-millions of dollars. Suddenly 1% is worth “real money.”
The best time to join a company is at the very beginning – to found or co-found the company. The second best time is to join before venture financing. The third best time is when the company has started to ramp sales/traction – at that point your equity grant will be small but at least the company will have a much higher likelihood for success. The worst time, from my experience, is right after initial (Series A) VC funding.
The flip side of this argument is after the company raises venture financing, an employee is more likely to get a “market” cash salary. Personally I’d rather see people get bigger option grants post Series A and sub-market (or better yet subsistence) cash salaries – until the company is cash flow positive. This is pretty much the opposite of Wall Street’s compensation schemes. To me, as a principle, that means it’s probably a good idea..
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As much as I love this post, the word “worst” here is a bit too harsh to me.
Consider: how many people would agree that LV is the “worst” handbag in the world because its price/quality ratio goes out of proportion with other commodity peers?
Joinging after an A round provides some sense of security and this little psychological assurance can be worth a lot to many even if the more quantitative analysis behind could go slightly counter intuitive.
the earlier you join the better. that said, joining after A is definitely better than after B or C or further rounds.
@jerry Chris’ analysis is bang-on: option grants to employees immediately post-A are a *lot* smaller than the risk indicates they should be. if you want the (perceived) security of market salary with some upside, you’re probably better off joining a company that has traction and is ramping up sales with a proven and repeatable process instead of an early-stage startup.
@chris thanks for this. you’ve posted some great stuff lately, please keep it up!
Jerry – Perhaps you are right and the word “worst” is off. I am mainly just arguing for less of a drop off in equity grants post Series A (and lower cash salaries).
Alex – I’d agree that joining after the B & C is a bad time if the company isn’t “ramping” yet. What I was trying to argue is that sometimes the smaller equity grant is made up for post B & C by this ramp. E.g. joining Google in 2003, Facebook in 2006, Twitter in 2008 – in all cases you’d get a sliver of equity, but at least they are highly likely a winner.
[...] Chris Dixon: The worst time to join a startup is right after it gets initial VC financing [...]
No doubt that from purely a risk/reward equity basis right after the A is the worst time. The VCs didn’t really validate the product (customers do that), they just provided runway/resources.
That said, people shouldn’t overengineer their entry-points to the detriment of a good idea. What is in short supply is amazing teams executing against amazing market opportunities. If you are building that as a founder, awesome.
But, if you have a friend who just closed a Series A and you think it’s an amazing opportunity, get on board and help him/her out! That is much better than working an idea you are moderately excited about but is your own, simply for the equity math.
Nabeel – agree. Great team is much more important than optimizing timing. My point is more in general that the compensation is out of wack post initial VC financing. As readers of my blog are probably aware, I am also partial to lower salaries. I think >$100K salaries at unprofitable companies are a bad idea unless a person absolutely needs it to live because of prior financial commitments (mortgage etc).
You’re an entrepreneur, which means that your risk profile is high. Mine too! That’s why we’re leading companies, not joining them.
I look at our current economy and see instability everywhere, which has made me even MORE risk tolerant. Being in an entrepreneurial company that’s trying to do something new and/or differently seems safer than almost anything else, but few people seem to share that perspective.
Most people just aren’t cut out for the inherent instability of an early-stage start-up, and the lousy economy has many people clinging that much more tightly to what they know.
You said:
“I’d rather see people get bigger option grants post Series A and sub-market (or better yet subsistence) cash salaries… This is pretty much the opposite of Wall Street’s compensation schemes.”
It’s not just Wall St that’s in opposition to that, it’s most people looking for jobs. Jobs are scarce to begin with right now, and there aren’t a lot of companies getting funded. A gig at a post-A start-up that provides a stable salary + any potential upside at all is definitely more appealing to lots of people, especially those w. family obligations, etc.
People who join pre-A are buying into a company’s vision and sharing risk with the entrepreneur. The assumption is that they’ll work hard to get the company to a stage where it’s fundable and/or profitable. Taking on that risk and responsibility is a huge commitment, one that’s hard to graph.
Why do the equity grants drop so much after initial VC financings? i would suggest:
4) founder hubris
often, having taken it to the point that they are now able to secure series A funding, founders tend to overvalue their importance / skills for continued success. the logic now becomes “the best of the rest (for the least equity)”. instead, if founders (who have the majority say in this matter) have a longer view of the “start-up” period, and are more generous in granting equity to post series A hires, they might attract better talent and more quickly create value. also another overlooked fact is that pre Series A, a startup may just have lower access to talent because of lower visibility. therefore often times, pre Series A hires/co-founders are restricted to your friends, loose network..this expands greatly when you raise Series A, gain new networks, greater visibility etc.
kartik – good points, especially about founder hubris.
JB – Remember that we are talking about a very rarified part of the economy here. Most managers at startups make well over $100K. My philosophy is that these people should themselves be entrepreneurial enough to take some real risk – even post Series A. I think among other things it makes the company more likely to succeed.
I think you are exactly right — this has been my experience at multiple startups.
A reasonable solution is to allow new post-series A employees to get more equity if they take a lower salary. I like to lay out a range of option/salary tradeoffs and let them pick the point they’re most comfortable.
BTW I don’t hold it against people if they pick salary over options. The important thing is that they be comfortable with what they choose.
I think you are also missing that once you are funded you actually pay employees a realistic salary. Everyone else is working for nothing. Often after the series A the founders are working for just ‘rent money’ not a real salary.
“Personally I’d rather see people get bigger option grants post Series A and sub-market (or better yet subsistence) cash salaries – until the company is cash flow positive. This is pretty much the opposite of Wall Street’s compensation schemes.”
In theory this is great, but the problem with this is that typically, the smartest/most capable/most talented individuals go where the money is, within whatever industry they’re in. I personally think human capital should be valued at whatever it’s worth -> employees should be paid at least at market salaries, AS WELL as with favorable options packages.
I’ve met a lot of entrepreneurs, but even the smartest are usually barely on par, intellectually/analytically/etc, with average/mediocre hedge fund analysts (just from my own personal experience). There is a reason for this; make startups more compelling for smart people to join; value human capital at its intrinsic worth, and pay accordingly; after all, that’s what the VC money is for half the time, right?
brad – the idea that startup people are less intelligent that hedge fund people is just silly. the people i know and work with are top engineers from top schools who turned down working at hedge funds because they wanted to create things of real value instead of just shuffling money around.
you also completely misunderstand my point about comp. the point is genuine risk takers are willing to only make money when they create something of real value (by taking equity), instead of end of year mark to market profits and the other nonsense that goes on at hedge funds, investment banks etc.
[...] cdixon.org / The worst time to join a startup is right after it gets initial VC financing – equity grants given to new employees soon after Series A financings are generally a bad deal for those employees on a risk/reward basis. [...]
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[...] So, you’re looking to join a small company. Guess when the worst time to join it is? It’s right after VC funding. [...]
I wrote a related article on at what stage executives should join startups. You can read it at:
http://www.fabricegrinda.com/?p=828
Great point and one I’m going to pass along to Prof. Noam Wasserman at HBS who does research on this using a giant database of venture / pre-venture funded companies (CompStudy).
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