Equity value

Warren Buffet once said:

Buy into a business that’s doing so well an idiot could run it, because sooner or later, one will.

This is a useful way to understand the meaning of “equity value”. You learn in finance that equity value is the overall value of a the stock (i.e. equity) of a business, which in turn is the present value of all future profits. Of course with startups the future is extremely uncertain, leading to a huge variance in valuations.

In perfectly competitive markets, all profit margins tend toward zero. So equity value is a function of the degree to which you can make your market inefficient by making your business hard to copy (so called “defensibility”). If your defensibility depends solely on having superior people, you have what VCs call a “service business.” In a competitve labor market, service businesses tend to have low margins and therefore low equity value. A popular saying about service businesses is “the equity value walks out of the building every night.”

Different types of tech businesses exhibit different relationships between capital, revenue, profits, and equity value. Enterprise software companies tend to require lots of capital to get to scale but command high equity values once they do, partly because enterprises are risk averse and like to adopt the most popular technology, leading to winner-take-all dynamics. Adtech companies tend to be quick to revenue but slower to equity value, and sometimes risk becoming service businesses. The equity value of consumer internet companies vary widely, depending on their defensibility (usually networks effects and brand) and business models (e.g. transactional vs ad supported). Biotech companies require boatloads of capital for R&D and regulatory approval but then can generate lots of equity value, with the defensibility coming primarily from patents. (Patents introduce market innefficiencies, but, proponents argue, are necessary to create sufficient incentives for entrepreneurs and investors). E-commerce companies generally require a lot of capital as well, since their defensibility comes mostly through brand and economies of scale.

The risks of being a small investor in a private company

With the passage of the JOBS act, it seems that many more Americans will soon be able to buy equity in private companies. I am no expert on the law, but I have been investing in private companies for about a decade, and during that time I’ve seen many cases where large investors used financial engineering to artificially reduce the value of smaller investors’ equity. Here are a few examples.

1) Issuing of senior securities with multiple liquidation preferences. Example:

Series A: Small investor invests in $1m round, getting 1x straight preferred

Series B: Large investor invests $10m, getting 4x senior straight preferred

Company gets sold for $30m. Management gets $3m carveout, Series B investors get $27m, and Series A investors get zero.

2) Issuing of massive option grant to management along with new financing at a below-market valuation. Example:

Series A: Small investor invests in $1m round, getting 1x straight preferred for 10% of the company.

Company is doing well and is offered a Series B at a significantly higher valuation. Instead, large investor invests $5m at below-market valuation, getting 40% of the company, and simultaneously issues options worth 50% of the company to management.

Result: Series A investors are diluted from 10% to 1% of the company, even though the company was doing well and in a normal financing would have only been slightly diluted.

3) The company is actually multiple entities, with the smaller investor investing in the less valuable entity. Example:

Company has entity 1 and 2. Small investors invest in entity 1 that licenses IP from entity 2. Value of IP increases and entity 2 is sold and eventually cancels entity 1′s license, making entity 1 worthless.

4) Pay-to-play or artificially low downrounds. Example:

Series A: Small investor invests in $1m round, getting 1x straight preferred

Series B: Large investor invests $10m in pay-to-play round (meaning any investor that doesn’t participate has their preferred shares converted to common). Smaller investor doesn’t have the cash to re-invest in Series B, but deeper pocketed investors do.

Company sells for $10m. Series B investors get $10m. Series A investors get nothing.

There are ways to protect against these shenanigans. Protections can be written into the Series A financings documents (pro-rata rights, ability to block senior financings, etc). There are also some legal protections all minority investors are granted under, say, Delaware or California law. But usually even when these protections exist (and they exist far less frequently these days than in the past), smaller investors usually can’t, say, invoke blocking rights by themselves (indeed, it’s often not economically viable for smaller investors to hire lawyers to review every financing document for every company they invest in). Another way smaller investors can protect themselves is to set aside capital amounting to, e.g. 30% of every investment made, in case they need it later for defensive purposes (I do this). But in my experience this is all very complicated and difficult to execute in practice, even when the small investors are “professional” investors. I worry it will be even harder for “amateur” investors to protect themselves.

Owning equity in your company should be as common as owning equity in your home

What belongs in common to the most people is accorded the least care: they take thought for their own things above all, and less about things common, or only so much as falls to each individually. – Aristotle *

A major policy goal of capitalist countries in the 20th century was to encourage home ownership. It is widely believed that owners take better care of their homes than renters as they have much more at stake financially. There is also evidence that home owners are happier, healthier, and participate more in civic and political life.

The desire to create an “ownership society” led to some smart policy decisions like the mortgage tax deduction and some bad decisions like hazardously low interest rates that contributed to the housing bubble. Home ownership is a noble goal even if home ownership fueled by excessive debt can be disastrous.

Entrepreneurs figured out a long time ago that the benefits of having equity in your company are similar to the benefits of having equity in your house. Silicon Valley expanded this concept by making it standard to grant equity to non-founder employees. It’s no coincidence that Silicon Valley continues to innovate and create jobs while the rest of the economy is stagnant.

Some people think we are in a startup bubble, and that once the bubble bursts people will run back to the supposed safety of non-startup jobs. I’d prefer to think we are at the beginning of a movement to create a true ownership society, where people own stakes not just in their space but also in their time.

Question from a reader

I’ve gotten some emails recently from readers of this blog with questions about early stage startups.  I’m sorry if I haven’t responded to all of them yet.  I’m happy to try to answer questions but would generally prefer to do them on the blog so they can be shared/discussed.

Here’s one I got recently:

So you’re joining a startup as one of the first, or the first, non-founding members.  At the moment, the company generates little or even no revenue, but they do have a working first version of their product and a few early users.  To this point the company has been surviving on a modest amount of “friends and family” capital, which has largely been used to support the founders as they built the company and their product.  The founders, however, are convinced that a significant investment is imminent and you will be receiving a reasonable salary in short order.  They are equally certain that their product and their plan is ready to take off.

Determining a fair equity grant at this time is tricky enough; there seem to be far fewer established norms and guidelines for determining compensation in a pre-investment startup than there are following such a milestone.  To further complicate this situation, fast forward 6, 9, even 12 months into the future.  That “imminent” investment has not yet materialized and you have yet to receive any salary (though perhaps the founders have continued to subsidize themselves from the earlier friends and family investment).  The original product has been slow to build traction.  The product has undergone significant upgrades, and one or more new products have been developed, all with your input and assistance.

At this time, both sides decide to sit down and more formally address the issue of your equity grant, but by now the boundaries of your role have become even more blurred than when you first joined the startup.  To be sure, you are not one of the founders, but it seems the founders were not as far along as they believed when they brought you in.  Of course both sides are still likely to overvalue their contributions, so what guidelines and norms can you and the founders possibly look to in order to reach a fair and reasonable agreement on your equity grant?

Honestly, I’m not sure my top worry would be my equity grant at this point.  If I understand correctly, you’ve been working for a year with no written equity grant, no salary, for a company that has gotten little traction, and for founders who were way overly optimistic about their chances of raising money…? (perhaps even misleadingly so?)  I guess if you really love the vision or have no other options then you stay, but otherwise I’d recommend looking for a new job.  At an absolute minimum you should be given an option grant in writing ASAP, and I think that given your sacrifice and the uncertainty of raising any money beyond friends and family that grant should be significant.  If your skills are as important to the company’s as the founders, I’d say it should be at or around founder level.

I worked for a startup once where my equity grant wasn’t in writing.  Needless to say, when the company was sold, I got nothing.  Always, always get your equity grant in writing. Quality entrepreneurs will simply give you your grant in writing without you even needing to ask.

Thales the Milesian

Like a lot of things we think are obvious today, financial options were first invented by a philosopher:

There is the anecdote of Thales the Milesian and his financial device, which involves a principle of universal application, but is attributed to him on account of his reputation for wisdom. He was reproached for his poverty, which was supposed to show that philosophy was of no use. According to the story, he knew by his skill in the stars while it was yet winter that there would be a great harvest of olives in the coming year; so, having a little money, he gave deposits for the use of all the olive-presses in Chios and Miletus, which he hired at a low price because no one bid against him. When the harvest-time came, and many were wanted all at once and of a sudden, he let them out at any rate which he pleased, and made a quantity of money. Thus he showed the world that philosophers can easily be rich if they like, but that their ambition is of another sort.

– Aristotle, Politics, Book 1, Part XI