The one number you should know about your equity grant

The one number you should know about your equity grant is the percent of the company you are being granted (in options, shares, whatever – it doesn’t matter – just the % matters).

Number of shares:  meaningless.

Price of shares:  meaningless.

Percent of the outstanding option pool:  meaningless.

Your equity in relation to other employees:  meaningless.

Strike price of options: meaningless.

The only thing that matters in terms of your equity when you join a startup is what percent of the company they are giving you.  If management tells you the number of shares and not the total shares outstanding so you can’t compute the percent you own – don’t join the company! They are dishonest and are tricking you and will trick you again many times.

I find it really depressing how often employees, especially engineers who are so smart about other mathematical issues, don’t get this.  I felt forced to post this after talking to a friend today who told me about how a prominent NYC startup has been telling hires the number of shares they are granted but won’t tell them the percent those shares represented (“it is company policy”), or the number you need to compute the percent – the total outstanding shares.  It’s really amazing people are getting away with this simple and incredibly cynical trick.

I’ve seen many companies “split the stock” 10-1 so that instead of, say, 10M shares there are 100M shares outstanding so the absolute number of shares granted sounds really big to naive hires who don’t understand that all that matters is the percent they own.

I think every engineering school in the country should have a week-long course on the basics of the capitalization of startups.  There are other things that matter too, but far less (like the number of preferences outstanding).   I’ll try to write about these other things in later posts.

Engineers – here’s how equity is paid out in a normal company sale/IPO (assuming a “good” outcome – in the downside cases it’s more complicated as investors have preferences which act like a max() function).  You get the percent you own multiplied times the price the company was sold for (or the market cap after IPO).  That is why percent ownership is the only equity number that matters.  Don’t work for someone who tells you otherwise or won’t tell you what percent you own.

The worst time to join a startup is right after it gets initial VC financing

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..

Dividing equity between founders

A friend asked me recently if I knew of any good guidelines for dividing up equity between founders, and specifically what to do in the case when a co-founder provides seed capital.

The truth is I don’t know of any great guidelines – this is seems to me a very case-by-case decison.

Obviously the main consideration should be the relative importance of each founder to the future prospects of the venture.  And, as in any negotiation, the alternatives each person has will also factor in.

Probably way too many founders divide things evenly just to avoid a difficult conversation.  Most likely, this will lead to a difficult conversation down the road (or worse).

(As an aside – you should also figure out titles early on.  When founders say “we are co-CEOs” or “we don’t have titles” that more often than not means there is a big fight looming.  Startups are little dictatorships for good reason.)

One thing I’ve also noticed is people tend to overvalue past contributions (coming up with the idea, spending time developing it, building a prototype, etc) and undervalue future contributions.  Remember that an equity grant is typically for the next 4 years of work (hence 4 years of vesting).  Imagine yourself 2 years from now after working day and night, and ask yourself in that situation if the split still seems fair.

Another consideration is if one founder has had greater career success and will therefore significantly improve the odds of getting financed at an attractive valuation.  One way to figure out how much this is worth is to estimate how much having that founder increases your valuation at the next financing and then, say, split the difference.  So if having her means you can raise $2M by giving away 30% of your company instead of 40% of your company, let that founder have an extra 5%.

If one founder had the idea for the company, it is sometimes reasonable to give that person additional equity.  If that idea involves a bona fide technology breakthrough, they could be entitled to considerably more equity, say 10-20% (or you may have to give some of that to a university or other IP owner). But if the idea is more abstract and doesn’t have real IP behind it (“User generated X” “A marketplace for Y”) that should only earn a few extra points of equity, if any.

If one founder is providing seed capital, assuming there are no other investors involved, the best way to do this is a simple interest bearing (say 5% annual rate), non-convertible loan to the company. I did this once and just had my partner write an IOU on a single sheet of paper, without using lawyers.  When you raise further money the best thing is to have that loan convert into equity at the same terms as the rest of the investors (it looks a somewhat bad to investors to take their fresh capital and pay it right out to a founder – unless the founder is in dire financial straights).

The reason you want to avoid granting equity for a founder’s seed capital is 1) it would cost a lot more in legal fees and 2) you would have to come up with a valuation without a 3rd party, arms length offer.

If there are multiple seed investors, including non-founders, things get more complicated and you might have to resort to a convertible note or full blown equity round.