1% of Nothing is Nothing

Equity isn’t interchangeable with salary, so why are our offer packages still acting like it is?

What this piece covers: a discussion of why stock options should no longer be considered a viable proportional equivalent to salaried compensation, as observed by someone who does compensation benchmarking.

What this piece will not cover: a moralized edict on how to value your own money or your own company.

Setting the Odds: Your Initial Startup Offer

Congrats, you’ve just gotten your first tech job offer here in Silicon Valley. You’re offered salary of $100k typical for an entry-level engineering role at a 50-person, A-round funded startup, and 100,000 shares of common stock. Gosh that sounds like a lot! You gleefully accept.

Two years, another round of funding, and a few big life-changes later, you decide to move along to a larger enterprise-sized company. It’s time to consider exercising the 50,000 vested shares of your stock, and you have to make this choice fast, within 90 days.

After a series B your company has not yet had a liquidity event or an “exit,” 
 which is an event like going public or being bought, at which time you would be allowed to sell your shares. You find out the strike price (what you will pay for each share, usually what they were each worth when you were hired) for your options comes out to $0.50 each. 50,000 x $0.50 = a total purchase price of $25,000.00, yikes.

You eye the $25k price tag for your stock options anxiously. That’s more than 12% of your gross pay for the entire time you worked at this company, and between your student loans and the grotesque realities of San Francisco rent, this will gut your savings (if you even have any). To add to the fun, the IRS will tax you on the difference between the stock’s value at sale and your strike price, meaning should things go really well, you’ll be stuck with a hefty tax bill. Should things go not well, you just threw $25k in to a hole in the ground.

Is it worth it to buy your stock? How do you know? How much will you kick yourself if you’re wrong? Can you even afford to be right?

If you decide to forgo the whole anxiety-ridden affair, you‘re in good company. Employee stock options are exercised less than 5% of the time, even by employees who took stock in lieu of cash compensation. If equity is supposed to be one of the perks of working for a startup versus anywhere else, why does that happen?

Equity has no meaningful relationship to salary in the current labor market.

The idea of offering equity in amounts inverse to levels of cash compensation (e.g. offer a candidate more stock and less salary, or vice versa) at early-stage companies has been pretty conventional compensation wisdom in the startup world for about as long as tech has bubbled, popped, and re-inflated itself again.

The startup equity story goes like this: as a new business an early-stage startup needs to save cash, but has the flexibility and agility to build something that could eventually be worth a lot of money. Early employees take a risk and often a lower salary to be there instead of a large stable firm, and that risk is rewarded with stock in the company, or a piece of the spoils for their sacrifice in birthing the product in to existence.

When startups tout that they want to “be the next Facebook” they refer back to this industry cultural narrative. The trouble with the archetypal startup success story underscoring our compensation structures is that it has come to be based on legend more than history.

Venture-backed companies are worth more now than they were even 5 years ago, but also take much much longer to reach liquidity than they used to. This means that the risk an employee takes is not likely to pay off for longer than is likely for them to remain employed at a given company. A typical 4 years of stock vesting isn’t often going to cut it to get you to an exit, and odds are most companies won’t reach a liquidity event at all. A startup may never even hit the point where it is ringing the register enough to bring its people back up to market salaries after a reasonable number of years, and early employees especially get flustered.

The Startup Genome Report Extra on Premature Scaling analyzed 3,200 high growth web/mobile startups and found that within 3 years, 92% of startups failed. Of those who failed, 74% failed due to premature scaling. So maybe, you say to yourself, this whole equity thing isn’t gonna go your way anyway. Maybe I’m better off somewhere that will pay me the same but has stock more likely to be worth something.

Salary and equity have thus come to be priced by two very different sets of influences:

  • Salary value is set by the market forces that price the individual employee’s labor, what they could make with the skills they have, how many companies need them, and how many of them there are available to hire.
  • Equity value is the consequence of funding institutions like VCs estimating how much money can be made with the things lots of different employees make, and how they choose to invest in the companies that employ them accordingly.

This means we can’t really plot a tidy relationship between what one will be worth versus the other all the time. There are just too many environmental variables affecting each that, despite our wishes, are not very tightly-related.

So why does salary tend to be less volatile of an estimation for an employee to make a bet on versus equity? To oversimplify a bit, the relative “interchangeable” nature of a given software engineer’s skills means that someone who has the coding knowledge to build one kind of product can still, should they lose their job, likely find a soft landing in another company that makes a totally different kind of product. This means the labor supply is largely transferrable or, “what a software engineer is worth” in salary to a company is pretty consistently predictable.

By stark contrast, how much money an investor might be willing to drop in to our companies and make them (and our stock) worth can fluctuate wildly based on factors that are not always tied to anything we can control. Investment decisions in tech are often influenced by terrifyingly abstract-sounding, speculative assumptions about what’s “worth it” to invest in at this point in time. This means the value of your company could be at the behest of, for example: bad timing, the performance of your competitors, your app’s similarity to Pokemon Go, your garden-variety global economic disaster. So what your stock “will be worth” in real cash-money down the line is far less assured.

And so for this reason among others, startups perpetuate the myth of the temporarily-embarrassed millionaire when they still treat equity offerings as proportionally-interchangeable compensation with salary.

And small startups can’t afford to make this mistake anymore when putting together their offer packages. The value-proposition of joining a smaller company for equity just isn’t there anymore compared to a large public company that is also hiring for their exact same role. As Sam Lessin notes, “[exits] are becoming even more binary and enormous, early employee equity grants are starting to feel truly like super-charged lottery tickets with extreme jackpots and very long odds.”

The larger post-IPO company has already beat those odds, and so can also offer a new hire publicly-traded stock (that you can actually sell for real dollars!) piled on top of market-rate salary. As a result, these same candidates often instead will choose the stable, large company like Facebook or Netflix if given the choice about where they’d like to hedge their long-term bets.

Continuing to insist that early stage startups can effectively leverage equity to compete for talent is as a result bad for employees, bad for our recruiting, and ultimately I think in the long run we’ll find it was also really bad for preserving an environment that incentivizes innovation.

Compensation is a philosophy, not a science.

I know people will look at this problem of relative stock exercise expense v. salary amount v. likelihood of company success and then jump straight to generating graphs of what exact amount one should make to think X amount of equity is worth it. I’ve seen these charts actually used to try and build compensation models, generated by well-meaning consultants, math-minded founders, and startup veterans trying to suss out a way to make this information asymmetry all hurt the individual a little bit less. I will confess that I too have spent countless hours sweating over Excel trying to do the same.

As much as we desire to understand statistical outcomes and place ourselves and our employees on a distribution of comfort with that risk, we as those who set the pay grades make choices to compensate our team with far greater information than they will ever have access to when they choose what to do with it. That we know more about the health of the company and likelihood of a positive outcome than our employees do endows us with a duty of care; we should honor it when we ask them to work here.

Fundamentally the last word on our compensation structures belongs to our founders and their prerogative to build a company that reflects their vision. They took the initial risk of starting a company, and it’s up to us to uphold our end of that bargain. It’s our duty then as people operations managers, compensation analysts, HR professionals, finance teams to be comp philosophers, not comp scientists or comp econometricians.

I propose that compensation structures and offers should instead focus on informing consent to work for us more than they try to incentivize particular choices that will or won’t benefit our companies. People are as it turns out really, really good at deciding where they land on their own personal marginal utility curve for a set amount of salary versus the other costs or benefits of a given role. It’s just our job to give our candidates good information, that’s all.

If we structure our offers, bonuses, and raises instead with a clear-eyed view of what we can or cannot offer someone for their life as they choose to live it now, if we can be transparent on the risks of our model and why we still believe our company is its own place worth being, we might get a teammate who actually wants the job and wasn’t misled or driven by fear of economic hardship in to a role that wasn’t right for them. In practice building a full compensation model on this First Principle is pretty hard, but you can start with one key proposition:

  1. Pay people the market-rate salary for their role.

Full stop. Every other tetchy, controversial choice about perks and benefits and equity comes out in the wash if you start from here. It’s gonna make your balance sheet shriek in terror, but the real competitive advantages we have to the Big Guys: flexibility, speed, leadership opportunities, creative control, ownership of success, the ability to work in a mission-driven space, are no longer going to be hamstrung by something as tragically avoidable as the fear of being unable to afford rent.

Plus you’d be really surprised how productive people are, and how many less of them you need to hire, if everyone feels psychologically safe enough at work to know they won’t go broke on a bad bet.

2. Consider your strike price and valuation in picking a stock grant amount rather than just what percentage is “typical” for that role.

This is especially true if even after reading this you still insist on offering stock in lieu of some amount of salary. We have all these numbers thrown at us, that 0.2% to 0.3% is typical for a senior engineer at blah blah blah. But when the number of shares in your stock pool can vary so much and be worth such varying amounts, these percentages end up being almost meaningless. They are an emotional number that actually robs our employees of real information.

Instead we should be asking ourselves: what number of stock options could this person realistically afford to buy on what I want to pay them? If I called back (or offered to re-purchase from them) their shares at what they are each currently worth, would the total price be equal to or greater than the hypothetical pay-cut I asked them to take in return? What about after a round of funding? Or another?

3. Negotiate exercise and vesting exceptions for individual employees.

Despite the stress it can generate for your lawyers/board/cofounders, there is always the option to modify a stock agreement for someone with individual asks or vesting schedules they’d like you to consider (your mileage may vary, please consult with counsel with respect to any individual stock plan.) They can ask for, for example, a “change-of-control clause” that lets them accelerate how fast they can purchase their shares if the company is bought, if they are terminated when that happens, etc.

When someone asks for a vesting exception, they are asking for information about our intentions and what is important to this company. Is our goal eventually to sell? Are we the kind of company that needs to reach profitability before we can raise again? Above all else, this discussion about stock plans is our chance to clarify to a hire what’s important to us. Even if we can’t meet their ask, hearing them out is a sign of respect that will go a long way with the high-integrity hires we seek to make.

In short, the idea of equity being a reliable bet to take instead of some “equivalent” amount of cash at the average early stage startup is these days mostly a nice bedtime story, not a surefire retirement plan. But we still want to work in this space, still want to take risks that we think can make a difference to the future, and still want to earn a living doing what we love.

I think that if we’re all honest about what we each need and each can sincerely provide to a startup’s journey, we can ride the wave of uncertainty together, and maybe still get to build something cool anyway.

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