New Venture Concept: The Employee Equity Exchange
Premise — What if early-stage tech teams could easily and fairly diversify stock options with teams across other startups?
Increasingly, I’ve been interested in exploring what it would be mean for early-stage employees at tech startups to be able to exchange and securitize their options packages in a diversified pool. Further, I’ve been trying to understand how a diversified options pool might act as a powerful social lever.
We’ll approach the discussion through this framework
1. Which problems does this solve?
2. How might this look practically?
3. What are the associated risks?
Problems with equity in startups
No ability to diversify
Startup founders and employees use labor as a means of wealth creation but have no way to diversify those efforts. These individuals face the risk of potentially valueless equity when starting or joining an early stage company. (Of course, this is a necessary forcing function to correctly incentivize teams)
Anecdotally, it’s known that most startups fail. A deeper look at the statistics collected through private market sources like Pitchbook and CB Insights only confirm this truth. Of the approximately 1,000 tracked companies that raised seed rounds in the US between 2008–2010, less than half, or 46%, managed to even grow to raise the second round of funding. Only 1%, about 10 companies, successfully clawed into the >$1B, unicorn class.
Potential solution: A diversified stock option pool can reduce the employee’s exposure to a singular asset, mitigating some risk associated with holding probabilistically worthless shares. This wouldn’t mean removing all exposure, but perhaps allowing the employee to diversify 5–10% of their total stock plan.
No mechanism to create skin-in-the-game across startups
Founders operate in silos with limited interaction across other early-stage ventures that might be experiencing similar problems. As you might imagine, there’s a lot of wheel reinvention happening within companies. Given the obvious economic incentive, most startups rely on their investors to guide strategic decisions — but, why not other founders?
Potential solution: By creating ‘skin in the game’, equity can act as a mechanism to incentivize collaboration across ventures, with no impact to balance sheet or cash position. Imagine being a founder with a supporting network of 10 or even 100 other, non-competitive companies.
The Liquidity Problem is Expensive
“SoftBank offers to buy Uber shares at a 30% discount”
SoftBank’s offer is close to what Uber was worth in 2015 when shares were priced a little less than $40 apiece. [Link]
“Unidentified investor initiates $150M tender offer for Lyft shares at 10% discount”
A tender offer is initiated to purchase up to 3% of Lyft, extending no premium to common stock shareholders willing to sell. [Link]
“Airbnb to sell employee common stock to investors at a 17% discount”
Investors to purchase nearly $200 million in stock from Airbnb employees in common shares, at a valuation of around $25B, immediately following Airbnb’s $30B priced round. [Link]
“The Need for Greater Secondary Market Liquidity for Small Business” — SEC
“The lack of a fair, liquid and transparent secondary market for private securities is a longstanding problem that needs an effective solution”
“Venture exchanges — both here and abroad — have suffered from low liquidity and, at times, high volatility. This means investors could lose a lot of money quickly and could have trouble selling their shares in a downturn.” [Link]
Precedence
Intra-Portfolio Models
In 2010, First Round launched their “Entrepreneur’s Exchange fund”. This exchange fund was created to allow First Round entrepreneurs to contribute a small piece of the stock they own in their company — and share in the upside of all the other First Round companies. The fund is only available to qualified First Round Capital portfolio companies and First Round Capital does not receive any economic upside from the fund.
Scout Programs
Though equity pooling is only a by-product of scout programs, it provides a unique source of equity diversification to participating founders.
Sequoia Capital has become well known for building an extensive network of scouts that helped the firm get early introductions to high potential ventures. Those scouts were primarily founders within Sequoia’s portfolio and received upside on the investments they referred.
VC firms are trying to quickly adapt to the changing terrain, and so we are seeing the rise of “working networks” that blur the lines between founder, investor, and advisor. Now, at least nine other venture firms have followed suit with their own flavors of scout programs, including the well known joint venture between AngelList and Accomplice VC.
Long Term Stock Exchange
Eric Reis’ Long-Term Stock Exchange (LTSE) believes that the U.S. is sorely in need of exchange that rewards businesses and investors focused on the ‘long term view’. If successful, more growth stage companies might feel comfortable creating liquidity for their investors earlier. This is separate from equity exchanges but solves some of the equity lock-up problems that teams face.
Potential Pooling Mechanism
Okay, so how might this work?
A tool to attract talent
An innovation that reduces the likelihood of zero-value equity might be welcomed by employees who expect their equity packages to compensate for less-than-market wages. Diversification is a direct increase in the value of an employee compensation package. In modern portfolio theory, the diversification premium is well understood and quantified.
Liquidity Timeline
As risk is pooled, the liquidity timeline changes. This is analogous to the duration calculation for fixed income assets. One of the variables that duration measures is how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows. In this case, the bond’s “price” is the upfront labor input of the employee.
Transferability
Most Stock Option Agreements provide that the option is non-transferable. The agreements also state that the stock purchased by exercising the option may be subject to rights of purchase or rights of first refusal on any potential transfers. Increasingly, companies desire to implement more robust restrictions on both the options and the shares received upon exercise of the options to limit trades in the secondary market that may cause practical concerns in managing holders of the company’s stock. This would need to be augmented for the pooled portion of stocks.
Potential Risks
Selection-bias
Companies that recognize they are performing exceptionally well, may not be interested in buying into the stock pools because there is a higher than average likelihood that their equity will become valuable
Corruptable selection process
A centralized selection committee may poorly select ventures. A decentralized committee (votes from existing participants) might be an unnecessary distraction to founders.
Disincentivizing
Employees may feel less incentivized to put forth effort for a startup if they expect or have already received a significant payout as a result of the model.
Gaming through timing
Employees may opt into the equity pooling platform immediately following a fundraising round, which, given a higher valuation, will imply a larger allocation of the shared pool of the securitized fund.
Conclusion —
While this could be valuable, employee equity needs to be handled very carefully. Stock options represent the blood, sweat, and tears of startup teams. Incorrect execution or small missteps in a selection/ participation system could result in sizable financial consequences. Poor management could result in adverse selection, moral hazard, and other negative emergent behavior.
Thanks for reading!
I’m always open to learn and collaborate. Feel free to reach me — 2amritsingh2@gmail.com
