This post piggybacks off of a post I'd made earlier about why people start startups. Aside from the personal satisfaction one can achieve from this scenario, there are clear financial motivations to found a startup instead of joining one. To summarize: the founders get a large equity stake, and successive employees take on much, much smaller equity stakes -- often one or two percent, even when the company is still very much trying to figure out its business model.
The traditional model is bad because it prices certain employees out of the startup market. In this post I'll summarize a typical scenario and then describe an alternative method which involves recycling options and which could make startups more attractive to strong, experienced employees. In the very last section I outline a very simple way for employees to decide when to take on a new coworker and how much they should offer to the coworker.
A typical scenario
In a very common scenario, a startup founder (or founders) will retain at least 50% of the company and offer small equity grants, say 1% to 3% -- plus a modest salary -- to early employees. These grants become meaningful if the company becomes worth $20M or more: a 2% grant may then be worth $100K per year if it vests over four years. With a salary of $60K, this is like getting $160K per year. Sounds good, right? Potentially, until you start looking at salaries at some of the top tech companies, which are regularly offering packages around $200K per year to candidates with experience. Even if the company sells for $100M (not bad for four years!), the equity grant is $560K/year. This sounds promising until you consider that $100M is the exception rather than the rule. If even 1/4 of these companies make it that high (and that's being optimistic), and the rest fail, the expected value is back down to $185K/year. And that's with high variance: the usual risk/volatility trade-off -- in which investors take on volatility to achieve higher gains -- is reversed.
This means that experienced, older engineers willing to work hard have very little financial incentive to join an existing, early-stage startup: it is more rational to either found a startup (where they might have a 17% or 26% stake) or work at a top tech firm. This is one of the factors contributing to the explosion of startups and the lack of engineering talent (easy credit and lower barriers to entry are two other factors).
This fixed equity + fixed salary mechanism is both antiquated and arbitrary. Standard equity grants (with modest salary) may also mean that the payoff gap between founders and early employees can be significant enough to incentivize the founder to sell the company cheaply; promising young talent is then left with modest (often below-market) income, while the founder has earned millions of dollars per year.
As I pointed out, this is largely an artifact of the equity-salary trade-off. What if instead we designed a payment structure in which employees' income grew at a rate proportional to the growth of the company, but inversely proportional to the number of employees? (Note that high-level roles in the company would of course have multipliers attached to their positions.) We can easily accomplish this by recycling options: early employees receive larger grant amounts than is currently typical, but they are then required to underwrite option grants to later employees at pre-specified increments.
To simplify the discussion, let's pretend that employees arrive in increments, and that we know the valuation of the company when they come in: the first four come in at valuation $0, then four more come in at $20M, then sixteen more at $100M, and so on. It's easy to extend this to a continuous-time case, but these assumptions make the discussion easier.
An option-recycling scenario would look like this:
- Employees one through four each get call options representing 8% stakes in the company with a strike price at the most-recent valuation. This high stake is mitigated by each employee's contractually obligated short position on call options representing a 4% stake with strike price based on a $20M valuation, and further short positions on call options representing a 2% stake at the even higher valuation $100M, et cetera.
- Employees five through eight each receive call options representing 4% stakes at $20M valuations, and they're required to hold short positions on call options representing a 2% stake at $100M, 1% at $500M, etc.
- This means several things:
- Early employees will lock in higher earnings sooner, with lower risk of the investors selling the company for talent. An early employee with an 8% stake in a fledgling startup has enough of a stake to reasonably appreciate a $20M acquisition: it's $1.6M total, or $400K amortized over four years -- higher than the vast majority of strong individual contributors will receive at a large top tech company. This contrasts with a 2% stake at a $20M valuation, which is $100K/year -- lower than an individual contributor will receive at top tech firms. Is this hedging of risk a bad thing for individual contributors? Not if you consider that the founder has a significantly larger cushion.
- Early employees will receive lower payouts for later company growth. An early employee's income per dollar valuation decreases as the company grows larger. If the company is worth $40M, one of the first employees will find that his income from options is (8% * $40M - 4% ($40M - $20M) ) = $600K per year (over four years). This increase of "only" $200K makes sense because there are more employees at this later stage of growth. It's not fair for early employees to take credit for later employees' contributions, unless it's been priced in based on a special role these early employees now play (manager, director, CTO, president, etc.). These special roles should of course be priced in by refresher grants and salary, but fixed equity stakes at the beginning make no sense.
- The first four employees (after the founders)-- who together might reasonably explain 32% of the first $20M of growth -- each get an appropriate share of that growth as well as an adjusted share of future growth.
Here is what the early-employee compensation world currently looks like:
You may wonder why the blue bars are stacked precariously. If you look carefully, you'll see that the top of each blue bar at the end of an epoch is aligned with the top of the blue bar in the next epoch. I illustrate it this way to show how an employee's cumulative contribution toward a company usually continues to grow, but at a rate which decrease with the number of employees. His increase in value-added (and compensation) during the entire period is the sum of his increments in each period -- the height of the small vertical bar on the right. Importantly, note that there are also no dark wages. This is because early employees held stock as it increased in value before passing it on to later employees.
A further thing to note is that offering employees equity which has higher value at earlier stages in the company does not require that the employees be able to cash out early. Instead, they are simply underwriting options for later employees.
Giving employees the option of when to hire (and when to split their equity)
A final model I'll propose is that employees be given the option of splitting their options to take on another employee.
At any time, the current employees (say there are N of them) will be given the option of bringing on more talent by offering a stake of their equity. There will be a point at which this should be not only rational but attractive: as the company progresses with a fixed number of employees, they will reach a local optimum of the company's valuation, at which point their options cannot increase in value. At this time, it is completely rational for an employee to realize that his X% stake cannot grow any further without bringing on another employee. If each employee gives X% * / (N+1) of his stake as call options to an incoming employee (who then has the same amount as each old employee, but with a higher strike price), then the original employee's remaining N/(N+1) * X% can continue to grow. Again, each employee gets credit for growth he has contributed to, but no more.