I have had many encounters with the question of how much equity vs. how much pay people should get for working on/in a startup. My basic philosophy was developed after one of my earliest startups, Legal Software Incorporated (LSI). This was a company I started with my uncle and cousin who ran a law firm (Apple and Apple in Pittsburgh, PA). LSI built a Unix-based software/hardware solution for law offices wishing to automate the processing of large volumes of cases. In this particular instance there was a combination of a standard law practice and a collection law practice. Collection law typically has lots of small- and medium-sized cases. I think our system had 25,000 or so cases from one client (a jewelry chain) at one point.
I designed and implemented a system that had user terminals and was designed to make it minimal effort for a trained legal assistant to do the specific repetitive tasks associated with the law practice, including tracking all the dates on every case and making sure the process was properly followed in a timely fashion and with the proper sets of letters and actions associated with every phase of the legal collection process. I eventually created "PayBack", a PC-based software product that automated this for even smaller law offices.
In forming the company, I had never before thought about the question of who should get what for what. Lesson learned. Even my uncle and cousin couldn't come to terms with me on how to do this, and my naivety was a substantial part of why the business never could compete with the one major competitor in the space. That and a total lack of funds... knowledge of how to get funds or the need and use for them, understanding how to succeed in a marketplace, business acumen, a go to market strategy, an intellectual property position, the list goes on and on. What I did have was technical skills and energy to implement a solution for a 25-person law office in my uncle's practice. They got 10 years of hardware-cost-only computing and higher worker output, and I got experience.
Perhaps fortunately, I owned a relatively small share of the equity in the company that failed. Otherwise, I would have lost a fortune when it went out of business. How's that for justification?
My current views
My basic philosophy is that earlier is worth more, more work is worth more, higher risk is worth more, and some work is worth more than other work (strategic, important, rare, etc.). Let's break that down:
Earlier is worth more: In a startup, who is there first gets more. In particular, those who decide to form a company and all of the things that entails, deserve and should get more than those who ultimately join it later. They take higher risks and deserve higher rewards as a result. Having said that, it evens out in the end, because most startups fail and, as a result, most of those early stage individuals put in money and time and get little or nothing back. The equity they get compensates for the risks they take, so that if a startup should succeed, they get more. Having said that, most of the people who do that end up with what I got from LSI.
More work is worth more: All other things being equal, if I spend twice the time you spend working, I deserve twice the compensation. If we are working for sweat equity, that means twice the equity for twice the sweat. Of course all things are not equal. Unfortunately, we generally assign equity before we do all the work. So that means it pays to be lazy because you get more equity for the time spent. However, this is also why we have vesting. Vesting means we can separate the worker from the company and limit the equity to the worker as a function of time, and thus work. Of course vesting after many years all at once causes huge problems with fraudulent firings, where the company fires everyone just before they vest to deny them their rightful share of equity. So the idea is to vest over time with the equity increasing month by month (or some such thing) so that departure from either side rewards close to proportionally to time spent. Note that workers rarely get this and exploitive companies do.
Higher risk is worth more: There is often a tradeoff between equity and pay. Some people seem to think that $1 of equity is worth $1 of pay. In IBM that might be close to true, but in startups, the odds of the equity every being with anything are small indeed. Classical assumptions are that 80% of startups fail in the 1st 2 years. Of the ones that live on and get to angel funding by groups, based on Wiltbank's 2016 study of the previous 10 years, 70% don't return the investment in 10 years. I generally assume the odds of equity being worth the paper it is written on at about 1 in 10. So for every dollar I give up in pay, I should reasonably expect $10 in equity to compensate for it. Of course the value of the equity is also indefinite unless and until it sells, so valuation comes into this, and naturally, folks who don't have much experience, value themselves more highly than those of us who look at them from the outside. Of course the people who put in real cash for equity set the price, but only once that actually happens. And of course value of equity increases with time for companies moving toward success, and the other way for the other companies.
Some work is worth more than others: Did I mention that all things are never equal? Under "more work is worth more", I had the assumption of all things being equal, but they never are. My pay rate is higher than most, but lower than some. I do things more quickly and accurately than most, but less so than some. All of our children are above average, but other folks' kids are probably below. Some people provide a small amount of critical information at a critical time. Either you have to pay them their rate or your have to compensate them with equivalent equity. Since forced labor is not the issue (and you likely cannot get the best out of people through force) you will have to give more equity to people who you value more highly if they demand it, or choose not to use them and suffer the consequences of your decision.
Things get complicated
In the simplest case, this is pretty directly calculable, assuming you have the knowledge you need to do the calculations. But things get complicated. One common example of a more complex situation is the holding and operating company model.
In a holding company model, a holding company owns some set of key things to the success of the overall business, and it creates operating companies to operate different facets of the business. Operating companies are generally separated based on projects and their funding or business functions. For example, there might be a research and development company that gets tax credits and government funding, several operating companies that operate in different states under different regulatory schemes, and a holding company that has the common intellectual property and connections to suppliers and customers. In such cases, each new operating company, as created, may have a combination of equity from local investors who fund the project, the holding company that brings intellectual property and connections, an advisory board, a CEO and local executives who run the operating company, initial employees, and so forth.
Determining the equitable distribution of equity is a function of what who brings to each table. For example, if each operating company reasonably needs an advisory board, that board may combine local expertise in the operating environment with expertise from the holding company, to provide the best combination of advice in context for the operating company. If there are 50 operating companies in 50 states, this means 50 advisory boards. The holding company representative who works on all 50 advisory boards will likely be extremely knowledgeable in how to do this function, and the information from each of the operating companies will be very useful to the others as well as the holding company. A CEO, on the other hand, typically has fiduciary duties to the operating company and cannot be the CEO of more than one such entity. For that very reason, they need the advisory board and its local and global content and team members in order to operate efficiently in context. But the decisions must remain local.
Employees getting equity starts to create problems at some point. Generally, anyone performing labor should be compensated for that labor directly. Thus pay becomes the path for compensation for time. As long as this compensation is fair, that is, at reasonable rates for the individual in the role, there is no problem. However, when people work for less than their normal rate and are compensated by equity, this becomes more complex, and some method of calculation should be used to determine fair compensation taking into account delays, risks, rewards, etc.
The problem is that there is only so much equity. 100% of all the ownership. The more you hand out, the less there is left. At some point, you run out or you have to dilute the equity holders in order to get more value in the company. But dilution changes the compensation equation for all of the participants. If you reserve some portion of equity for workers, as you get more workers, the value of their equity per workers goes down until it is almost worthless. And of course that equity is only realizable if you are a public company or if there is a monetization event.
In many cases, worker equity is effectively worthless, and it is often used as leverage to convince them that they are worth more than what they are paid. Thus the average worker gets underpaid and never recovers the difference. Of course you hear about the winners and how it makes the worker part of the team. We are all in this together. In truth, this is rarely the case financially, even if it works psychologically.
As a further complication, there are different sorts of equity that can be present in different sorts of entities. This includes non-dilutive, preferred, founder, and other special sorts as well as common. Each has different rights under different agreements in different jurisdictions, so note particularly when there are operating companies in different jurisdictions, you may need a legal advisor on each just to advise you on the equity issues.
Here are example particulars for a small startup situation:
Each operating company:
CEO salary $120K/y, Founding CEO equity 5%
Other executive salaries $80K/y/ea, founding executive (combined) equity 5%
Advisory board combined rate for all advisors $5K/mo, combined fouding equity for all advisors 5%
Holding company equity in operating company 10%
The other 75% is owned by the people who put money in.
The numbers here are not based on anything in particular, but hopefully, this makes sense as a structure.
Equity is complicated and should be well thought through. Once given you cannot really take it back, and it lasts till the end of the company or its monetization. Think though these issues for yourself, including the issues of what happens over time. Otherwise you may be surprised at how little you end up with and how complicated the legal case gets.
Copyright(c) Fred Cohen, 2017 - All Rights Reserved