Startup Equity Compensation

Before we Begin

In this post I would like to express my personal opinion about joining technology startup companies. I will try to show that it is a waste of time in most of the cases. The conclusion is based solely on my personal experience. I am not intending to put anyone down however I will do my best to put things into perspective at least the way I see it.  I am not referring here to investors, founders or even early employees but I am referring to the average software engineer just like me who is probably happy at his current job at a well established company.  Here we go…

Few years ago I applied for a senior quality engineering position at some technology startup company in Sanfrancisco Bay Area and got an offer that I eventually turned down. I am glad I asked experienced friends and researched the topic extensively before falling into the trap. This does not mean that joining a startup company is always bad; on the contrary if you are lucky you could make a fortune overnight.

Well Established Company

If you work at a well established company, depending on how the company is doing and your seniority then probably you will be having a competitive salary along with stock options and bonus. Good companies do provide salary increases based on business and employee performance and have perks and benefits. You can grow your skills, advance your career, have good income and enjoy a stress less work environment so why would one join a startup in the first place.  Let us see…

Startup Company

Each one of us has his own take on things but I think most software engineers flock to startup companies because one or more of the following reasons not in a particular order:

• People join startups to make money. I personally believe this is the main reason for most people even for those who claim otherwise.
• Software engineers join startups to improve technical skills. This is a valid reason as there is huge opportunity to learn allot when building a technology company from the scratch. On the other hand, in a well established company you will probably work on a small piece of a big product suite. In a startup company you witness the product being built from the ground up, you will have the chance to learn a technology stack end to end and work very closely with chief technology officer (CTO) architecting systems and planning for scalability. This is a great learning experience for sure.
• As you build a working product from A to Z you will encounter many problems. Some people join startups because they love to be challenged and enjoy solving technical problems. They just love to do things and get their hands dirty.
• New technologies keep emerging while competition drives the pace. Keeping up with the latest technologies is not an easy task if you are not involved. Engineers join startups to be up to date with technology.
• Though there are hundreds of thousands of software engineers yet there is way less entrepreneurs so joining a startup gives the opportunity to network with smart and successful individuals.
• Startup companies start small then grow to become something big. You grow as the company grows. If you would like to be a manager, director or VP the chance at a startup is relatively easier than that in a well established company.
• You have a good job at some well established company but you got bored from needless meetings, more talk less work, bureaucracy, friction, politics and all the BS.
• You are a fresh graduate and you do not have anything to lose. You just need to grow your skills and start your career.
• You hate middle managers or people managers who keep talking and talking while being disconnected from technology, those who still live in the Stone Age while having extremely high salaries.
• You want full control; if an idea crosses your mind you can go ahead jump and implement it without waiting boring approval process that takes years.
• You want to have an impact and get recognition for innovation.

There are definitely more than that but I think this gives an idea about why people tend to switch from well established companies to startups. So far so good, where is the problem then?

Learn or Earn

Ask yourself the following question: are you joining to learn or to earn? If you are joining to learn then this article does not apply to you.  As I mentioned earlier, there is a great chance for learning new stuff at startups. It is not free though, you will be working your butt off, there is nothing called weekends, the pay sucks, you might get fired if the company runs out of cash or even the company might close the doors earlier than anyone can think. On the other hand, if you are joining to make a fortune then that is the actual waste of time. In few words, no one makes money except investors and founders. By the way, I am not talking about being a millionaire I am just talking about making money in comparison to what you make at a typical well established company for someone at your level of experience.  If you did not hear me I said it is not worth it and here is how…

Got an Offer

Let us assume that you applied to a dream startup company, they liked your skills and wanted to extend you an offer. The recruiter will call you and share how the company is so thrilled and excited about you. The unofficial offer will include two pieces of information (Salary and Equity). Unless you are very lucky or some clone of Steve Jobs maybe they will give you a 10-20% salary cut on what you make because most startups live on funding and short on cash. As if it is a universal law of physics that you must accept as a fact because the equity part is supposed as they claim to compensate for the loss. You need to live on the hope that the company will succeed and exit by getting acquired or go public. Let us see how the equity part is a waste of time unless you are very lucky.

Over the Phone

I was over the phone with the recruiter discussing a potential offer. Here is roughly how the conversation looked like…

Recruiter:  we are going to give you 20,000 shares in common stock

Me: wow that is amazing. It sounds great but I have a question!

Recruiter: go ahead

Me: I think absolute numbers are sometimes misleading.

Recruiter: What do you mean?

Me: 1 out of 10 is better than 20,000 out of 2,000,000. What is the total number of outstanding shares?

Recruiter: around 30 million shares

Me: with that, can you tell me what the percentage is?

Recruiter: less than 0.1%

Me: ok sounds good, got an idea about the salary and equity. I need some time to think and make my mind. I will send you an email next day morning with yes/no.

Recruiter: not a bad idea, was there a specific number you were thinking of?

Me: actually yes, I was expecting at least 0.5%. The current offer is almost 7 times less.

Recruiter: that is the equity of a VP level position and you are applying for a senior position.

Me: I do not know maybe I am mistaken, I appreciate the offer. I just need a day to think about it.

Recruiter: Yes it makes sense. Talk to you soon.

I asked some experienced friends of mine and researched it on my own and found out that the offer is not good. Next day morning I sent an email turning the offer down. I was very polite in the email and showed that I am very interested in the job, team, technology and business however the offer was not good enough to switch jobs.  The first reaction of the recruiter is that he offered me 10,000 extra shares in common stock totaling 30,000 out of ~ 30M outstanding shares. The percentage was below 0.1% and now it is approximately 0.1%. I replied back saying this is not what I am shooting for and I have certain expectation. I provided some details and numbers. The recruiter suggested that I visit the company and meet the CEO in person and have some chat. I said why not and met with him a week later. I shared with him my feedback regarding the offer. He tried to convince me that the offer is great by saying I made inaccurate assumptions regarding company valuation, stock dilution and some other startup related terminology. I told him I might be mistaken, what you said makes sense to me, I am almost convinced, tomorrow morning I will give the official yes/no answer. I also informed the recruiter on my way out that it is probably 90% yes and 10% no as I need to leave a chance for saying no just in case. I returned home and started to research startup equity in more depth, read several articles and went through comments on articles by engineers who joined startups and talking about their experience. I really got scared because the result of mining these articles can be summarized by the following two points:

1. Only investors, founders and very early employees make money. Do not join unless you have a good offer which means good salary and good equity. Otherwise it is not worth the extra hours of work and stress.
2. Are you joining to earn or to learn. It does not heart to join if the whole purpose is to learn. This does not apply to most experienced professionals who have other stuff to worry about like family and school.

I contacted the recruiter again and thanked him for giving me the chance to interview and turned down the modified offer for the second time. He was very disappointed because I was in the final stage in the hiring process. He said would 0.2% works with you, I told him I said I want 0.5% percent and also showed him that I am not convinced when he said 0.5% is the equity of a VP level position. I said if the company is a cake then half the cake goes to investors, let us say 30% for founders, 10% for early employees and the remaining 10% option pool goes for hiring more people. The company was 20 employees which mean 10% can hire 100 more employees if they want to give 0.1% each which did not make much sense to me.  Let me show you a simple formula (I admit it is very conservative) that I used to evaluate how good or bad the offer was.

Why it is not worth it

Take a look at the following terms:

• Equity:  total number of shares in common stock does not mean much. What counts is the percentage. Divide the number of shares in common stock by the total number of outstanding shares. For a senior engineer at least in my humble opinion should not be less than 0.5%.
• Dilution:  as the company raises more funds to spend and hire more employees it will issue more stocks. This means the number of shares that you were granted will have less value. The percentage that we calculated in the equity is not the same as before. Assume a dilution factor of 50% (again I am very conservative)
• Tax implication: the money you will potentially make will be taxed. The sad news is that common stock will be impacted dramatically compared to other types of stock such as restricted stock. Assume the tax implication factor 45%
• Company valuation: I was informed that my dream startup is valued at $100M and they were shooting for a billion dollar business. Do not take that for granted, most startups fail and when they succeed, they get sold for less than $100M. I am not saying that startups cannot be higher. I am just saying the vast majority of startups are not like that. I assumed my dream startup will be $100M and to be more conservative assume $50M valuation.
• Vesting period: In order to have the full value of the given stock options you need to wait typically four years. You need to take that into account because leaving a well establish company for 4 years means a loss in salary and benefits for 4 years as indicated in the next point.
• Salary cut: multiply the salary cut that you had along with other benefits such as stocks at your current position before joining by 4 (number of years)
• Successful exit: we are still assuming the company will exit successfully otherwise it is a total loss in time, effort and money.

Example Equity

Here is an example equity calculation:

• Number of shares in common stock = 20,000
• Total outstanding shares = 20,000,000 which means the percentage is 0.1%
• Dilution factor = 75%
• Tax implication = 40%
• Company was sold with valuation = $100,000,000
• Salary and benefit cut = $10,000 a year

After 4 years you will make (20,000/20,000,000) x (75%) x (60%) x (100,000,000) = $45,000. After 4 years you will be losing 4 x $10, 000 or $40, 000 in salary cut and benefits. As you can see the money you get is almost the same as the money you lose assuming a successful exit. If the company fails it is going to be a total loss. The only way to make some money (I am not talking about millions) is to have a better equity. Company valuation plays an important role but it is always hard to tell what the company valuation will be on exit assuming it is going to succeed. Having a fair percentage is the key here even if the company is valuated at the high end because everybody will get the benefit according to his or her percentage.

Conclusion

Startup equity is like selling fish in the sea. It is risky, one should not take a risk unless the winning is rewarding. It just does not make any sense not to get the benefit while the company is exiting successfully by either going public or getting acquired. You should not join a startup unless you get a good offer or you join for the experience. I am not intending to discourage software engineers to join startup companies, on the contrary, startups are great but you define what is great from your own perspective. This topic can be controversial, I am just expressing my point of view.