Equity: Value versus Vanity
OK, we’re going to own up to something here… With every role we take on, our clients ask us for market comps on equity compensation. Our annual compensation study includes pages and pages of equity benchmarks sliced and diced by functions, levels, capital, etc. But the more we dug into the question and the more conversations we had, we recognized that percentages are likely not the best way to think about equity benchmarking because it sets a narrative that focuses the conversation on ownership versus value. Equity is a scarce resource for a company, no matter how much you’re sharing. Even more importantly, we’ve seen in our annual compensation study, that fewer individuals know how much they have on a percentage basis as a company grows. What matters more is the actual economic value. And as can be seen in the chart, even that fact is elusive.
Philosophically, having equity means that as an employee, you are directly incentivized to work towards a common goal alongside other members of the team who are also working towards the same north star. Practically speaking, having equity can help make up for the lower cash compensation often associated with startups versus larger organizations. With the right company, equity plays a big role in upside potential. Big risk, big reward, right? Equity sounds “cool” – the more the better. But for all the talk of equity, many people don’t actually know how to value it, let alone evaluate it.
We’ve found that many individuals, particularly if they’re entering an early-stage company for the first time, focus squarely on the percentage. And while percentage demonstrates ownership and potentially “value” of that individual to the organization, it is not the thing that matters. We like to ask our candidates a version of the following question that almost always leads to silence – “When the company is acquired, what do you want your take home value to be?”
Why is equity hard to understand?
Before diving into the topic, we need to uncover why equity is so hard to understand.
- Complexity: Equity is really complicated, and most of us don’t have the requisite education around it to understand the complexities. There are so many terms! And how they interact with each other is different inside every company.
- Lack of transparency and incomplete information. What do the number of shares represent vs outstanding shares? How does the preferred share price play into your strike price and vesting schedule? What happens when more money is raised? And what about the actual cash waterfall during an exit? Some companies don’t effectively communicate this information to their teams, so even when there’s a liquidity event, it becomes hard to calculate what you will actually receive.
- Unrealistic expectations. Just because you are granted equity, does not mean that you are going to get rich overnight. More importantly, it requires that the entire company is rowing in the same direction in order to grow the overall pie. That responsibility doesn’t merely rest on the shoulders of the CEO, so make sure that you understand what needs to be achieved in order to increase that value over time.
Stop asking for percentages, and ask for value
The major reason that people don’t know exactly how much they want to earn at the end of the day is because they’ve been conditioned to think in percentage terms. 80% ownership of something that amounts to nothing is still nothing, though the stock certificates make a nice souvenir. 0.8% of a company that skyrockets, can be quite valuable. But 0.8% just feels… icky. It’s less than a percent! Am I really not worth even a single percentage point, you might ask the company and yourself? Those percentages you’re dreaming of are a vanity metric and you need to de-condition yourself out of it.
The truth is, that the more equity you have in a company, the higher the likelihood is that the company is at an earlier stage. At that time, the company is trying to attract top talent and equity is all they have to play with when cash is scarce. So if your goal is ownership, you need to be ready to really work for it at a company whose value (and existence) is still up in the air.
As a member of a team who is about to be granted equity, ask yourself the below questions, in this order:
- Why do I even want equity? Yes, it seems like a very silly question, but it’s an important one. You need to understand what equity represents to you. Ownership, autonomy, respect, money… All those reasons are valid – you just need to understand your own motivation.
- What is my risk tolerance? You are not getting 5% at a company that has already gone through a Series D. But you could at a seed stage company. But those are two very different risk profiles. Weigh the pros and cons of both.
- Can I actually contribute to the company’s growth? If the company wants to 5x its value in five years, how much confidence do you have in yourself to impact the company’s ability to do so.
- How much money do I want to make at the end of all this? This is a hard question to answer, but it’s the only way that you will be able to properly assess what you are being offered.
- What are the economics? Number of shares, Strike price, Vesting schedule, Preferred price today and expected preferred price of the next round. Those numbers will enable you to calculate for yourself your gross and net value at least into the next round raise.
- Bonus: Keep asking for information over time! The onus of education is not just on the company; it’s on you as an employee to get information. Don’t just sit there being frustrated. If you don’t know something, just ask!
Education when you’re hiring
As much as the employee needs to have a soul-searching conversation with themselves, employers need to present equity in a way that becomes “real.” As discussed, percentages don’t mean much, but dollars do. So lead with the value! We can’t tell you how many times we’ve heard offers be presented that state the percent ownership or just the number of shares without giving the full picture of what this equity grant represents today, and more importantly, what it can represent in the future if your chosen candidate joins your organization. At the offer phase, the company is in sell mode, so lead with your strengths.
When you’re hiring a key team member, education around how equity works within your organization is a key moment. Below are some tips and tricks to make sure your hire understands what they’re receiving.
- Use a visual model. Many of the companies we work with will present a summarized financial model. Companies that do this most effectively have a model built that enables them to show a visual to a candidate that includes basic assumptions around future dilution, and a variety of potential outcomes. It is elegant in its simplicity, and leads to a much more productive conversation. This can be in excel, a single slide, or even a platform like Pave that will demonstrate different exit scenarios to paint a picture.
- Enlist the help of a champion. Your CFO is an excellent resource to describe what equity looks like today and in the future. For anyone making an offer, remember that you are still in “sell mode” and you should be the biggest champion for the value of the company.
- Talk about value. Unless you’re a seed stage company when you’re attracting team members purely by ownership alone (i.e. percentage points), as there is no value to speak of yet, your conversations should be in value terms. What does it look like today, where can it grow with the help of this amazing human that you’re hiring?
Continuous education for the team
Some executives and investors get a little cagey around equity because they deem it very confidential information. And while you may not want to share all the dynamics of how cash waterfalls will work or what the percent is that a person holds, education is still very important. With proper education, you can:
- Avoid misunderstanding. Misunderstanding of the true value of equity can lead to disappointment and frustration. If employees think the value of their equity is higher than it actually is, they will be quite disappointed and frustrated during a key event.
- Retain talent. Be transparent about company developments that influence equity value. An employee will typically remain at the company if they feel that the value of their equity will increase. So if the value of the equity is higher, or there are important developments on the horizon for the company in the short term that will bolster the value, share the great news with your team.
- Align the team. If an employee knows how their daily work builds value, they will have more purpose within their job and continue to contribute to the company’s growth over time.
- Build trust. When companies are transparent through good times and bad, it enables you to build goodwill, collaboration, and commitment. You can be a company that’s different, and as a leadership team set an example for your team across other functions of the business.
Equity is a fantastic alignment tool to ensure that everyone is rowing in the same direction and will benefit from the collective success of the company. But it is also complicated due to its inherent structure. As such, company leaders need to be deliberate in educating prospective employees, finalists in a process, and their current team members alike on what equity looks like at their company. At the same time, rather than negotiating for basis points on an offer letter without correlation to the economics, candidates should remain focused on value today and how they can contribute to the value increase tomorrow.