Equity is often handed out like play money. Then it becomes valuable and the knives come out.
I get the same panicked email about once a month, without fail.
A founder writes in all freaked out because someone is now holding on to way more equity than they deserve.
The question to me is always: How do I claw that equity back?
And the answer I give is always: You don’t. Not without a fight.
Improperly valued equity can create a big gap at exit. Some of my more successful startup exits were actually on the smaller side in terms of the sale price of the company. This was because I owned much more of the company when it sold.
It is an amazing feeling to bootstrap a company to exit and not have had to give up so much as a splinter of it. It’s the exact opposite of that awful feeling when your company sells for an insane amount of money and you’ve optioned and diluted your way to only hanging on to a few of those splinters.
As you might imagine, the latter scenario kept playing out earlier in my career, until I learned how to value equity and options properly.
The Two Extremes
The value of early-stage startup equity can be impossible to determine. There are two extremes of perceived company value at the early stages
On one side, there’s the notion that equity options in a startup are worth less than the paper they’re (no longer) printed on. This leads early stage founders to err in handing out wads of options like play money.
On the other side, there’s the notion that holding startup equity options can be a path to ridiculous wealth. That notion makes the handing out of wads of worthless options attractive.
At the beginning of the company’s life, both of those extremes are true and false at the same time. Most of the time, the value of equity options in a new startup are going to go to zero, because most new startups will fail within a couple years.
Thus, handing out options in a brand-new, pre-revenue startup is a little like buying everyone on the team a lottery ticket with the same numbers.
But what if those numbers hit?
Startup equity value plays out over time. Just like a lottery–not the scratch off cards, but the multi-state mega games where those jackpots get up into the eight-or-nine figures–the timeline of startup success is like watching those ping pong balls stamped with a number pop out of an air machine. Only this process happens over years instead of seconds.
And here’s where the startup gets into trouble.
Let’s say the first ping pong ball pops up at the end of the first year of the startup’s existence. Maybe the startup hits a major revenue milestone or lands a seed round. When that happens, everyone on the team looks at their ticket, sees their number match the ping pong ball, and the gears in their head start turning.
At some point, everyone asks themselves: “How much of this company do I actually own?” The answer usually leads to one of two scenarios:
- Some people don’t feel like they have enough ownership. They might be right, they might be wrong.
- Some people have either already lost their passion for the startup or now consider themselves locked into what they’re due, and they quit on you.
3 Questions and 3 Answers
Startup equity must be allocated over time.
Everyone on the team should be excited when the company starts to become valuable. Hell, it’s the very motivation that those equity options are supposed to generate.
But every time one of those metaphorical ping pong balls drops, the startup’s leadership needs to answer these questions for everyone on the team:
- How much of this company do I own?
- How much of this company will I own?
- How much of this company could I own?
And to maintain that motivation, those answers should always be:
- Very little.
- A good amount.
A vesting schedule is critical. I’d say in about half the cases that trigger a panicked email to me, the clear mistake was that options were granted without a proper vesting schedule. For example, options were granted to a co-founder to come work for free for an immediate grant of 5 percent of the company or more. Now the co-founder isn’t showing up, physically or mentally. In those cases, there is no turning back that doesn’t involve ugliness and legal action.
But in other cases, that first ping pong ball takes a couple years to drop, and maybe two or three of them drop at once, and suddenly everyone on the team is vested.
That’s a timeline issue, not a procedural issue, and the mistake that was made was a lack of proper vision in the valuation of that equity as those options were granted.
In almost all the cases I’ve seen, if that valuation had been properly considered at any time in the life of the startup, the problem would not exist, or at least be far less impactful.
The moral of all those cautionary tales isn’t “Don’t hand out equity like play money.” That’s too simple. The moral is: Always consider the value of what your company is trying to achieve, in the beginning, in the middle, and as you get close to the end.
Don’t sell the dream of ridiculous wealth, sell the value that backs up that equity. With each step on the path to startup success, your team should be focused on what’s left to achieve, not what’s already been accomplished.
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Original source: Inc.