Have you ever heard the expression a “Google Dream”? We throw that around all the time in reference to the most envious of all Silicon Valley experiences – joining a start-up, having it magically become worth zillions of dollars, and parachuting out with tens of millions in equity value. Kind of akin to going to Hollywood in the hope of a perfect audition, getting discovered by a hit-machine director, and hearing those immortal words: “Baby, I’m going to make you a Star!” (puff a big one on your stogy when saying that). Indeed, we hear about that friend of a friend of a friend who joined company XYZ a few years ago, parachuted out in a huge acquisition (hmmm, think WhatsApp), and is now a semi-retired angel investor, life-long vacationer, and global VIP! Yep, this really does happen but with the frequency closer to that of a lotto winner than an everyday occurrence.
Most people I know want to be an “owner” of something – if only once – in their lifetime. Some of us take our half basis point of unvested stock options and feel the rush of that potential, yet highly unlikely, equity windfall. Others simply settle for a golden retriever and the guaranteed outcome that, at least, one person will be waiting at home with anticipation as if you were Ulysses returning from a decade of war.
For the rest of us, we fall in-between; and the complexities of private company stock ownership are either something difficult to understand or frequently uncomfortable to discuss. However, in the high velocity venture backed world, most executive candidates factor equity in as a material component of their job package. Often times, it is a critical decision factor in choosing one opportunity over another.
Our objective in this blog is NOT to provide a granular view of every variation of equity or a strategy to help you negotiate details at offer time. Those idiosyncrasies will be very case specific, and we always recommend that a candidate find an exceptional securities attorney to navigate them through the waters. However, my goal today is to insure that YOU – the interviewing candidate – can ask the right questions, and thus demonstrate to the potential employer (frequently the CEO/President and or Board) that you intimately understand how early stage growth companies work. You want to impress, differentiate yourself, and have your future boss infer that you recognize how value is created for both investors and employees.
The power of a single question can be best summed up this way. A friend of mine – a long-standing VC and successful company exec – told me point blank: “If we’re at the final negotiating stage and the candidate doesn’t ask me about [investor] liquidation preferences, I’m going to automatically assume he/she hasn’t been around the block before.” Now, that doesn’t necessarily preclude the candidate’s hire, as those decisions may be driven primarily by competency and capabilities. However, really great executive teams looking for seasoned leaders may see this as an indication of one’s lack of experience or timidity in asking hard questions (or questions deemed too personal). Often what isn’t asked echoes the loudest, right?
I’m also hoping that by sharing our perspective – built upon hundreds upon hundreds of executive placements into venture backed companies – you will have a framework for comparing one opportunity to another. And perhaps you may even redefine your risk propensity for that next great challenge! What I will not do is spend time on the obvious, in which there are endless peripheral recommendations. Here are a few:
- Make sure the CEO and current team has the history and track record to drive to a likely exit.
- Insure there is adequate funding to reach your next milestone.
- Do your homework to make sure the space is hot with tons of future growth opportunities.
- Understand the uniqueness of your product and service in the competitive market and decipher whether you can lead the pack.
These could go on ad infinitum, and all represent good basic vetting questions for assessing a company’s long term prospects. However, our purpose today is to consider whether the equity structure itself – in broad terms – has any real shot of getting you over the rainbow. Best case – the answers when posed will confirm or deny your feelings of risk. Worst case – the potential hiring manager will think you are one experienced dude (or dudette).
A STARTING CONSIDERATION
Perhaps the first question a candidate needs to ask him/herself is: Will equity in a non-institutionally funded private company EVER have any material value? How many times have you heard that a friend has “a piece” of company? Or perhaps you know a relative who is busting his/her chops in a family run business (not theirs) and own 5% or so of the company’s stock? I’m not one to poo-poo private companies as they are the backbone of America. Many are wonderfully run family businesses, and potentially worth a lot of money. The problem is that an “exit” is neither imperative nor scheduled. Without an institutional firm driving for an IPO, acquisition, merger, or equity recap, your shares may sit in limbo for an awful long time. I stopped counting how often an owner that “wanted to get out of the business,” suddenly had a change of heart, brought in family members or outsiders, or simply ran the company into the ground over time.
And therein lies the problem for you – the minority shareholder – zero voting rights, zero board influence, zero equity trade-in/buy-out vehicles, and very little of just about anything to force a liquidation of your position. Countless books have been written about this scenario while an entire financial services consulting industry has emerged to help private businesses create liquidity channels for closely-held shareholders. Over 30 years, I’ve seen people sit decades in a go-nowhere situation, hoping that this will be their year. Now there are certainly examples of good outcomes – and even creative structures – where equity is marked to market and built outside the company coffers for certain employees. Ever heard of equity indexed life insurance, phantom stock, and ESOPs?
But one thing is certain; private equity and venture backed boards are generally looking to make their returns in 4-7 years, while privately held, non-institutionally backed companies often have little compulsion to do anything. The primary owners may decide to grow the business and take larger risks (maybe by adding huge amounts of debt), or they may go on permanent vacation colleting their auto-pilot check while running with a “lifestyle business.” Venture capital/PE firms make most of their money on “the carry” [carried interest] – that percentage of the company’s profit (including capital gain) in excess of their investment. So, from a pure “odds play” perspective, who is more likely to drive towards that big exit? Just something to think about.
WHAT EVERY INTERVIEWING CANDIDATE NEEDS TO KNOW
1. How many shares/what percentage should I ask for?
I’m asked this question 50% of the time. Once my daughter said (with total puppy dog eyes): “Daddy, can I have my own piece of pie tonight and not share any with my brothers/sisters?” Her question was clearly aimed at quantity and exclusivity. What she could have also asked (then again, she’s only 7) was: “How big is the whole pie tonight? How many pieces will you be cutting it into? If some of our cousins drop by, will you cut them into even tinier pieces to accommodate? What if Daddy wants some; he usually has dibs on a very large chunk no matter what anyone else wants . . . and he’s the one actually paying for the pie!”
I often see candidates who simply want to know how many shares they are going to get. My response (tongue and cheek): “Ok, how about 500? Or better yet, 5 million? What’s more important is the percentage of ownership at issue/grant. However, the bigger question is: What will your percentage of ownership be at exit? To even begin surmising an answer requires a deeper understanding of what the CEO and board anticipate as the amount and number of future financing rounds required, and their dilutive effect on your shares. I always think it’s a good idea to ask “how many future rounds do you anticipate prior to exit,” and how much additional capital is expected to reach break-even, profitability, expansion and so forth. Additionally, do you believe the ending valuation targeted is something realistic for the type of company, its space, and the competitive landscape of others that have recently exited?
We’ve seen too many execs go into an unpredictable A-round funded company, get 1-1.5% in options; only to blow through 3 years of their life, 2 more funding rounds (several as down-rounds), and end up with diluted ownership of .03% at a much lower than anticipated exit valuation. Granted, the CEO can only make predictions based on loose assumptions; however, how he/she answers these questions will paint a picture of how deeply these issues have been thought through. Moreover, they may also indicate whether the CEO is being realistic or just an overly enthusiastic entrepreneur. In either case, your questioning will show that YOU are thinking through it!
2. How important is vesting?
Have you ever heard a story like this? A friend joins a company and gets a load of stock. Google dreams are in the air. He works his toosh off for a year and a half (doing a terrific job), but the company’s next funding round is permanently stalled . . . something about needing more “traction” (that’s VC speak for you haven’t gotten enough customers yet and may never). To conserve cash, the CEO has to scale down his team, and your bud didn’t’ make the cut. Not the end of the world, however, as he still “owns” 1.5 years’ worth of stock and perhaps his ship will come in, whether he’s there or not. But after a review of his subscription agreement and or his offer letter details, he notices that the plan is based on a 5 year vesting schedule with 2 years of cliff vesting. In other words, none of his shares actually become his unless he completes two full years of service! Ugg . . . sounds like that shaft, no? Is this scenario possible? You betcha, and it happens more times than one would like. On the other hand, what if he wasn’t terminated, stayed on board, and the company gets acquired after 1.5 years? Did he have an “accelerated vesting” clause that allows 100% of his unvested shares to automatically vest at exit? Most agreements today do, but many do not.
I find that candidates typically just take the vesting schedule and terms as “non-negotiable” items. And it’s an easy sale for the company. All the CEO has to say is: “This is the company plan; it’s the same for me and everyone else.” But we have seen countless cases where the standard plan is modified for the right candidate. Sure, sometimes it requires board approval, but if you are being brought in as a high impact player – someone whose effect will literally increase valuation in the tens of millions of dollars – then you have some negotiating pull.
If the company cannot modify the schedule and terms, then you have additional leverage to discuss adjustments to your comp plan as a compromise. Perhaps you get a cash bonus if the exit occurs prior to your cliff vesting date (or in the case where accelerating vesting is absent). It’s perfectly Ok to say: “I really love the company and the offer, and I fully expect that my contributions will make a material difference in the value of the company over a number of years. However, I’m really concerned that if do my part – and we sell early, or an unpredicted contingency hits us out of left field – I may have nothing to show for it.”
Remember, when you get down to offer time – and have been heavily recruited – there is an emotional vesting on behalf of the company as well, and tweaking plans/offer letters to accommodate hotly desired candidates is not unrealistic. Now there are a zillion plans ranging from stock grants to warrants/options, time vested shares, performance vested shares, and everything else under the sun. What matters most is that you think through some of the contingencies, and use your leverage to up the ante if the plan doesn’t totally turn you on.
3. What about liquidation preferences?
Those who have been around the block a while understand the potential time bomb that exists with investor liquidation preferences. Most candidates probably don’t even know what they are, or have heard about them vaguely but not given the subject too much thought. A great primer can be found in a 2013 Entrepreneur Magazine article by Bo Yaghmaie (http://www.entrepreneur.com/article/229615). I find that most candidates never ask or are afraid to ask. The subject seems too taboo, as if you were demanding a tour of the board member’s bedroom. Oftentimes, the CEO will not know the specifics or will pretend to not know. Two things are important here, since you cannot control anything related to the preferences: i) find out what they are in the event an uncommon deal was worked out between the company and VC (your securities attorney can decipher), and ii) demonstrate your experience level – either historical experience or knowledge obtained through research – by simply asking the question. You may discover that a secret “nuclear option” has been built in. But, for certain, you’ll be in the minority for asking and will clearly show your level of diligence and understanding of the venture funded world.
4. Don’t I have a better shot at a home run getting in early before multiple rounds?
A long time VC buddy of mine once said that a chimp in a tuxedo throwing darts has as good a chance of picking winners as the average VC. “Think about it for a moment,” as he continued, “only 25% of total VC funds have historically generated a return that exceeds that of the S&P500” (additional noteworthy reading on the subject can be found at Forbes – http://www.forbes.com/sites/petercohan/2014/01/03/will-venture-capital-beat-the-market-in-2014/).
There is a reason why the funds comprise a portfolio of companies. Most VCs I know are very smart, but even the most intelligent bear cannot anticipate the endless challenges that arise for early stage teams and their nascent industries. So to spread the risk, they invest in many companies with the expectation that several will fail, the bulk will break-even, and a few Googles will reach the finish line. And those few that exit at a billion dollars plus will make up for the balance, while generate an IRR that makes the risk premium for investing in the fund a more valuable use of their dollars than buying shares in Fidelity Magellan.
But you – the candidate – are essentially making a single investment and rolling the dice that this team will be the Barry Bonds of the Series A world. Can it happen? Of course; we see it every month, but we also hear about lottery winners weekly on the evening news. That doesn’t mean I have any predictable shot at walking down to the local liquor store and picking my winning eight numbers. The more important question isn’t just quantifying your stock’s potential long-term value, but the “likelihood” of it ever getting there. In other words, would you rather have a 50% shot at making a million dollars or a 5% shot at making $10 million? If the equity equation is a key driver for your playing in the early stage game, then maybe it’s better to go after a few singles when the pitcher’s fast ball is clocked at 70 miles an hour. Consider this: Ten years spent at 3 mid-later stage venture/private equity backed companies – where 2 have modest exits (1 fails), leaving with you a cumulative million dollar payday – probably still beats your return from a decade’s worth of hard labor at many Series A companies, even though you had a chance to make the mother lode at the latter.
I can’t tell you how many times I’ve heard candidates turn town offers for terrific B and C round companies in fear of leaving a few hundred thousand dollars on the table at their current middle market or public company employers. They frequently say: “If I’m going to take that type of risk (working for a venture backed company), then I need to see x-millions of dollars of potential on the horizon.” If you are ready to shoot for the stars, then by all means go for it. But just remember that moderate risk with a moderate return (replicated a few times over) may yield a far better bang over the long haul.
As I mentioned in the beginning, my goal in writing this blog was NOT to provide a lesson in the nuances of employee equity; there are endless books and professionals specializing in the field. But rather, I wanted to give you some “discussion points” that can be addressed with the hiring manager to help demonstrate your knowledge and seriousness as a candidate (a potential edge over others interviewing), as well as giving you a framework for thinking about company risk and opportunities. Warren Buffet once said: “Risk comes from not knowing what you are doing.” If any of this information has been helpful, then a big “congrats.” You have officially entered The Risk Reduction Zone!