Steve Blank Business Startup Options – Why a Great Deal Goes Bad


A version of this article was first published in the Harvard Business Review

VC has just changed the social contract over 50 years old with start-up employees. In doing so, they may have removed one of the key incentives that differentiate new businesses from work in a large company.

For most novice employees Startup stock purchase options are now a bad deal.

Here's why.


Why do startups offer stock options?
Stock options had existed virtually from the start, first offered to founders in 1957 at Fairchild Semiconductor, the first chip startup in Silicon Valley. When venture capital became an industry in the mid-1970s, investors in venture-backed start-ups began offering stock options to their shareholders. all their employees. On the surface, it was a pretty radical idea. Investors gave up part of their stake in the company – not only to the founders, but to all employees. Why would they do this?

Stock options for all startup employees have several purposes:

  • Because startups did not have a lot of money and could not compete with large companies for pay, the stock options stored in front of a potential employee were like offering a lottery ticket in exchange. a lower salary. The start-up employees calculated that a) their hard work could change the odds and b) that someday, the stock options they bought could make them millionaires.
  • Investors are betting on offering potential job candidates a stake in the future growth of the company. with a visible time horizon of a gain – Employees would act more like homeowners and work harder – and this would align the interests of employees with those of the investor. And the bet worked. She led the incessant culture of "doing all the right things" of 20th century Silicon Valley. We slept under the tables and spent the entire night of the night conveying the first customer, holding booths at trade shows or shipping products to generate quarterly revenue – all because it was " our society.
  • While the founders had more shares than the other employees, they had the same type of stock options as the rest of the employees, and they did not earn the same amount of stock. only when everyone won (though much more.) At the time, when Angel / Seed investments did not exist, the founders put a lot more money at stake: to stay without pay, to mortgage their house, etc. This "we are all in the same boat" allowed the founders and employees to stay aligned with the incentives.

The mechanics of an option of buying shares was a simple idea – you received an option (an offer) to buy part of the company via common Stock options (called ISO or NSO) at low prices (the "exercise price".) If the company succeeds, you could sell it at a much higher price when the company goes public (when its shares would be publicly traded and could be traded freely) or has been acquired.

You did not have the opportunity to own your stock options at one time. The stock has run out over a period of four years, as if you were "wearing" 1/48th of the option every month. And just to make sure you're in the business for at least a year, with most stock option plans, unless you stay for a whole year, you would not get any stock.

Not everyone has the same amount of stock. The founders had the most common Stock. The first employees got a lower percentage, and later, employees received an even smaller fraction – percent fractions – over the two-digit owners.

In the 20th century, the best companies listed on the stock market in 6 to 8 years from start-up (and in the Dot-Com bubble of 1996-1999, which could last only 2 to 3 years.) Of the four start-up companies in which I am went public, it took as long as six years and as few as three.

Another thing to note is that all employees – founders, first employees, and later – all had the same four-year acquisition contract – and no one has earned money on stock options until a "liquidity event""(A sophisticated word referring to when the company went public or was sold.) The reason was that since it was impossible for investors to earn money until then, no one would Another should do it. Everyone – investors, founders and start-up employees – was, so to speak, in the same boat.

Changes in start-up pay with growth capital – 12 years for an IPO
The startup economy has changed a lot in the last two decades. And Mark Suster, from Upfront Capital, has published an excellent article that summarizes these changes.

The first big idea is that unlike 20th century where there were two phases of financing startups –Seed capital and Business capital – today there is a new third phase. This is called Growth Capital city.

Instead of a start-up open to the public six to eight years after its inception to raise capital in order to grow the business, companies can now achieve more than $ 50 million in financing, thus deferring the need for an initial public offering of 10 years or more after the creation of the company.

Suster emphasizes that the longer the company stays private, the more valuable it is. And if, during this time, VCs can keep their pro rata (fancy word for what percentage of the startup they own), they can earn a lot more money.

Growth capital is based on the premise that if private investors remain private investors (venture capital and growth investors), they can reap the full growth of public markets (Wall Street).

The three examples used by Suster – Salesforce, Google and Amazon – show how valuable companies were after their IPOs. Before these three companies were made public, they were not unicorns – that is, their market capitalization was less than $ 1 billion. Twelve years later, Salesforce's market capitalization was $ 18 billion, Google's $ 162 billion, and Amazon's $ 17 billion market capitalization.According to Suster, it's not that startups today can not collect money by becoming public, it's that their investors can do more money by keeping them private and making public later – now 10-12 years old. And currently, there is an influx of capital to do it.

Founders Rule
The emergence of growth capital and the launch of an initial public offering for savings of a decade or more have resulted in a radical shift in power relations between founders and investors. For three decades, from the mid-1970s to the early 2000s, the rules of the game were that a company had to become profitable and hire a professional CEO before an IPO.

It made sense. Twentieth-century companies, competing in slowing markets, could prosper for long periods of time through a single innovation. If venture capitalists exclude their founder, the professional CEO who intervenes could grow a business without creating something new. In this environment, replacing a founder was the rational decision. However, 21st century companies face compressed technology cycles that create the need for continuous innovation over a longer period. Who is leading this process best? These are often the founders, whose creativity, comfort with disorder and risk-taking are more valuable at a time when businesses need to maintain a start-up culture, even if they grow up.

With the observation that the founders added value over the long period of growth, the venture capital firms began to cede the compensation and control of management to the founders. (See the story of HBR here.)

Startup stock options – Why a good deal went wrong
While the founders of 20th century had more stock than the rest of their employees they had the same type stock options. Today, that's not true. On the contrary, when a young company is formed, the founders agree Restricted stock awards (RSA) instead of stock options. Essentially, the company sells them the shares at zero cost and their capital is reversed.

In the 20th century, the founders took a real wage risk, betting their mortgage and their future. Today is less true. Founders take a lot less risk, organize multi-million dollar seed tours and have the ability to withdraw money before a liquidity event.

The first employees take the same risk as the company, and often work in the same way. However, today, the founders own 30 to 50 times more than the first employees of a start-up. (What happened in the founders 'compensation and the control of the board of directors reflected the growth of the compensation of the company' s chiefs. In the last 50 years, the remuneration of the chiefs The company has gone from 20 times the average employee to more than 300 times their compensation.)

In addition to the stock disparity between the founder and the first employees, Venture capital companies moved liquidity target positions, but not acquisition target items. for non-founders. Consider that the average term in a startup is 2 years. By the third year, 50% of employees will be gone. If you are a former employee, today the company can only go public eight years after your acquisition.

So, why should non-founding startup employees have to deal with it? You will always keep your stock and you can leave and join another startup. There are four problems:

  • First, as the company collects more money, the value of your initial stock option grant is diluted by the new money you enter. (Credit companies usually have the right to keep their ownership percentage intact, but employees do not.) Venture capital companies have the benefit of keeping a private start-up, while employees benefit from the inconvenience.
  • Second, when IPOs no longer occur close to an employee's term of office, the original reason for stock options – offering future employees a stake in the future growth of the company with a visible pay horizon for their hard work – has disappeared. Now there is few financial reasons to stay longer than the initial grant.
  • Third, as the fair market value of the security increases (relative to what is paid by growing investors), the high exercise price is not attractive for the hiring of new employees, especially if they fear have to leave and pay the high lift price in order. keep the shares.
  • Finally, in many high-value startups where there are thirsty investors, the founders have the opportunity to sell parts of their shares acquired each round of financing. (Sometimes this opportunity is offered to all employees in a "secondary" offer.) A "secondary" typically occurs (although not always) when the startup has achieved a significant turnover or momentum and is considered as a "leader" in his market. , on the way for an IPO or a major sale

The end of the high commitment / high performance work system?
In academic literature, the work environment of a start-up is called a high-engagement / high-performance work system. This is a set of human resource start-up practices including recruitment, self-managed teams, rapid and decentralized decision-making, integration, flexible tasks, communication, etc. and stock options. And it is proven that stock options increase the success of startups.

Successful startups need highly committed employees who believe in the company's goals and values. In exchange for sharing the potential benefits – and being seen as key members of the team, they are ready to respond to the hope of putting work and society ahead of everything else. But this level of engagement depends on employees perceiving these practices to be fair, both in terms of process and results.

Venture capital companies have deliberately changed the social contract of more than 50 years with start-up employees. At the same time, they may have removed one of the main incentives that differentiate start-ups from work in a big company.

Even if a single technology or market knowledge is one of the components of a successful start-up, everyone agrees that attracting and remember A + talent distinguishes the winners from the losers. In trying to keep private companies longer, but without passing any of this new value to employees, venture capitalists may have killed the gold goose.

What should employees do?
In the past, founders and employees were aligned on the same type of common share allocation, and it was the venture capital firms that received preferential treatment. Today, if you are an employee, you are now at the bottom of the list of stock preferences. Founders have preferential stock treatment and VCs have a stock of preference. And you work so hard. Add to that all the other known disadvantages of a startup: absence of work-life balance, hours of madness, inexperienced management, risk of bankruptcy, and so on.

That said, joining a start-up still has many benefits for employees who want to work with high-level, loosely structured teams. Your impact will probably be felt. Constant learning opportunities, responsibility and advancement are there for those who take them.

If you are one of the first hires, there is no problem in asking for the same limited purchase agreements as the founders. And if you join a larger start-up, you may want to consider those who offer restricted stock units (RSUs) rather than common shares.

What should investors do?
One possibility is to replace the stock options of the first employees (the first ~ 10 employees) with the same restricted share purchase agreements as the founders.

For future employees, make sure that the company offers discounting options to long-time employees. Better yet, offer restricted stock units (RSUs). Restricted Stock Units are a promise of the company to give you shares of its shares. Unlike stock options, which always have a strike price (buy) greater than $ 0, a RSU is an option whose purchase price is $ 0. The lower the strike price, the less you have to pay to own a stake in the company.. Like the stock options, the RSU vest.

But for employees to stay engaged, they should be allowed to buy their acquired UAI stock and resell it whenever the company raises a new round of financing.

Lessons learned

  • Venture capital structures have been put in place to create a world in which successful companies have been out in 6-8 years without raising too much capital
  • Venture Capital Growth Funds now give start-ups the money they would have received at an IPO
    • "Growth Capital" has shifted the need for a five-year IPO
    • This allows the capitalization companies to capture the increase in the company's market capitalization.
    • This may have eliminated the incentive for non-founders to want to work in a startup compared to a large company
    • The stock options with a four year acquisition being no longer a bargain
  • Investors and founders have changed the model to their advantage, but no one has changed the model for the first employees
    • Venture capital firms must consider a new RSA equity incentive model for first hires and then RSU – Restricted stock units for all other hires
  • Large companies now have the opportunity to attract some of the talent that had previously gone elsewhere

Filed under: Venture Capital |