Note
This post was originally published on Margins in April 2019.
Suppose you are joining an early stage startup and you are faced with choosing an offer that is either heavy on the options or cash. Which one do you pick? Do you lean more decisively on the stock side, or prefer cold, hard cash? Obviously, this is not a common occurrence, but it’s not purely stylized. I’ve even gone through this ordeal twice.
There are several ways you could approach this problem. For example, you could be a Paul Graham retweeting, Hacker News reading believer in the tech ecosystem-cum-bubble. Presumably, you are well aware the chances of hitting a home run is tiny, but the potential is really big. If you are really nerdy, you can put this into an Expected Value type of equation. Following this startup-forward approach, you clearly want an equity heavy package.
You can also follow a more capitalism-forward approach to arrive at a similar conclusion. You’ve read your microecon textbook, and realize production is a function of capital and labor. And given our capitalist setup, you then realize, the spoils flow to capital, as opposed to labor. In other words, if you want to make some real money, you don’t want to just turn your labor into cash, but rather be on the capital side of the productivity equation. Then, again, you lean towards equity.
Yet, you could just be a cold, clinical realist and think that most venture backed startups fail. In this perfect storm of cheap capital and irrational fascination with anything startup-y, there are so many startups, you think, that come and go. Put differently, you again make an expected value calculation in your head (or Excel, I am not a cop), but your probability is much closer to zero than it is in the startup-forward approach. In this case, you just take your cash and go home. Let’s then call this the cynicism-forward school of thought. Of course, it is hard to separate realism and cynicism at times, but it’s not like you can pay your grocery bills with unbridled optimism and La Croixs you, ehem, borrow from the fridge.
Or, as my cohost Ranjan put it in the The Margins Executive Slack Lounge (it’s ok to be jealous), you might think this is a futile exercise. Most startup offers really come in narrow bands, that are simply a function of your level of experience and the stage the company is in. Even if you convince yourself that you are making a good decision by taking more equity (or cash), it’s all a shot in the dark. No firm will realistically show you their cap table, or tell you the number of outstanding shares. Even if you magically got some of that and put them in a spreadsheet or some app, there would still be so much hidden from you in terms of dilution rights, clawbacks, ratchets, it’d be pointless to lose sleep over any of this. To be frank, I am not sure what you’d do in this case, or what you would call this philosophy. I’m going with gamble-forward. They don’t call it a startup lottery for nothing!
Let me say this outright: I fall somewhere in between the “capitalism-forward” and the “realist” approach, but really, lean towards the former. If you are accepting a startup offer, you should be better off with more options, rather than more cash, but only after covering your most essential needs. If you are really worried about immediate cash, then you should probably not join a startup, as there are much more surefire ways to make a lot more money. Of course, you might say as one of my favorite finance professors like to say, “Nothing Compares to You”, Can. That is true; every financial situation is unique and you should definitely not take financial advice from this newsletter. I happen to not have any debt, and have some savings to live off of for a while.
But then, even my personal preferences are built on the assumption that the capital structures that were built for startup employees many decades ago still are relevant to the current macroeconomic conditions. What if they are not? What if the deck is so stacked against early stage employees that it’s really, really hard to tell people to work for equity these days? Would that be too cynical?
This is what Steve Blank has to say on Harvard Business Review, just last week:
Investors and founders have changed the model to their advantage, but no one has changed the model for employees. Moving the liquidity goal posts may have removed the incentive for non-founders to want to work in a startup versus a large company. Stock options with four-year vesting period are no longer a good match for employees when it may take 10 to 12 years for the company to go public or be acquired.
Blank’s argument largely builds on how the rise of growth capital has changed the mechanics of early employee stock options, much to the detriment of its recipients. As time to liquidity events goes from a few years to more than ten, the early employees who forego cash see more uncertainty build up.
With each infusion of cash, the capital structure becomes more complicated, with dilutions, ratchets, preferences, clawbacks and various other complexities slowly eating away at any chance of meaningful financial outcome. This is all mechanical, but also, these firms are run by people who do have human flaws. As more startups, if you can call them that, get accustomed to such monstrous cash inlays, they become lax with financial discipline, further lowering the potential outcomes.
In such an environment, can you really blame potential employees to sour on the whole idea of startups? The exorbitant costs of living in places like San Francisco definitely colors people’s decisions here, but I’ve heard first hand from CEOs that hiring has practically become impossible in places like the Bay Area. Prospective employees simply discount their options to zero. Such a cynical and negative hiring environment is not conducive to long-term health of an industry that is built on not just increasingly rare skills, but also optimism to a fault. Something has got to give.
I joked on Twitter that we always talk about Venture Capitalists in the tech ecosystem, but you rarely hear about the Venture Laborers. And I should know. I worked at not one, not two, but three firms as an early employee (well, sort of). They all got “acquired” but, as my financial advisor would testify, I definitely have not seen much (any?) of those spoils. Of course, that also has more to do with why those quotation marks are there in the first place, but the point remains.
There’s definitely some hope at the end of the tunnel. Many companies such as Pinterest and Quora have extended their exercise windows to several years, allowing employees some flexibility. On the transparency side, Square engineer and writer Jackie Luo is attempting to bring some transparency into the startup windfalls by anonymously collecting “exit” outcomes. These are all good steps, but they are not enough. A systemic issue will not be solved by individual actors, whether they are persons or companies. And while I play a cynic on Twitter often, I still believe in the tech ecosystem to be a force for good. Sure, it can be at times a bit hectic, or truly dark. Nonetheless, for the ecosystem to thrive as much as it did before, the doors of opportunity should be kept open for new entrants as well.