A fair, mathematical approach to equity programs for pre-IPO companies | Hacker News Reader

A fair, mathematical approach to equity programs for pre-IPO companies

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57 pointsmaxcan25 comments

I'm not a lawyer; this is not legal advice.

I like the fundamental idea. However:

1) This risks pricing the common, which is bad. It certainly isn't the same as preferred, due to superior rights (liquidation preference most seriously)

2) In general, you should discount equity vs. cash because equity, even granted today, is illiquid. Even if you claim you're willing to buy it back at any given time for the then-current market price, you're better off motivating employees by giving them equity than cash, all things being equal -- the employee can improve the value of the equity through work, but can only in the most absurdly indirect way increase the value of cash itself (by tearing up other cash...)

In practice, I love what Palantir does (or did; I know about this from Ari Geller on Quora, not directly). You basically get 3 discrete offers e.g. -- $130k/500 shares, $100k/1k shares, $85k/3k shares. It's essentially a way to reveal your preference and beliefs about the company (although, Palantir is now so big that an individual's contributions don't materially move the price.) (I'd personally be WTF at someone who picked the $100k/1k; either extreme would be defensible, but I'd generally prefer to hire the 85k/3k person, unless I knew he had high cash expenses like kids in school).

> This risks pricing the common, which is bad. It certainly isn't the same as preferred, due to superior rights (liquidation preference most seriously)

The common/preferred issue is a good criticism and I have added a paragraph partially addressing it. For your convenience, here it is:

This issue deserves more thorough treatment but as a temporary remedy, I’d offer up this solution: unbundle the liquidation preferences and other preferred terms from the underlying equity. Instead of an investor purchasing preferred shares, they would purchase common shares and separately purchase rights or swaps to synthetically realize the economic exposure of the preferences. Since the investor would be purchasing the synthetics at their theoretical market value, the increase in the company’s cash would equal the increase in its liabilities. Therefore, this transaction, theoretically, would not have any effect on the dilution or value of the equity held by any of the founders, employees, or investors.

>unless I knew he had high cash expenses like kids in school).

Thats the rub for us older startup joiners... I had two options at my current company, and while the spread was very small as compared to your Palantir example - because I have high kid expenses I chose less stock but higher wage...

Although, I'd prefer if they looked at the discussion going on over employee equity, with only 20 employees thus far, their option package are nowhere near even what people have been throwing out for discussion :(

I actually think investors put enough of a premium on equity vs many employees that a reasonable case can be made for very tight equity distribution, using something like this proposed model, and periodic cash bonuses.

I actually have an even weirder idea for equity in big companies -- each class of incoming employees gets founder shares in a company comprised of hires. (Per month, per team, not sure); essentially like a PEO. Company buys that entity giving employees a capital gain related to their group's contribution at purchase time. Standard 4/1 repurchase on the founder shares within that group.

That is an incredibly interesting idea... It would be really interesting to attempt to model and see how it could play out in various forms.

You could grant some sets of options to the older employee-groups too....

See, I think that its really unfair to offer employees these options with the high cash one being the "wrong" choice. people have expenses and there's nothing wrong with choosing less risk in favor of cash up front. It doesn't mean that you "don't believe" in the mission or any bullshit like that.

One motivation behind this model is exactly people in situations like yours. Your liquidity needs should be cyclical. The IE model fully supports taking varying amounts of cash each month and getting something approaching a fair-valued amount of equity each time.

This is probably the best equity compensation plan for pre-IPO companies I've seen so far. Vesting schedules for a fixed quantity of equity have always irked me for the same reason Max explains: they assume a constant value over the life of the vesting, which is almost never the case in a pre-IPO startup.

If I was choosing between multiple offers from startups, the ones using this model would have a huge advantage in my book.

The one (big) issue I can think of is that it does not provide a way to value the common stock. The valuation events in a startup will very often be investors purchasing preferred shares. Preferred shares tend to be worth quite a lot more than common shares (and the gap tends to be larger the younger the company is), so assuming a 1:1 value between them will severely undervalue the common stock grants.

Using the pre-money valuation of a venture capital round to price common stock is a bad idea that is not supported by economics. The rights granted to the VC's preferred shares are REALLY, REALLY valuable, but the pre-money valuation values all shares as if they have the same package of rights. With things like participating preferred, dividend rights, not to mention the base liquidation preference, the value of common stock bears no relationship to the value of the preferred shares. They are only remotely similar in the event of a billion dollar IPO, when all the downside protection gets lost in the wash. This is a fundamentally low-probability scenario.

A valid criticism. I've addressed this above and added a paragraph in the essay to deal with it too.

Thanks!

How much should the common shares be discounted vs the preferred shares? Do you have any rough rules of thumb?

While prefs and commons certainly differ in value, I don't think it's matters much given that the goal here is to give employees a fairer, more transparent way to allocate between cash and equity compensation.

The valuation differences are more stark in mid- and late-stage startups; at the same time, only a small amount of the overall equity is being granted to employees.

Where I think this model has a real impact are to help the first few employees figure out compensation, which is a complete unknown right now. Pref vs common valuation matters much less at that point.

I like this approach, but this sentence gives me pause: "Interpolated Equity requires just one assumption about pre-IPO startups: the value of the equity grows at a constant rate between valuation events."

What about cases where the value drops between valuation events? If I was considering an offer, and the equity portion of the offer was valued based on a model that didn't consider the possibility of a drop in valuation, I would discount that equity severely.

Furthermore, how realistic is it to have a constant rate of growth? Perhaps I'm misreading it, but I think it is likely that the rate of growth between Event n and Event n+1 won't be well correlated with the rate of growth between Event n+1 and Event n+2.

You're absolutely right. The problem is that there are no market mechanisms at play in between valuations.

The goal of IE is to base equity pricing on market mechanisms as much as possible. In the absence of market signals, we essentially choose the simplest, most economically justifiable assumption. The alternative is to simply let the board or management massage the intraperiod valuations as they see fit which is less transparent and yields values that don't necessarily have a market basis.

I guess the "real" assumption of IE is that market mechanisms are the fairest, most efficient pricing system.

Just to clarify, the "constant growth" refers to exponential growth, compounded at a constant rate, like a bank account growing at 2% per year. Its not linear growth.

What I liked about the article was simply the maxim: "Companies should minimize the impact of the inevitable information asymmetry between prospective hires and founders and management."

Many people have raised preferred/common pricing issues and it is a valid criticism. I don't have a complete answer but have added a partial answer to the original document and have reposted it here: https://news.ycombinator.com/item?id=7625099

Mad brings up a lot of interesting points. I esp agree with having more transparency around equity.

*Max

"edit" link is right up there ^^

thanks but super weird, i dont have an "edit" anywhere

It's only there for a couple hours after the comment is posted. Not sure if green accounts behave differently, I don't create new accounts willy nilly.

This model doesn't seem to handle down rounds well, unless I missed something.

It "handles" them in the sense that the math doesn't call apart. What happens is that the implied rate of return is negative and purchases towards the end of the period get more shares than those at the beginning.

The only problem with such "justified" models is that it always comes down to what everyone thinks of everyone else's value to the company. For example -

1) A first employee might feel he should have been a founder

2) Two co-founders who might feel the 3rd one has not contributed enough to justify their share

3) Employee/contractor #20 (or whatever it is) at Facebook who painted graffiti on the walls ended up with a package worth $100M while it is hard for anyone to say with a straight face they actually created that much value (i.e. what is the reason for granting equity by job role)

4) Sizing of equity grants to engineers vs. sales staff, given that salesforce's primary motivation should be based on hitting their quotas with all incentives built around that

5) Someone fired a few months before the vesting cliff might think they are being cheated, while the company might believe they have been toxic to the culture (I won't name any examples here)

6) Employees "resting-and-vesting" at pretty much every level of the equity grant cohort

7) Later employees who end up carrying the weight of the earlier ones without comparable rewards

In every deal it all comes down to a willing buyer meeting a willing seller. Compensation packages are no exception.

I think you misunderstood the article. It's not about choosing how much to compensate someone. It's about how to allocate equity given a known compensation total.

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