How Wizards of the Coast distributed equity as a startup

One problem is that a lot of people look at equity grants as a meritorious service award. But that's not at all what they are; they're compensation for risk.

Developers look at risk compensation and say, "well, I undertook a lot of risk to work long hours for a lower wage". That's true, but the market prices that kind of risk, and the market cares a lot about substitutes, and the typical developer taking basis points for their participation is eminently replaceable by other developers.

On the other hand, the market has no replacement for an entity legally authorized to trade $1MM for X% of the company, so that risk is priced highly. Similarly, the market has fewer substitutes for the people who actually start the company; or rather, those substitutes tend to react to the mispricing by simply starting their own companies, and thus aren't competing with the founders for equity.

Pithier:

* there's a lot of ground to be made up in how founders/operators promote startup jobs to developers!

* there's probably some marginal ground to be made up for developer equity compensation

* it probably won't dramatically alter the way startup cap tables look

* developers who genuinely (in a market sense) are poorly served by how startups allocate equity should start their own companies

* developers who can't start companies probably aren't being as screwed as we think they are by small grants --- or, if they are, they're being screwed by being persuaded to work at startups when they should instead work for larger companies that can pay them better wages.

I am employee #1 for a rapidly growing startup, been here nearly two years. It's my first developer position, I'm definitely underpaid (until our A-round apparently), but I have .5%. I feel like pretty soon it'll be apparent whether this is going to ~really~ take off (I honestly feel it will).

Any advice on what steps I should take to prevent getting shafted?

Here was my response:

Everything I have seen, read, watched and smelled has made it clear that it is much better to be over generous with equity than to be stingy.

With that in mind I plan on following the Sam Altman model as follows:

Founder(s): 10%

First 10 employees: 10%

Next 20 employees: 5%

Next 50 employees: 5%

Vesting would happen after 5 years with a 1 year cliff.(I chose 5 instead of the 4 in Altman’s model because of the growing trend of companies taking longer to reach liquidity)

Not only would this model differentiate a startup from competitors to potential hires, like you mentioned, sharing the growth with those who put in the work is the right thing to do.

Besides, what can the gal who owns 10% of Google do that the guy who owns 1% can't?

One thing that's never really brought up in these discussions because it's extremely poorly understood is that startup employees are the only ones given options (in the financial sense) and options are always more valuable than the underlying asset with the degree of premium based on the volatility of the asset.

Think of it this way, as a startup employee, your optimal strategy is to join a company, work for a year and then immediately quit if the company isn't 5x as valuable as when you joined. Over the course of an engineering career, this gives you approximately 20 shots on goal to hit on a hyper growth company. Once you've hit one, you essentially have to do enough work for the next 3 years that you won't get fired and you're vesting stock that's 10x - 1000x more valuable than what you negotiated. Nobody else is allowed to have the option of buying startup stock at 4 year old prices except employees and that's the extreme advantage.

Unfortunately, engineers are not experts at options pricing (nor should they be) so they tend to devalue the equity portion when considering total compensation which leads to the overall dysfunction in the system.

Because Wizards was never an idea based company I don't think its fair to put them in the same bucket with the usual suspects who try to exploit naive young developers by not paying them for hard work.

anytime you see two types of stock, you can be 110% sure that you are going to be screwed.

and last time i checked there was no tech company, HN included that didn't have restricted and unrestricted stock.

Another challenge is you are limited to the # of owners you can have in a pre-IPO company.

If the person getting the stock qualifies as a "friend or family", the restriction doesn't apply. Hence the term "Friends and Family Round".

It's a very bad idea to ignore the "reg D" type rules, but it's not the kind of thing where random people are likely to be able to report you to the SEC and get you fined.

Yeah, it probably violates some securities laws... but when everyone makes lots of money on the deal, there's rarely an issue. When investors lose money, they're all too happy to bring up securities law violations and fraud claims. Better to do everything by the book and not give anyone an excuse to sue you later.

I'm not a securities lawyer, but in a nutshell, startup companies should prefer a very small number of professional (and accredited) investors.

However, in practice the Section 4(a)(2) exemption is often not strong enough protection (since we're talking potentially significant civil and criminal charges) so companies go for the Reg D safe harbors even when not technically required. Particularly for unsophisticated / unaccredited investors, the courts have found that 4(a)(2) is not good enough, even when the sale was arguably private. See, for example, SEC v. Ralston Purina Co., 346 U.S. 119 (1953). [1]

Following the path of Reg D 506 is actually quite simple, and carries no downside. But even with Reg D 506 you generally try to avoid unsophisticated investors, since then you get into scenarios where you are supposed to provide 'access to the kind of information that a registration statement would disclose' which is very difficult. The crowdfunding regs in theory are supposed to help alleviate this.

[1] - http://scholar.google.com/scholar_case?case=6019539454143305...

[2] - IANAL

I recall that if you raise money from people in only one state you may be able to rely on state level rules and registration requirements

It's easy to criticize it for being $280k because we don't know the scenario where they don't have a table. Maybe that scenario is, "fuck it I'm not working on the floor any more" and the whole company is worth zero.

Then there is the economics of it. Hindsight makes it all easy when you only question the costs of the winners.

You should be completely mistrustful of anyone who offers you shares and doesn't tell you the # of shares outstanding. Alternately, if they tell you the value of a share, they should tell you the estimated value of the company.

The alternative is presented in Mel Brooks' The Producers.

even if it's not and depending on the type of grant the strike price matters quite a bit for tax purposes to the grantee.

As a shareholder you should have an understanding of how many shares are authorized (i.e., how many units of measure the company has been divided in to) and how many of those shares are issued (i.e., how many units of measure have been given out and are no longer up for grabs).

The reason it's done this way and not via simple percentage (which I agree is WAY easier to understand) is a matter of practicality; as new shareholders come on board it would be prohibitively difficult to go back to all existing shareholders and modify their percentage.

Really interesting to see how his view on equity shaped his businesses.

I loved it and I'm calling it a roaring success in most respects, but balance is not something I would attribute to the first several incarnations.