No Exit
Equity compensation has long been an essential element of the startup mythos, and the economic linchpin of a system through which Silicon Valley converts “hustle” into intellectual property. Valley lore about early Google and Facebook employees whose stock options made them overnight multimillionaires plays an important role in enticing ambitious young workers to spend prime years of their lives in service of someone else’s vision. The sense of employee investment that equity instills helps perpetuate the Valley’s cherished self-image of enlightened altruism. As Homebrew Capital’s recently published guide, “Compensation at Startups,” explains, it’s important to “over-equitize” employees because “This is not about taking a job — this is about building something meaningful.” Even for less credulous, more experienced hands, the prospect of getting in on the ground floor of the next Twitter is a powerful incentive to abandon that cushy job with one of the established tech giants and throw in with an untested team and product. Since some form of equity is part of the compensation package for almost all startup employees, and everyone from CEOs to low-level support personnel generally receive at least a modest slice of the pie, equity also bolster’s Silicon Valley sense of meritocracy. After all, thanks to stock options, the Valley is a place where even the recent Stanford Art History grad who lands at the right reception desk on Palo Alto’s University Ave. can end up driving a Tesla.
That’s the dream anyway. In the near term, all of that potentially lucrative equity comes at a cost — generally in the form of below-market salaries and diminished opportunities for advancement relative to traditional firms. As a CEO I worked for told a compensation-minded employee in an all-company meeting: “Startups don’t really believe in raises.” Facebook’s Molly Graham echoes this thinking on First Round Capital’s blog when she advises that salary increases are to be avoided until after a young company’s second round of funding at the earliest. “…if [a compensation] increase is absolutely necessary,” Graham urges, “it should come in the form of equity.”
Implicit in this pervasive granting of equity is a contract of shared sacrifice, in which the long-term fates of capital, management, and employees are understood to be linked — sink or swim, we’re all in this together. As investor and startup sage Peter Thiel explains in his Stanford course on startups, cash compensation is both a potential source of “misalignment” in startups and a red flag for investors, but equity should be seen as a more virtuous reward that ensures everyone’s self-interest is harnessed for the greater good:
“Equity is critically important because it is the thing that everybody has in common. Since everyone benefits from an increased share price, everyone tries to increase the share price. It’s hard to overstate the importance of equity in forging the long-term perspectives that matter most.”
Startup compensation, then, is founded upon an almost Puritanical promotion of shared sacrifice and delayed gratification based upon equity. Like the high-performing children in Stanford’s famous marshmallow experiment, startup employees opt for a lesser reward today in exchange for the opportunity to receive a much greater one tomorrow.
Unlike research marshmallows, however, startup equity has never been a sure thing. Despite the fact that it’s factored into almost every salary analysis of tech companies, and that it often carries significant tax implications, equity is less like money in the bank and more like a golden ticket guaranteeing the holder an opportunity to partake in future wealth creation event that may or may not materialize. Anyone who lived through the dotcom boom likely remembers the painful stories of overnight paper multimillionaires who suddenly found their options worthless — the consequence of an overheated stock market bubble that finally burst. In recent years, the tech industry has found itself in a different sort of boom, and is possibly now experiencing a different sort of bust — an ending that is neither a bang, nor a whimper, but rather an extended shrug. The problem this time around for employees isn’t that they’re waking up one day to find their equity suddenly worthless, but rather that their equity faces an increasingly hazy path toward what finance types refer to as a “liquidity event.”
The traditional venture-funded startup’s journey is a progression through successive rounds of investment, with new stakeholders (generally investors and employees) climbing aboard at each stage, all looking toward the horizon for the eventual “exit” that will allow them to reap the benefits of their equity. For true believers placing their faith in the startup dream, a liquidity event is bit like a financial rapture, in which the faithful are finally rewarded for their perseverance through the transmutation of private equity (which employees are generally restricted from selling) into some form of cash or unrestricted public stock. Unfortunately, a number of factors have conspired to make liquidity events more elusive in recent years.
One of the roots of the problem is that it has become far less common for startups to go public. In the go-go ’90s, liquidity was generally generally understood to arrive in the form of an IPO, at which point employees’ stock options could be converted into the company’s newly available (and hopefully rapidly valuable) public stock. In 1996, at the high water mark of the dotcom boom, 676 companies went public — a substantial portion of which were small tech companies. By contrast, 2015 saw only 173 IPOs, and only 28 of those were tech companies. In the old days, startups that survived tended to go public within four years, and during the dotcom bubble it often happened much sooner — Netscape, which kicked off the IPO boom, took just over a year, and Pets.com’s entire run, from inception to IPO to liquidation, took only about three years. Today, on the other hand, the few startups that make it to an IPO generally take closer to 8 years.
Many have blamed the decline of the IPO market on regulatory changes, such as the Sarbanes-Oxley Act, which have sought to curb the excesses of the ’90s. And it does seem likely that contemporary Wall Street’s greater concern with financial fundamentals (like, say, actual profits) may be keeping overcapitalized but under-performing companies from submitting themselves to the glaring spotlight of the IPO process (venture capitalist Mike Moritz has even gone so far as to compare VC-backed companies hiding behind opaque, sky high, private valuations to the subprime mortgage-backed securities that brought down several major banks in 2008). There’s another important reason fewer and fewer startups go public these days, though: acquisition by an established company is a far easier, and, often, more lucrative, exit strategy. As Xiaohui Gao, Jay R. Ritter, and Zhongyan Zhu observe in their 2013 paper “Where Have All the IPOs Gone?”:
“We posit that there is an on-going change in the economy that has reduced the profitability of small companies, whether public or private. We contend that many small firms can create greater operating profits by selling out in a trade sale (being acquired by a firm in the same or a related industry) rather than operating as an independent firm and relying on organic (i.e., internal) growth. Earnings will be higher as part of a larger organization that can realize economies of scope and bring new technology to market faster.”
A few extreme outlier exceptions such as Google and Facebook notwithstanding, acquisitions have been by far the most viable exit for small tech companies since the end of the dotcom bust. In the best cases, such as Facebook’s billion dollar acquisition of Instagram, these unions can actually be quite beneficial for everyone involved — offering the acquirer a fresh infusion of innovation while taking the pressure off big picture-minded founders to satisfy equity-holders longing for a near-term exit. While loyal users aren’t always thrilled with their favorite product’s new ownership, and employees can still end up left behind (Facebook, for example, has been known to “acquire” companies while leaving corporate shells intact, relieving them of the need to honor existing equity), acquisitions have become integral to a symbiotic ecosystem that allows modern Silicon Valley to function — the big, sustainable fish eat the small, innovative ones, and employees and investors achieve liquidity for their equity in a reasonable amount of time.
This system functioned fairly well through the mid-2000s, but, as they always do, eventually things started to get frothy in Startupdom again. If the Instagram acquisition was our current boom’s Netscape IPO moment, then the rise of the “Unicorn” phenomenon that followed may well be remembered as the point where things started to tip into Pets.com territory. This time around, the exuberance arose, somewhat paradoxically, from the ashes of the 2008 economic crisis. While the fallout from a series of banking collapses plunged the rest of the economy into recession, near-zero interest rates produced a simultaneous flood of cheap money and a starvation for returns on more conservative, traditional investments. While venture capital is traditionally considered an especially risky asset class by larger institutional investors, if you happen to be a mutual fund or pension plan manager finding it difficult to make money through more conservative vehicles like bonds, why not roll the dice and see what those boys at Andreessen Horowitz can do?
With capital in apparently endless supply and Instagram’s at-the-time shocking acquisition price acting as a new de facto valuation benchmark, startup founders suddenly had little reason to focus on plausible exit strategies — or much else aside from growing as big as possible as quickly as possible. Where Instagram had succumbed to Facebook’s gilded embrace only a year earlier, new industry darling Snapchat now famously rebuffed an escalating series of Zuckerbergian advances — ultimately betting on becoming the next Facebook rather than taking a sure-fire, $3 billion dollar exit courtesy of the current one.
As the sky became the limit for tech companies again, a wave of techno-utopian optimism soon began to take hold among the Valley’s more imaginative boosters. “Software is eating the world,” VC Marc Andreesen famously declared, providing the requisite “this time everything is different” rationale every speculatory boom requires. A growing emphasis on “disrupting” entrenched market leaders, as well as a renewed focus on companies involving physical infrastructure (long taboo in the Valley after expensive dotcom-era failures like Kozmo.com), provided justification for companies taking on round after round of funding at increasingly astronomical valuations (Uber currently sits at a staggering $66 billion after 8 years and 15 rounds of funding, and lost $1.2 billion dollars in the first half of 2016). Meanwhile, cooler-headed VCs who normally might have been tempted to suggest companies consider an exit tended to bite their tongues for fear of compromising a “founder friendly” reputation — a must in what was rapidly becoming a highly competitive market for the next hot deal.
Still, however optimistic the climate, even the hottest startup can only survive on venture capital for so long — at some point even the most stalwart investors have to stop providing new funding without a clear promise of returns. Even if VCs are willing to keep anteing up, later funding rounds generally carry greater baggage — such as dilution of an existing equity pool’s value, and occasionally even more onerous terms such as a “ratchet” (a penalty that kicks in if the company doesn’t IPO by a certain date or doesn’t hit a certain stock price). While some companies, including Square and Box [Disclosure: I was an early employee of and am a stockholder in Square], have bitten the bullet and made such concessions (both eventually paying a ratchet penalty as part of their respective IPOs), many have managed to simply buy time by resorting to non-traditional sources of funding — old-fashioned Wall Street funds, private equity firms, Middle Eastern governments, and even leveraged debt.
While such unusual tactics may help founders keep dreams of independent greatness alive without opening themselves up to the harsh public scrutiny of an IPO, the advent of what some more optimistic VCs have begun to call “The Private IPO” has resulted in a new kind of startup limbo for a different class of equity-holder: employees. Massively capitalized and bound by what are almost certainly highly-inflated valuations, many Unicorn companies find themselves too big for acquisition, not profitable enough to pull off a real IPO, and therefore with nary a liquidity event in sight. While investors can generally afford to take a long bet, especially on a potentially massive opportunity like Uber or AirBnb, and founders often have opportunities to sell portions of their equity to investors as part of new funding rounds, employees tend to be the ones left with a substantial portion of their compensation stuck in illiquid form.
Given this reality, it’s reasonable to wonder why long-suffering startup workers even bother to stick around, rather than cut their losses and seek greener pastures. And indeed, attrition has, in fact, become enough of a concern lately that companies like Palantir have taken the unusual step of funding stock buybacks aimed at providing early liquidity to employees. One reason startups have less incentive to offer such concessions than one might imagine, however, is that equity grants have traditionally served an additional purpose aside from compensation: as golden handcuffs. The traditional terms of startup stock options, by design, make it difficult for employees to simply walk away and hold on to their equity without incurring substantial costs. This is because, while employees are allowed to retain their options indefinitely at no cost as long as they’re employed by the company, once they leave, they generally have a relatively short time (traditionally 90 days) in which to exercise them at face value. In addition to the cash outlay involved, an exercise can also trigger a tax liability, which can be substantial if, say, an employee exercises early options priced dramatically lower than the company’s current valuation. Given all of this, unless an employee has the resources to cover what could be a sizable out-of-pocket hit, he or she is often faced with a difficult decision between sticking it out and waiting for some sort of liquidity event, or quitting and leaving a substantial amount of earned compensation on the table.
This has not gone completely unnoticed by investors. As it has become increasingly clear that the startup lifecycle is evolving, VCs have begun quietly debating various ways of making equity-based compensation more fair to employees in the face of an ever-lengthening liquidity horizon.
The most common suggestion for reform is to increase the exercise period for stock options from the current standard of 90 days to as much as 10 years — effectively allowing employees who leave a startup to retain their equity without the need for a large cash expenditure. This may seem like a fairly straightforward solution — until you consider it through the eyes of a venture capitalist. As Andreessen-Horowitz’s Scott Kupor explains in a recent, widely-debated blog post on the subject:
“The challenge in broadly adopting the 10-year exercise rule for all employees at the outset of the company as a solution is that it disadvantages employees who choose to make a long-term commitment to the company relative to those who leave.”
Translated from VC-speak, Kupor’s point can basically be boiled down to this: startups actually rely on a certain number of employees leaving and not being able to afford to exercise their options, because attrition is a good way to replenish the pool of equity available for new investors and employees without diluting the value of existing options. While most employees likely think of their vested options as compensation earned, to a VC a stock option is an abstract financial instrument. Andreessen-Horowitz in particular is fond of Black-Scholes, an options pricing model borrowed from the derivatives trading world, which posits the length of an option’s exercise period as a key component of its value. Since one of the functions of stock options is to ensure loyalty, giving departing employees a dramatically longer period to exercise their options would, to the mind of many VCs, be effectively robbing faithful current and future employees of value and transferring it to deserters.
From Kupor’s perspective, one way of addressing this inequity would be to offset the increase in the exercise period with a commensurate decrease the number of options that are likely to be exercisable at any given point. In practical terms, this would mean lengthening the vesting term.
Vesting is yet another variable in the complex options equation. While startup employees are generally granted a block of options as part of their compensation, the employee’s non-forfeitable right to those options (that is to say, his or her ability to hang on to said options in the event of a separation from the company) generally accrues only gradually over a multi-year time period. The most common arrangement in the tech world is that an employee must remain with the company four years for his or her percentage of options “ownership” to reach 100%. In addition, most options grants also specify a one year cliff the employee must reach to take home *any* options whatsoever (a provision that gives rise to one of the startup business’s dirtiest secrets: you’re never more attractive a target for firing than right before your one year anniversary [Disclosure: Tumblr fired me approximately one month before my vesting cliff.]).
As VC Jeff Bussgang explains, the current four year vesting standard is closely related to the shorter time-to-IPO standard of yesteryear, but ill-matched to today’s Unicorn-friendly environment:
“But since then, the average time to exit has crept up meaningfully from 4–5 years to 6–8 years. So shouldn’t vesting schedules reflect this reality? Shouldn’t the vesting schedule for stock options be 6 years?
Boards are finding that they have to reissue options every 3–4 years because once an employee is fully vested, they naturally come back to the table with their hand outstretched asking for more incentive options to stick around.”
Sure enough, companies like Snapchat and Palantir have adopted policies that either vest employee options over a longer period of time (five years in the case of Palantir) or back-weight the bulk of vesting later in an employee’s tenure (Snapchat vests only 10% the first year, 20% in the second, 30% in the third, and 40% in the fourth). Still, while this adjustment may strike VCs and founders as a reasonable tradeoff, lengthening the time workers are expected to remain bound to the company doesn’t exactly scream “employee friendly” — particularly when it could be argued that the Unicorn phenomenon at least partly driving today’s longer time-to-exit is very much the result of particular management and investor choices, not necessarily anything the employee has any control over.
Perhaps what modern Silicon Valley really needs is a different vehicle for equity compensation — one that behaves like a stock option but more honestly acknowledges the long road many startups today have to justify their valuations and provide liquidity to employees. One such alternative was popularized by Facebook, which became a sort of proto-Unicorn back in 2007 after a strategic investment by Microsoft jolted the company’s private valuation from $525 million to $15 billion. Since a private company’s option strike pricing is tied, per the tax code, to its fair market value, and an option’s value lies in the appreciation of the company’s stock value above it’s strike price, and since living up to (let alone surpassing) its stratospheric new valuation seemed at the time to be a tall order for Facebook, Facebook suddenly found itself in the difficult position of being unable to grant options with enough upside to attract potential new employees.
Facebook’s response to this crisis was to start issuing employees Restricted Stock Units (RSUs) instead of stock options. Unlike options, RSUs aren’t simply guarantees of the opportunity to later buy stock at a particular price, they’re full-value proxies for the company’s stock — stock coupons, if you will. Like options, RSUs generally vest over a period of years and cannot be sold without the company’s agreement (ergo the “restricted” modifier). Unlike with options, however, an employee doesn’t need to come up with cash to “exercise” RSUs within a certain period of time upon leaving the company — he or she already owns all vested shares outright. Because there is no exercise price to be paid, an RSU can technically never be “underwater” in the way an option can if the company’s valuation declines (as Facebook’s subsequently did by $5 billion). As long as the company is worth something, RSUs are worth something.
On the face of it, RSUs seem to offer a better option for today’s breed of startup. They still provide for Thiel’s all-important alignment of the employee’s success with the company’s but are less likely to be rendered totally worthless if the company doesn’t manage to live up to an inflated private valuation. They still encourage loyalty since the employee has a reason to stick around throughout the vesting period, but they don’t impose a potentially onerous exercise cost on employees who leave before a liquidity event. They address a number of emerging problems in today’s startup environment but don’t necessitate a complicated reassessment of the equity value equation, as the proposals for reforming options are generally perceived to do. RSUs also have another key benefit that is attractive to scrutiny-shy Unicorn management: the SEC doesn’t consider employees with RSUs investors the way it does employees with stock options — which means that rapidly expanding companies can avoid running afoul of an SEC rule that requires companies with over 500 investors to be subject to the same financial disclosure rules as public companies. Indeed, this last point was another major reason Facebook adopted RSUs back in 2007, and part of the reason RSUs have today become common among larger private startups like Uber.
Unfortunately, RSUs lack one important attribute of stock options: deferred taxation. While in general options are only taxed upon exercise (which, assuming the employee doesn’t leave early, usually coincides with liquidity), RSUs are taxed as soon as they vest. This means that employees with RSU grants are continuously accumulating illiquid but taxable income based on the company’s current fair market value. This can prove disastrous for employees who have already paid taxes on RSUs whose values have declined precipitously. Employees of defunct Unicorn Good Technologies, for example, saw their RSU valuation decline so far that one told the New York Times that after taxes “Employees essentially ended up paying to work for the company.”
Gotchas like this are why odds are, if you ask a VC how to reform equity compensation, he or she will likely suggest it’s a matter best left up to the suits in Washington. And indeed, as VC Fred Wilson observes, if the IRS clarified its position on a legally ambiguous scheme that defers receipt of an RSU’s underlying stock until liquidity, we might be onto something. Minnesota Rep. Erik Paulsen recently provided some hope of this by introducing the “Empowering Employees through Stock Ownership Act,” which would allow employees to defer taxation on an option or RSU for up to seven years. Still, while tax reform would be a good start, in the age of the Unicorn, one can’t help but wonder if there’s something amiss in the startup-employee contract that would be better addressed by a different branch of finance than accounting — the one that deals with ethical notions like “moral hazard.”
Despite all of the high-minded rhetoric about equity aligning incentives, it has become increasingly apparent in recent years that structural changes in the startup business are driving the interests of Silicon Valley’s elite and their labor force further apart. The dearth of liquidity opportunities arising from today’s dramatically longer road to an exit tends to be far less of a concern for VCs and founders than for employees. Unlike employees, who generally have limited visibility into important equity-related matters such as fund-raising, growth, and acquisition offers (Good Technologies reportedly declined an $825 million acquisition before eventually being acquired for half that), founders and investors are the ones whose speculatory enthusiasm and utopian optimism is pushing companies into uncharted financial territory in the first place. The megalomaniacal zeal driving Unicorn fever has certainly been know to filter down through the ranks, but, as in any cult, the level of faith demanded of the followers tends to be greater than that of the leaders. The preferred stock held by investors and founders is a bit like a guaranteed place on the first lifeboats off the Titanic, while employees with mere common stock are left to fend for themselves in steerage. Management alone can OK pre-IPO liquidity opportunities such as secondary offerings and stock buybacks (something they’re generally reluctant to do because of the complications they can create), and founders are often able to arrange liquidity options for themselves that are never offered or even disclosed to employees (David Byttow and Chrys Bader-Wechseler, founders of flash-in-the-pan app sensation Secret, were famously allowed to sell $3 million worth of restricted stock to new investors right before their company tanked; Snapchat founders Evan Spiegel and Bobby Murphy have each pocketed $10 million). While Unicorn CEOs are often effectively making high stakes, one-way bets on world domination with their positions already relatively secure, their employees are, in many ways, the ones whose outcomes are most at risk.
Startups are inherently risky propositions, and as such, will likely always rely on some form of compensation that attempts to balance risk and reward. In the coming years, we will likely see a good deal of experimentation with novel equity units, longer vesting schedules, tax reform, and even alternative liquidity outlets as the industry attempts to recalibrate employee equity for the realities of the post-Unicorn, “Private IPO” world. While such reforms are important and necessary, though, perhaps it’s time take a more fundamental step back and consider whether the startup business’s fundamental operating assumptions are still fair to employees, and whether employee equity grants can still realistically be thought of as a way of aligning incentives, or rather are simply a handy way of paying employees below market wages while CEOs pursue delusions of grandeur.
Special thanks to my wife and editor, Briana Mowrey, for her help with this essay.
