That startup equity is likely a raffle ticket disguised as a lottery ticket

I’m not a young engineer anymore as this year I’m turning 40. With the grey hair came the experience in engineering systems, but also in how to detect and avoid bad deals.

I decided to write this after seeing a Twitter discussion about how startups are having a hard time competing for talent with big tech companies, given the rather large compensation packages they offer. The original tweet came from Sahil Lavingia, here.

Although it’s true they can’t compete with cash, the reality is that they don’t want to compete with equity. The industry standard, of how much equity early employees get is very low, mostly because:

• Most people don’t have access to a job in a big tech company. Google recruiters never ping them.
• Most people have no idea how to judge how good X amount of shares in a post Series B company will be worth. Trying to calculate it is complicated and involves a lot of educated guesses, but most people just never even try.
• There are other benefits to working in a startup, like the speed of learning, learning how the sausage is made (if you plan to launch your startup in the future), the ample opportunities to transition to management (for the ones that want that path) and the friendships you’ll get out of it. Nothing binds people closer together than fighting in the same trench with a common goal, heavily under-gunned, being constantly reminded they can be destroyed at any moment.
• People generally like to believe in things, and CEOs are great at selling their Kool-Aid. Even if the company is sinking, if you ask the CEO how it’s going, the answer will always be it’s doing great.

It’s very common to see job postings like this:

This job, in particular, required 3 to 5 years of experience

From a 23-person company that raised a $7M Series A round, 3 years ago.

Let’s suppose you’re lucky enough to be offered the maximum amount, or 0.2% of the company, over 4 years of work, and want to analyze its value.

The first thing to do is to calculate the current value of the company. Assuming the Series A round was a standard round where a VC got 20% of the pie, we can estimate the current valuation to be $35M. This number is likely very outdated, as 3 years is a long time, but you don’t know how much better (or worse) the company got since then. It may be doing great and the current value is like $100M or the company could be struggling to show progress and get to Series B, with a short runaway nearing bankruptcy. For the lack of information, let’s stay at the $35M number.

Ok, so 0.2% of 35M is $70K, divided for 4 years, it ends up at $17.5k / year. That doesn’t sound like much, but there’s always that chance that the company will become a unicorn and have a great exit, right?

Right! But first, let’s not forget about the risk. This is how likely the company is to fail and not have an exit at all:

Source https://techcrunch.com/2017/05/17/heres-how-likely-your-startup-is-to-get-acquired-at-any-stage/

But in case it does survive and ends up with a great exit? Well, in that case, assuming the startup goes through a few more funding rounds (B, C, and D) after the 4 years, and that your equity will get diluted every time by 20%, you’ll end up with ~0.1% of the company after Series D. If it gets bought by then for $1B, you’ll, in theory, walk away with $1M, or $250k / year, but taxes will eat close to half of that. But still, you’d net $600k or so. Cool right?

Cool indeed, but if you were an engineer at Google or Facebook, you likely could get something close to that amount, with virtually no risk.

So this is what happens if you take that offer:

• If it fails, nobody gets anything
• If there’s an exit, but for not much more than it raises, only investors get their money back, everyone else gets nothing
• If there’s an exit for 10x the company valuation since you joined, the investors and the founders get rich, and you get a nice bonus
• If there’s an exit for 30x the company valuation since you joined, the investors and the founders get rich, you get what a random Facebook employee gets
• If there’s an exit for 100x the company valuation since you joined, the investors and the founders get rich, you get to buy a house in California
• If there’s an exit for 1000x the company valuation since you joined, everyone gets rich.

Don’t believe me? Check out this thread

It doesn’t sound that appealing anymore, right? Equity is supposed to align incentives, but the industry standard stingy equity grants simply are not attractive anymore. If one is to risk a large portion of their income with a pay cut, that better come with a large reward if things work out. Otherwise, it makes no sense.

Put another way, the delta in risk between the founder's outcome and early employees doesn’t justify the delta in equity between the two groups.