recursion

Sam Altman’s blog post on employee equity has started a much-needed conversation in the startup world. With a typical equity grant, most employees will not come out ahead given the lower salary of a startup over an established company. This presents considerable challenges for recruiting software engineers (especially experienced software engineers) to join startups. As Hacker News user marvin puts it:

Has anyone stopped to think what a massive failing of the startup part of the industry this is? Practically everything I read online indicates that if you consider your stock options to have any value at all even in a moderately successful company, you are a major sucker and about to get exploited.

Surely this must reduce the quality of the talent pool available to new startups, as the experienced developers conclude that other options are a better use of their time.

There’s a cynical reason why startups should grant more equity: many employees do not receive the equity they were granted. Therefore the cost of granting equity to employees is lower than the face value.

There’s three reasons for this.

First, the tenure at startups is typically shorter than the vesting period for the stock options. While equity is intended as a tool to retain employees, people still leave before they are fully vested. If a startup grants an employee 0.5% and they leave after two years, they will end up with only 0.25%. The unvested shares are returned to the option pool. Partially vested employees must make a calculation: now that they know more about the company, is it worth staying to vest the rest of their shares? This is one reason why Andy Rachleff’s Wealthfront Equity Plan includes regular grants of significant amount of new stock options.

Second, when an employee leaves the company, they must decide whether the buy their options. The cash outlay for this can be significant. Even if the employee has the cash to buy the options, they may weigh the chances of the stock becoming liquid and decide not to purchase them. Worse, if they company has raised a round of funding since they have joined, the employee will have to pay taxes on the difference between their grant price and the current value (David Weekly’s guide to stock options has a good explanation of the “AMT bear trap”). Again, the employee may decide that paying a big chunk of taxes now on stock that may have value later isn’t worth it. If the employee doesn’t buy their options, the options will be returned to the option pool.

Third, a reason that’s less favorable for startups is that there’s a very real chance that all the equity in the company is worthless. The company may completely fail, in which case the equity will be worth zero; or be acqui-hired, in which case the compensation will mostly be based on retention agreements, not equity in the original company.

Sometimes buying options is a no-brainer, but most of the time it is not clear-cut. Even a decent exit at $100M (a fairly rare occurrence) leaves most employees with little liquidity. In a typical startup, an employee must value the options based on not only the chance that the company will do well, but that they will still be with the company when it exits. Since startups grant options that are frequently unclaimed, they can afford to grant more. This would dilute founders somewhat more, and may complicate relationships with investors, but this dilution will only really be felt if the company is successful and it seems fair that that success be shared with the employees that helped make it possible.