Some Thoughts On Equity Compensation

A hallmark of startup companies, the tech sector more broadly, and certainly our portfolio companies, is that they include equity in their compensation packages for their employees, often all employees.

If you work for a tech company, chances are good that you will get options as part of your compensation package.

I have written extensively on this topic over the years and even published a framework for issuing equity to employees on this blog.

That framework is now out of date as the market has moved (up in case you were wondering) and I need to update it. It’s a project and we are working on it at USV but I can’t promise it any time soon.

A few years ago I met with a very successful entrepreneur who built his company outside of the tech sector. When I asked him about equity compensation he said to me “You people in tech are crazy. I pay my employees handsomely in cash and I keep all of the equity for myself.”

I’ve thought about that comment a lot in the years since. I grew up in the business doing things a certain way and never questioned it until that moment.

The truth is that equity comp has its disadvantages. You can’t pay your rent or take a vacation with your options. They might be worthless if the company fails or is sold in a fire sale. You have to pay taxes when you exercise and if you can’t sell the underlying stock that can be painful. If you leave and can’t exercise, you could lose the equity.

And it is hard to compare two competing equity packages if you have two (or more) competing offers. Companies often purposely make it hard to understand the equity they are offering you. But even if they give you everything you need to know to value the equity, you still need to make assumptions about the future value of the equity to value it and nobody has a crystal ball.

For all of these reasons, many employees don’t really value the equity and they often don’t understand it either. But they understand the cash part of their compensation and know how to value that.

For companies, the equity they grant their employees is costly. Annual dilution can be as high as 5% per year just for employee compensation. We work hard with our portfolio companies to keep this dilution as reasonable as possible but I have never seen it, regardless of stage, much lower than 2% per year. Compound that over ten years and you can see what happens.

And companies have to expense the cost of issuing equity to their employees on their income/loss statements and the amounts can be massive when the companies get to be large publicly traded companies.

This recorded cost on the income statement is not theoretical. If you bought back as much stock as you issue to employees every year, something I strongly recommend to companies that have the cash flow to do it, the expense in terms of cash is very real.

So this issue of employee equity, whether to include it in your comp packages, for whom, and how employees should value it, if at all, is a big fucking deal for our industry.

And yet we treat it like something that is non negotiable, like it is part of the ten commandments of tech companies handed down by God to the Hewlett Packard founders eighty years ago when they were starting their company.

I don’t have any specific recommendations to make on this topic except that Boards should be thinking way more deeply and creatively about this issue than we are. We should be confronting the true cost of this practice and asking ourselves if it is best for our employees, and if so, which ones, and if it is best for our companies and our shareholders.

The answers to those questions is not definitively yes for all employees and all companies. As the unnamed entrepreneur who got me thinking about this proves.