Job candidates may choose to work for a startup to help build something new, to work in an environment that fosters and rewards creativity, or to get the thrill of climbing aboard a "rocket ship." New employees rarely, if ever, guide the rocket ship's trajectory, even though they often directly help determine it. And startup employees' incentives usually skew heavily toward equity in the company's option planrather than salaryeven though these employees usually have no say in how the company's fundraising activities will impact the eventual value and payout of the common stock held by the employees.
In April, well-known venture capitalist Bill Gurley wrote a detailed blog post on companies that are raising money at increasingly high valuations and what this practice means for not only these companies, but also their early investors and employees. Gurley highlights employees' limited knowledge about their company's capital structure, and he explains how lack of liquidity, plus "dirty terms" in mega-rounds and late-stage funding, can affect what returns employees see, if any. Large liquidation preferences, combined with dirty terms, may result in employees questioning whether there really is any value in the equity awards granted to them, and whether they can truly count on any return from their equity. Frankly, the Bay Area and other tech hubs are expensive, so it is fair for employees to ask for, and companies to think about, ensuring their superstar employees are suitably compensated. You can't pay a mortgage with an illiquid option grant.
Discussions about the value of employee equity have increased in both frequency and urgency in recent months. Meanwhile, companies have been trying to determine how to meet growth goals while being as fair as possible to employees. One particular issue companies have grappled with in this regard is how to ensure that employees, as common stockholders, are not left empty-handed in acquisitions after investors, as preferred stockholders with a liquidation preference, have taken their share of the pie.
There are several ways startup companies can start to manage their liquidation preferences that will result in good outcomes for investors, better retention for companies, and better economic outcomes for employees. There are two primary levers to do so: (i) adopting a management carve-out plan so that key employees are paid before the investors, and (ii) recapitalizing the business to reduce or eliminate...