>Importantly, these projections assume a successful outcome for your company and don’t account for relevant factors such as dilution, timing, and liquidation preferences.
For me, this is the big one. I've never had ISOs in a company that had an IPO event, but I have had them (over 1% of total equity in one case) in two companies that were acquired. In both cases, there was nothing left once investors and/or founders got paid, so total value of my ISOs was $0.
Liquidation preferences. Large investors can negotiate a liquidation preference with their investment. This means they will receive some multiple (1x, 2x, ...) of their investment from the liquidation proceeds. These investors can also be "participating members" which means after receiving their liquidation preference they can still receive their pro rata share of the liquidation proceeds based on their equity stake.
So if a company was liquidated for an amount at or below the sum of the liquidation preferences there's nothing left for the shareholders to divvy up.
There are tiers of equity. Any money that comes in flows from the top tier downwards like a multi-step waterfall. Employees are usually in the bottom tier. You get what is leftover after everyone else partakes.
All equity is not created equal. Employee equity pool is usually the first to be diluted and the last to be paid out. Read your offer materials closely. You’ll want some anti dilution clause that gives pool refreshers. But 99% of the time investors will get paid out before employees or founders
If you exit under the money taken, exit under the money taken plus any preference multipliers, have founders that foolishly agreed to double-dipping schemes like participating preferences, and so on. There are myriad ways your common shares can go to zero even with an acquisition, even with an acquisition to the tune of hundreds of millions of dollars.
The board can, basically, do whatever it wants, and you have no protection at all, unless you managed to get some kind of agreement into your equity agreement (e.g., Larry Ellison's anti-dilution clause).
> I often talk to startups that claim that their compensation package has a higher expected value than the equivalent package at a place like Facebook, Google, Twitter, or Snapchat. One thing I don’t understand about this claim is, if the claim is true, why shouldn’t the startup go to an investor, sell their options for what they claim their options to be worth, and then pay me in cash?
> So how come startups can’t or won’t take on more investment and pay their employees in cash? Let’s start by looking at some cynical reasons, followed by some less cynical reasons.
> There are a lot of differences between the preferred stock that VCs get and the common stock that employees get; let’s look at a couple of concrete scenarios.
> Let’s say those investors that paid $300M for 30% of the company have a straight (1x) liquidation preference, and the company sells for $500M. The 1x liquidation preference means that the investors will get 1x of their investment back before lowly common stock holders get anything, so the investors will get $300M for their 30% of the company. The other 70% of equity will split $200M: your 0.1% common stock option with a $0 strike price is worth $285k (instead of the $500k you might expect it to be worth if you multiply $500M by 0.001).
> The preferred stock VCs get usually has at least a 1x liquidation preference. Let’s say the investors had a 2x liquidation preference in the above scenario. They would get 2x their investment back before the common stockholders split the rest of the company. Since 2 * $300M is greater than $500M, the investors would get everything and the remaining equity holders would get $0.
> Another difference between your common stock and preferred stock is that preferred stock sometimes comes with an anti-dilution clause, which you have no chance of getting as a normal engineering hire. Let’s look at an actual example of dilution at a real company. Mayhar got 0.4% of a company when it was valued at $5M. By the time the company was worth $1B, Mayhar’s share of the company was diluted by 8x, which made his share of the company worth less than $500k (minus the cost of exercising his options) instead of $4M (minus the cost of exercising his options).
Founders (and early investors) don't necessarily have preference. The thing about founders and possibly key individuals is that they can be taken care of other ways in the earn out, even if their equity ends up hugely devalued. It's one of the ways deals like this can get made, and one way employees can get left holding an empty bag.
> Founders (and early investors) don't necessarily have preference
It completely depends on the term sheet, but liquidation preference has been a thing for a loooong time. Also I meant to say "preference stack" instead of "preferred stock".
> they can be taken care of other ways in the earn out
The OP was asking why employees can make nothing during an acquisition, not if founders or investors are charitable.
> The OP was asking why employees can make nothing during an acquisition,
Right, and one of the ways that can happen is that founders do not have preference and their stock goes to nothing with the rest of the common (e.g. an equity group has your debt and 2x preference, they get almost all of the sale price). But to keep the founders on side and "cohesion" through the transfer, they are offered money outside of the equity sale in the earn out terms. If all goes well they still make ok/good money on the deal, but none/little of it is from their equity. If you are engineer #47 you may or may not have a job after the acquisition but your equity value just vanished.
This. Founders, at least critical ones, may be compensated by a payment to help complete an acquisition, especially in the event that the exit was not a good one.
Founders and other employees who the acquirer wants to retain and the founders will then be given a retention package that vests over a few years. While the payment to support completing the deal generally goes to all of the founders and the CEO, the retention can, but usually doesn't include the CEO if not a founder or most non-engineering resources...
Excellent point. This is what happened in the case where I was the VP Eng. Everyone in Engineering got low to high 5 figure cash payouts depending on seniority, and C-levels and VPs (only a group of 5) got low/mid 6 figure deals. Everyone then got joining RSUs at their level for the acquiring company.
So, everyone made some money, but not from the ISOs.
Separately from the pathologies of investing in startups as a mere employee, there are also more transparent mechanisms for public companies to dilute minority shareholders or force minority shareholders to sell their stakes:
1. A company can dilute existing shareholders by issuing more shares to raise capital. That said, if a company is at a high risk of bankruptcy, the value of a minority shareholder's diluted shares may be worth more than the pre-diluted shares if the company's balance sheet is bolstered by the new cash reserves.
Some recent examples:
1.1. Rolls Royce recently performed a rights issue where existing shareholders were granted the right to purchase additional shares in the company for a particular price [RR]. Shareholders who do not want to be diluted need to pony up more cash to exercise the rights or otherwise buy additional shares to compensate for dilution.
1.2. Telsa raised an additional $5b cash by issuing more common stock on the market. [TSLA] If you were a Telsa shareholder with a 'buy and hold' perspective, if you believe that the current market price of Telsa shares under estimates the true value of those shares to you as a shareholder, then this action reduces the value of your shares. Conversely, if you believe the current market price of Telsa shares massively over estimates the true value of those shares to you as a shareholder, then this action might increase the value of your shares (e.g. the value of your claim to future earnings is reduced by dilution, but the tangible assets per share of your diluted shares may increase due to the additional cash reserves).
2. In some cases, a public company can be acquired and minority shareholders can be forced to sell their shares through a squeeze-out [SO], provided a majority shareholder owns at least 90% or 95% of the company (depending on jurisdiction). It might make sense for a majority shareholder / acquirer to do this if they believe their private value of owning the entire business is higher than the current "fair-value" market price per share, and they can force minority shareholders to sell at the current market price. In the worst case this enables majority shareholders to take advantage of temporarily depressed market prices and lock out minority shareholders from participating in future gains if the company's situation improves or is turned around.
One arbitrary current example of an upcoming squeeze-out is the situation with hunter douglas group [HDG].
If your company is not doing well over time, there is a good chance the common stock is approaching $0 value. The longer this goes on, the more certain you can be.
If you get a sense of deja-vu every time a C-level at an all hands says "next year we'll be profitable" , "we just need this funding round, and then" "we missed revenue targets this quarterb but" etc. then you are probably there already, or nearby.
There are exceptions of course, sometimes a rough patch is just a rough patch.
Yep, I've had this happen. The "rough patch" has been going on for years, with down round after down round. At some point, you have to accept it's not working out.
Totally missed this 10 days ago, but here are some things to consider based on my experience.
Look at their funding. Not always bad, but have they taken a bridge round (something to keep them afloat while they get a bigger round together).
Did they have a down round i.e. valuation stayed flat or went negative after they took more money. This almost always dilutes common stock way more then preferred stock and VCs usually have preferred. They often re-cap in this case as well (change the terms of the cap table). Basically any time VCs have the upper hand they will dilute common stock holders.
Really, don't expect to get any meaningful amount of money unless the company sells for way way more than they raised or if the company goes public and the only way you're going to make the big bucks is if the company sells for a huge multiple while they are relatively small or goes public.
Intransparency and closed rooms. Financing rounds with undisclosed value, less or equal to the last round. Financing rounds that are less than 3x of the last one. Too many financing rounds with slowing growth. Growth of less than 50% per year. Hiring Freezes. Founders leaving. None of this is a hard criterion, but more than one of them and the chances of your equity being worth something quickly appoaches zero.
For me, this is the big one. I've never had ISOs in a company that had an IPO event, but I have had them (over 1% of total equity in one case) in two companies that were acquired. In both cases, there was nothing left once investors and/or founders got paid, so total value of my ISOs was $0.