Startup Equity: Why are VCs Getting so Stingy with Equity? (Part 3 of an n part series)

6a0134836082f8970c01b7c8b0ac08970b-200wiDoes this familiar?

You had a great idea and turned it into a company. Somehow you got to the point where Venture Capitalists were willing to invest. You may have had less than 50 employees and less than 15% of the company committed to non-founder employees. You grew and kept innovating. Equity compensation was the currency of the day and the hope of tomorrow. Your value grew and more investors came on board. Then the equity spigot became a trickle.

What’s up?

Many VC returns have shrunk in 2016. When VCs see their value melting, they react exactly as you might expect. They become more protective of what they have and less excited about the risk of the future. Many behavioral economic studies have shown that the risk of loss drives actions more strongly than the potential of reward. This is especially true when the values are large. You may not worry about losing 5% of your investment when it is worth $100, but you are very concerned about 5% when your investment is worth $1B. So, as values have risen over the past 5-10 years, the gut punch of losses feels even more traumatic.

In addition to VC’s seeing losses, there are a few other things going on right now.

  • Weak IPO market. A less than stellar IPO market means investors cannot liquidate their investment even when there is a strong growth in value. When this occurs investors tend to tamp down on equity compensation. They want to be assured that their own investments will have value before they continue a steady stream of sharing more of that potential value.
  • Unexpected long periods to become “IPO ready.” Many current “unicorns” and “half-a-corns” would have gone public a long time ago if the markets worked like they did in the past. Long periods to IPO have two main impacts on equity compensation. First, many of these companies have far more employees than IPOs had in the past. For companies using broad-based equity, this means far more people with equity. Second, a lot of people have had outstanding equity for a while. Keeping equity compensation fresh after a decade or more can prove difficult.
  • Huge company values. Most startups use percentages or numbers of shares to determine grant sizes. With high values, this can result in grants that look to have enormous value when they are given. This is especially true with the move to RSUs. Investors look at grants that are worth tons of money on paper and start to wonder how much of that “money” is really needed.

The best thing you can do is study and prepare.

Find out what successful companies in your industry had as equity overhang when they went public or were acquired. Understand that stock plan overhang grows the longer you remain private and generally drops very quickly after you go public. This is especially true for companies who require some type of corporate action to trigger vesting. Exercises of options and vesting of RSUs reduce your overhang. Restricting these types of transactions can make overhang concerns much worse.

Learn how many employees it took to get companies to an event. There is a big difference between a company that requires 500 employees to go public and one that requires 5,000 employees to get to the same point. Here’s an interesting article looking at HUGE companies.

Look at the potential value of equity awards given your business plan and its impact on company value. The values of companies going public have continued to rise. The same percentage of ownership that made sense 15 or 20 years ago may be more than needed in today’s environment. Are you looking at 10% of a $100M or is 6% of a $950M company sufficient?

Your investors will respect you more and work with you better if you have done your homework and can negotiate with an understanding of their side of the equation.

Dan Walter, CECP, CEP is the President and CEO of Performensation. He is passionately committed to aligning pay with company strategy and culture and has been deeply involved in equity compensation for a long, long time. Dan has written several industry resources including the recent Performance-Based Equity Compensation. He has co-authored ”Everything You Do In Compensation is Communication”, “The Decision Makers Guide to Equity Compensation”, “Equity Alternatives” and a few other books. Connect with Dan on LinkedIn. Or, follow him on Twitter at @Performensation and @SayOnPay.