Employee Equity: Appreciation

This is the third post in an MBA Mondays series on Employee Equity. Last week I talked about Dilution. This week I am going to talk about the antidote to Dilution which is Appreciation, specifically stock price appreciation.

When you start a company, on day one the stock is basically worthless. There are some exceptions to this rule such as a spinoff company where Newco is getting some valuable assets day one. However in the vast majority of cases, the value of a startup on day one is zero.

One of the objectives of an entrepreneur is to steadily increase the value of the business and the stock price.

At some point, the Company will generate revenues and earnings and can be valued using traditional valuation metrics like discounted cash flow and earnings multiples. But early on in the life of a startup it is trickier to value the stock.

Fortunately we have a marketplace for startup equity. It is called the venture capital business. Every time a startup raises capital, there is a competition between investors and a negotiation beetween the Company and the investors. Those two processes provide a mechanism to determine stock price.

There is a growing trend to finance the ‘seed stage’ of a startup’s life with debt, specifically convertible debt. One of the reasons I am not fond of convertible debt is that it obfuscates the equity pricing process. But that’s a digression.

So between the formation time when the stock price is most likely $0.01 per share (ie zero) and the time of exit at hopefully $100/share or more, there is a progression of price appreciation along the way marked by the progress of the business, financing events, and eventually revenues and earnings which lead to financial analysis.

If you are an entrepreneur or an employee in a startup who has equity as part of your compensation, it behooves you to understand the appreciation in the value if your equity.

One thing that you need to know is that the price doesn’t always rise. There can be setbacks in the business that lead to price declines. There can be setbacks in the capital markets that make all businesses less valuable including startups.

And if course your Company could fail in which case all of the employee equity will be worthless.

In the case of a startup that becomes a successful business, the price will appreciate over time. There can be price declines or long periods of price stagnation, but if you are patient and the business succeeds, the employee equity will appreciate over the long run.

There are some specific issues that require a deeper dive, including the impact of liquidation preferences and the role of a 409a valuation. I will tackle those issues in the comings weeks.

#MBA Mondays

Comments (Archived):

  1. Matt A. Myers

    Happy Thanksgivings to any Canadians reading

    1. Matt A. Myers

      All AVC writers must be Canadian and busy with thanksgivings…Or, all of the internet is down except for Fred, me, and Charlie. 😛

  2. JimHirshfield

    Despite history showing us that very few employees get rich from start-up equity, it is a big attractor of talent…along with the choice to work in a small environment on innovative products. But I find that it’s the most obfuscated benefit in employee packages. Even if the start-up only has 2 employees, the company clearly articulates the base salary, medical/dental benefits they’re offering. But most start-up offer letters include only a number of shares in the company’s option plan. Full stop. No other details about how many outstanding shares there are in total or liquidation prefs. That’s like telling an employee their salary is 200,000, but not telling them which currency (USD = good offer; JPY = bad deal). Unless you’ve been through this before, it may seem like a fair offer, but you never know until you’re given the full picture. And this reflects poorly on entrepreneurs and their backers.

    1. fredwilson

      I’m trying to fix that JimYou are spot on in your critique

      1. JimHirshfield

        A fix – that would be refreshing 🙂

    2. Fernando Gutierrez

      The amazing thing for me is that someone accepts an offer with just a number of shares and no more info.It reminds me to a passage in Grumby, a book discussed here a few weeks ago, which illustrates this. The founder has been giving ten thousand shares promises to everyone and when he sits with the lawyer she tells him that with just that he can do whatever he wants: he can issue a lot of shares and keep most of the company, or issue very few and give most of it…

      1. JimHirshfield

        It’s mostly naive employees. As for the entrepreneurs, I think they have trended towards secrecy and not giving out more info if not asked to.

        1. William Mougayar

          I think it’s because they want to avoid discussions around – why didn’t I get x instead of y.But you have to consider there are different ways employee equity is obtained.If you’re negotiating to attract a key contributor, then it’s absolutely part and parcels of the deal with all its details. But if you’re hiring employees as part of your growth and you have limitations imposed by the pool you set aside, then it’s more of a standard distribution- i.e. around x salary, I give y shares, and for this other range, I’ll give another number. Reality is that for this last segment, you’re trying to divvy up the pool equitably, and the % itself isn’t the primary factor.

    3. Matt A. Myers

      I don’t think I’d want someone working for me who doesn’t think through this and understand it …

  3. PhilipSugar

    I’ve been through this a bunch of times and had people really happy and really upset.I now tell people this: The equity portion of your compensation is purely setup so if we hit it out of the ballpark you get a taste of the upside. That’s it period.Don’t come if that’s the only thing you focus on. Focus in on the experience. You are going to learn, you are going to grow, you are going to have a much better time being a part of the experience, rather than being a cog in a giant machine. If I do my job right worst case is you have a great time, grow professionally and are in a position to advance in our company or outside at another company.I try to pay fair, maybe just maybe you could make more at BigCo, but one day a consultant might come in fresh out of an Ivy League school and declare your department non-core and out you go. If we grow of course you’ll get paid more.Come work because you want to work here not because of the options.That being said I think its ridiculous to give out options without just saying number of shares, percent of company, total company valuation. If you don’t give out those you’ might as well say “just trust me” which never works. I haven’t though ever given out the company has to be worth X to get past the current liquidation preferences.

    1. awaldstein

      PhilI agree that transparency on what options mean is still a rarity but a necessity.I can’t agree with a general statement across all levels of a startup that you should come to work because you want to learn and work there (of course!) but not because of a dream of life changing economics.It’s both. And it requires both to drive the 24/7 dedication that start-ups require. It’s a matter of levels…but it is still about life enhancing wealth. In my experience taking companies pubic or being acquired, for some people it gives them the ability to get their first car, down payment on an apt, getting married and all the way up to starting their own companies and bootstrapping it.I’ve been watching this discussion across many blogs but in the trenches, the camaraderie of a startup is at its core based on shared economic success.

      1. PhilipSugar

        Of course you want to hit it out of the ballpark. That’s all you want to do and you’re right it takes a ton of effort and dedication. I take that as a given because if you don’t believe the company is going anywhere why would you work for a small company???? Why not go work for BigCo?But there are going to be ups and downs. If all you have is people that are only focused on the ups and that’s all they can dream, when the downs happen its really a down and they don’t have the commitment to stay and push through back to the ups.

        1. awaldstein

          Agree….Of course there is no argument that daily satisfaction and learning and growth are the keys for every day being worth being at work.But tucked away, in most people and in all entrepreneurs, it is the dream of accomplishment and success that pushes the daily downs aside.We are most likely saying the same thing…just with a different emphasis.

          1. PhilipSugar

            We do agree. A very important point in my post is the word “only”. I find many people want to work only for the upside (and I guarantee that dream is all over the place every single day…you’re closest to success when you think you’ve failed)…..you have to weed those people out.

          2. ShanaC

            phil, i needed this comment today. guarantee that dream is all over the place every single day…you’re closest to success when you think you’ve failedMy quote of the day.

    2. JimHirshfield

      But there’s no denying that equity packages in start-ups are often in lieu of 401Ks and other retirement packages – sometimes in lieu of a higher salary. Many a start-up has attracted talent at a lower pay scale with the attraction of stock options. That’s a double-edged sword; could work…statistically, it won’t. But an employee joins up because they believe the start-up will succeed. As such, the equity package needs to be structured such that it’s no mystery – structurally, and as you point out, not a sure thing.

      1. PhilipSugar

        Yes but if all you’re focused on is money you should go to law school and go work for a big firm, that’s what all the liberal arts majors do when they figure out the want to make money. Sorry I haven’t gotten a dig in on lawyers lately :-)Seriously, except for the founders people should be paid a fair wage….yes it might not have all the benefits to start…but the company should work towards it. And as for the benefits….every person that I know (very small sample size) that works for BigCo got their benefits chopped during the recession.

        1. JLM

          The difference between lab rats and lawyers?There are some things a lab rat will NOT do.

          1. Matt A. Myers

            LOLz… I’d ROFL but then I’d have to take a photo of it.

          2. JLM

            The difference between a lawyer and an artful hooker?An artful hooker will STOP screwing you when you die.BTW, my beloved wife is a lawyer.

          3. Mark Essel

            That means you’re a lawyer by marriage. Any and all lawyer jokes are above the belt.

          4. PhilipSugar

            We have to start thinking of some good iBanker jokes. I like your “don’t know what the mousse in their hair is made of”

        2. ShanaC

          Not all liberal arts grads can or want to be lawyers.Me- liberal arts grad. Me- does not want to be a lawyer.Me- also someone who knows that most lawyers default on their debt and don’t end up in big firms, nor do the ones that start in big firms stay there for very long. Such is the business of lawyering.11% unemployment in the legal profession- and Bigfirm law is overproducing Bigfirm law and not enough, you know, criminal defense? Every day law? That’s a problem…

    3. fredwilson

      Great comment PhilYou are spot on with everything you say

  4. William Mougayar

    The CEO’s role is to move appreciation upwards. We’re doing this to create wealth.I’m doggedly focused on it, and if not- I would have failed my investors, myself, my employees and my customers. You need the appreciation momentum.

  5. Eric Friedman

    Great post. This is arguably of greater importance to readers as a majority fall into the “employee” category than the “founder” category which is why going into these details is helpful for folks. As another topic idea for #mbamonday – the positives and negatives of allowing early exercise purchase options and the tax ramifications on some of the growth trajectories you outline. Capital gains and other things typically have great impact when a liquidation event occurs.

  6. Tereza

    Rosanna: “Hello. This is Rosanna Rosannadana. Today we will talk about Employee Appreciation. Entrepreneurs show many many people they are appreciated, for all the help they give these charming people, for free, by giving them smiles, thank yous, and a small percentage of nothing.”Chevy Chase: “Uh, um…Rosanna….” (whispers in Rosanna’s ear)Rosanna: “What??! Huh???? Employee Equity Appreciation means the stock needs to go UP????!!”Roseanna: “Oh. Never mind!”

  7. jv

    It’s work mentioning that, should you give or receive stock valued at a fair-market valuation of .01¢ a share… you should be aware of the IRS Special Tax 83(b) election — which would allow you to claim the restricted stock as income based on its current value, not when restrictions expire as normal. You only have 30 days from the date of a stock grant to decide if you want to make that election.

    1. fredwilson

      great point about 83(b) electionsi take them every time i can

      1. jv

        Of course *you* do ;)I meant it as something worth your mentioning for the readers.

  8. JLM

    At the end of the day, everybody is responsible for managing their own careers. Sometimes, these discussions seem to disregard that an employee goes to work for a company with a set of objectives that are looking way over the horizon. They have their own plan and you are not really part of it.From the second I knew I was not going to make the Army a career — a close call and one I might have made wrong given the number of wars we have had since I got out — I knew what I wanted to do.I was an engineer w/ an MBA in finance and I wanted to go into business for myself and I wanted to be in the thick of the money game. I wanted to build great buildings which morphed into wanting to rehab great old early century buildings. My passion was sort of an “Ayn Rand, Fountainhead, Howard Roark world be damned I want to do it my way kind of passion”.And I did it.But I did it by working for a Fortune 5 company in a flunky position for the Chmn of the Bd and then in their real estate department.I had one more stop along the way in which I got thoroughly screwed which provided me the impetus and the energy to nail my own shingle up.Everybody treated me very, very well — well except for one chap who taught me a wonderful but expensive lesson, tuition mind you — and paid me handsomely and when I left always tried to buy me back.I was never really listening because I knew where I was headed.I don’t think you have to be the ultimate or penultimate employer or career move for a bunch of 20-somethings. But you do have to be kind, consider they have their own plans and understand that nothing in life is certain.

    1. William Mougayar

      “I was never really listening because I knew where I was headed.” I see myself too in that quote. So true. I tune out when I hear things that are distracting.

      1. JLM

        I think that entrepreneurs hear “other voices” and one of the symptoms of the illness is the ability to reject or peacefully co-exist with information which is diametrically opposed to what you really want to hear.My father — easily the most natively intelligent man I have ever met — used to always tell me — when you get in a fight, remember to fight hard because the outcome is determined by the actual fighting. Nothing is pre-ordained.I have often heard that refrain in my head in matters small and big. And, it is true.Entrepreneurs want to get into the fight and want to contest the issue even when they possess contrary objective information because they know they can fight and win.I think that those contrary voices and facts are the edge of the risk and risk tolerance that entrepreneurs almost need to fashion their way in the world.

        1. William Mougayar

          Agreed. I would add “pick your fights”. Some issues/people aren’t worth fighting for. It’s the difference between distraction and positive outcomes.

          1. Mark Essel

            What of the times when the fight picks us?

          2. JLM

            Get in the fight and fight like Hell.Remember, it is not the size of the dog in the fight, it is the size of the fight in the dog.Remember that the Airedale breed was developed to hunt lions.

          3. William Mougayar

            Ah…you mean if there’s a lawsuit? That’s the only fight you can’t escape. Well…get a mean lawyer to do that fighting for you 🙂

          4. JLM

            Never, ever, ever allow a legal dispute to get near a courtroom.Do you have any idea how dumb juries really truly are?Skirmish like hell but settle everything.

          5. William Mougayar

            I wasn’t suggesting courtroom stage, but rather working thru issues via a lawyer if you’re faced with a legal situation, in response to Mark’s comment.I can see that you have a strong opinion on the legal system, probably with scars to prove it :).

          6. JLM

            In the turnaround business, you are always up to your eyeballs in legal issues. I once was involved w/ a company that had 35+ pieces of unresolved legal issues. I resolved each and every one of them.I won a bunch I should not have. <<< brings a smile to your faceI lost a couple I should have won. <<< makes you feel like a degenerateI settled a bunch. <<< makes you feel like a pimpAll the legal fees combined would pay for every house I own (homestead, lake, mountains, beach), every car I owned during that period (BMWs, MBs, Volvos — hey it was a convertible), my airplane, all my childrens’ educations and all my wife’s jewelry.So, yes, I have very, very strong opinions about the legal system and plaintiffs’ lawyers.Many would consider me as being extremely comfortable in such a contentious environment and I have stared down some real blood suckers in my day — but I have never made an honest buck in a legal confrontation.Nonetheless, you can create some value on the other side if you can just get your foot out of the trap.And, I am sure I will do it again some day soon.

          7. Tereza

            At my first job out of b-school we had someone in training come visit us from the OGC (that’s the Office of General Counsel to the uninitiated).We thought….YAWN….this one’s gonna be a snoozer.Then he tells us: “Lest you think a ‘jury of your peers’ is going to get you out of trouble, let me fill you in on one thing. The only thing you have in common with a ‘jury of your peers’ is an opposable thumb.”

    2. ShanaC

      WE’re an anxious bunch right now JLM. Thanks for being a good boss to those you have underneath you. The anxiety is a killer right now because of the economy.

      1. JLM

        Funny thought but I was never, ever anxious at any point in my business career especially as a young person. I was always hungry. Today, is a very funny time.I wish you could have known the job market in mid 1970s when I was getting out of the Army. Officers were getting 10-20 job offers after 1 hour interviews. America was hiring.I have never seen a more desperate job market than what I see today. I have never seen more qualified applicants than I see today.I only hope that the economy will kick in and you can see what it was like once upon a time. It will take some real changes to make that happen.

        1. ShanaC

          I should totally write you an email about how good/bad things are and what Iam seeing here in NY

  9. DaveR

    Obfuscating the equity component of compensation is a set up for disappointment.Having led a couple of software startups, I’ve made it policy to communicate what an option grant really means. Similarly, I’ve taken the time to discuss the mechanics of equity, fundraising, etc., at all hands meetings. Initially I was surprised by the lack of understanding of the basic concepts, particularly among those who had previously worked at early stage companies.In my experience, bringing transparency to these topics is greatly appreciated and increases employee trust of the business leaders.

    1. William Mougayar

      Agreed, but at the end of the day, it’s the upside appreciation that will make everybody happy. So it’s best to focus on that, and not get hung up by the initial terms which are a promise at best.

  10. lushfun

    In some sense this feels like employees are provided a viable carrot for their endeavor, but also are put on the bottom of the benefit structure. Especially if you consider the liquidation preferences and risk/viability of the company to survive and prosper. Ergo, there is a feeling that employees (not founders mind you) should be happy with stock options even though their trade offs are the worst risk/reward wise by not getting as much cash as possible per labor conveyed.The dynamic I am trying to get at is thus: as prices for starting start-ups came down the gap between founders and employees seems to have widened instead. I totally understand the self-serving bias and the necessity to get as much for your buck as possible the notion I am trying to figure out is, why? I am certain funding bias (ergo serial entrepreneurs) being favored instead of first timers plays into it but still curious.

  11. HowieG

    Glad you bring this up Fred. Maybe you can respond to the Facebook $33bil valuation being tossed around. This is technically fictitious (on paper only) until an IPO or someone buys them for that price correct?

    1. fredwilson

      not that fictitiouslots of people are paying that price with their own cash buying FB stock in the secondary markets

      1. HowieG

        If FB IPO’s at $33Bil I am going to short it with every penny I have! LOL Lots of pressure on Facbooke yet the numbers I see on user activity don’t equal what a $33bil ad based model warrants. Unless they start charging users or selling the Op System to other parties I am bearish on Facebook. When I buy a Lotto Ticket I imagine wealth too.

  12. eldsjal

    Fred, would be helpful if you got into a bit more detail in what type of equity compensation packets you’ve seen in early companies as well as high growth companies (Twitter, Foursquare etc.)

    1. fredwilson

      do you mean restricted stock versus optionsor how much equity was set aside?

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  14. Matt A. Myers

    Pretty sure Fred requires an option pool to be setup pre-money.It only makes sense unless you want to run a business where:a) you don’t want to attract and keep high-quality people, orb) you have boatloads of money to pay high-quality people.

  15. fredwilson

    The option pool issue is just a price/valuation issueI’ve written about that in the past

  16. Maurizio de Franciscis

    The employee option pool should exist before an institutional investment because the company needs it to attract talent. In the rare cases when that is not the case, the practice of requiring its creation pre-money is simply a reflection of market power. It does not come out in the wash, it comes in with the money.

  17. JLM

    A noble sentiment, indeed. You must be a very good person based upon having your face licked by a dog and your sentiments about giving back. Good on you, Charlie Chrystle!

  18. Matt A. Myers

    Oh okay. 🙂 Thanks for clarification.

  19. ShanaC

    What would be your other option for options (do it post money?) How should it look?

  20. ShanaC


  21. ShanaC

    oh and thank you