With every funding event you’ll own less of the company, but is that a bad thing?
One of the sexiest aspects of joining a startup is the prospect of winning big with an exit through acquisition or IPO. But while we fantasize about the windfall, that may be the exception rather than the rule. Even for employees of unicorns.
The value of equity changes over time. This is a seesaw equation: As time passes, your company’s valuation will most likely grow as your percentage of ownership will most likely shrink. The basic principles of dilution go like this:
- Startup value is like a pie and shares of equity are its slices. All the slices of shares add up to one pie. So in the beginning, with the pie divided between just a few players, the slices are relatively large.
- However, with every new funding round, the investors require a slice of the pie. So the pie is re-cut. This shrinks the size of the original few slices. Distributing advisory and employee shares has a similar but lesser effect.
Is this slice-shrinking a bad thing? Not if your company’s valuation is increasing with each round. In that case, the value of each share may increase, though the percentage of the company it accounts for may shrink.
However, valuation does not always increase. A down round, or funding round/exit at a lower valuation than the previous one, is not uncommon. This list of examples includes plenty of big names. If your company has had a down round, your equity value may have actually decreased.
The preference stack is another minefield. A liquidation preference stack is the order in which shareholders are paid when a startup is acquired or IPOs. In general, the more rounds of funding, the greater the complexity of the preference stack. It’s increasingly common to guarantee payback to investors in multiples, especially in later rounds. For example, some investors may have been guaranteed payback of 1.5x their investment. So these investors may receive an outsized percentage of the whole (their shares will pay back more than yours). These are usually paid first, and employee shares are paid last. So it’s possible that the all or most of the pie would have already been fully consumed before employees are to be paid.
Here’s an excellent article detailing this problem, and this sums it up:
“The basic math is simple: In order for your shares to be worth anything, your company’s sale price needs to meet or exceed the value of its preference stack. The more money a startup raises, the harder it gets to fetch a high enough acquisition price.”
Remember, too, that to acquire or exercise your employee shares, you may have already paid a hefty tax bill in advance through alternative minimum tax or capital gains. Which makes an unfavorable exit result even more heartbreaking.
Angelist recommends asking these questions to get a true read on how your equity may stack up in liquidation:
- “What was our most recent valuation?”
- “What is our current yearly growth rate?”
- “How much would the company need to sell for before my equity has value?”
A fair salary and work you enjoy are the most reliable measures of whether a startup is for you, never the prospects of equity payout.
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