One of the more intriguing questions, I keep asking myself, is whether the myopic fixation on bubble valuations is reasonable.
At the end of the day, I think what I have convinced myself is that
- investors are not investing at ridiculous valuations,
- founders and very early employees are cashing out, and yes
- some people are going to lose money
- it’s not like it was 2001 where retail investors buying on margin were buying theglobe.com
Then who cares? The reason I do is because
- I like to understand things
- In any new financial instrument someone is assuming more risk and someone less
And I am beginning to conclude that employees are assuming more risk.
In the valley, we’ve created a system where you have a relatively low-base salary and a very high variable income. The goal of the system is to encourage employees to keep playing lottery with their time in the hopes that they strike it rich.
The problem with this system, from the perspective of the owners of the company, is that the more equity you hand over to the employees, the less equity the owners have.
If a company has 1000 shares, the goal of the owners is to maximize the number they own and minimize the number everyone else has. The problem is that the way employees think about their compensation forces the company to keep giving out shares to new employees, and thus the % of the company owned by owners shrinks over time. The company has to keep issuing new shares, because at some point they have no more shares to give out. The owner to retain his share of the company, has to keep buying shares and that increases his risk as more and more of his money is put into one company. And one important class of owners, the founders, typically doesn’t have the cash necessary to preserve his share of the company.
Therefore, the goal of the owner is to minimize the number of shares issued for employees. An approach to solving that conundrum is to increase the per-share value. The way you increase per-share value is have investors buy into the company at a high valuation. The problem is that investors don’t want to assume that kind of risk for their investment. And so we have liquidation etc preferences that allow the valuation to be set high but the effective purchase price to be set low.
To keep dilution to a minimum, the founders are able to drive the value of the stock up with investor money and allow the investors to not assume the risk of the high valuation…
The risk of high per-share price is transferred entirely onto the employees for the benefit of the founder and early investors.
Let’s try that again…
Any half-decent engineer will evaluate their salary like this:
Total Income = Cash + Equity
And stock option equity will be valued like this:
Equity = %of company (Expected Value at time of Cash Out – Current Value)
Any RSU equity will bed value like this:
Equity = #RSU * Current Value + #RSU * Expected Value of company when you cash out.
Suppose you are at a company X, your compensation at company X is TotalIncome(X).
When you go to a Unicorn what they will do to make a competitive and attractive offer is the following
TotalIncome(Unicorn) > TotalIncome(X)
Where TotalIncome(Unicorn) = Cash(Unicorn) + Equity(Unicorn)
The way they do it is by saying:
Equity(Unicorn) > Equity(X)
So far so good… Nothing wrong so far.
But remember the value of Equity is very dependent on two parameters:
- Current Value
- Cash out Value
And here’s where Unicorns can really hurt employees. Unicorns like to offer RSU’s.
- Because of the high current value of RSU they can offer a small number
- The cash out value – because it’s only common stock – only matters if the company IPO
Giving out a small number really matters to founders and investors who care about dilution. The more shares you give out, the less each share is worth. A high-growth company that is hiring a lot of people prior to the Unicorn phenomenon would keep printing shares to keep hiring employees and that would cause the early investors to get PO’ed. The stock dilution and the employee lockup was a big deal in 2001.
Not so much now.
And here’s how ….
If you are a Unicorn, any time you need to issue more shares or deal with compensation issues, you just artificially increase the value of your company through another round, and hand fewer higher value shares to new employees. This allows you to both simultaneously keep TotalCompensation competitive and keep the number of shares static.
If you are particularly craven as a Unicorn, you can have Cash be lower than your competition with a small number of RSU’s whose value is mythological.
so far so good.
And this is okay if and only if every single company IPO’s and the public markets agree to the private market valuations.
And that still would be okay if everyone was taking on the same risk. I mean everyone, founders, all employees and investors. Except they are not.
The founders benefit the most from the lack of dilution since they own the most shares at the lowest possible value.
The investors are buying into the company at a much lower value. Think about it, you as an employee are buying with your sweat equity valued at 1 billion, and the investor is buying equity valued at 200 million … The guy buying at 1 billion is going to be worse off than the guy buying at 200 million.
At some level, you can argue that I am just describing how start-ups work. And at some level I am…. Except … the valuations are not being set in the public markets, but in private ones, and the valuation is being set to a billion for reasons other than the actual earnings of the company.
The Unicorn valuations are useful for retention, hiring, advertising, lead generation and ego and a product of a negotiation with little downside for the people doing the negotiation.
In effect, employees are getting less equity based on valuation that has nothing to do with the actual earnings of the company … Instead they are getting paid based on a valuation whose opacity exists by design.
Unfortunately, this kind of shit never ends well…