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Sunday, October 21, 2018 10.58AM / By AngelList
Blog
In 2014, mobile security startup Good
Technology was valued at $1.1 billion. Employees thought their equity packages
were winning lottery tickets. They were wrong.
One year later, Good sold for $425
million. Employee share prices tumbled from $4.32 a share to $0.44. While executives
made millions, employees—some of whom paid $100,000+ in taxes on
their equity—made next to nothing.
Good Technology's situation isn't
uncommon. Like so many startups, it had investors and board members whose
equity was protected
by high liquidation
preference—a guarantee that they get paid first and at least a
certain amount when the company sells. When startup investors make millions in
a sale, but money runs dry before reaching employees, a bad preference stack is
often the cause.
To avoid being surprised when the company
you work for is acquired, you need to understand what preferences are, why
they're important, and how you can negotiate around them.
If your equity package works out to 0.1%
of the company, shouldn't you be entitled to 0.1% of the acquisition? Startup
financing isn't that simple.
When a startup is sold, the money it
makes is paid to shareholders in a predetermined order, called its “preference stack.”
As a rule, employees are last, while shareholders with liquidation preference
(LP) come first.
Three factors affect liquidation preference,
and understanding them can give you a better sense of who gets paid how much
and when:
The more rounds of financing a company
raises, the more complicated its preference stack becomes. Eventbrite is a good
example. At the time of its August IPO filing, the company had eight classes of
preferred shares, average
among unicorns. While Eventbrite's Series A through F-1 had been raised at 1x
multiples, its Series G was raised at a 1.5x multiple, and the resulting
liquidation preference was huge:
While large preference stacks could ultimately mean less money trickles down to
employees in a sale, they exist for good reason: Liquidation preference give
investors the protection they need to make the high-risk investments that startups
thrive on.
Imagine an investor puts $3 million into
a young, eight-person company. In return, the investor gets 20% of the company.
The two cofounders retain 70% of the company, and the other 10% is split evenly
among the six employees.
If the company sells two month later for
$5 million, the payouts would look like this:
The founders become millionaires, and the
employees each get a payout, but the investor loses $2 million. If there had been a 1x
liquidation preference in place, the investor would be guaranteed to get $3
million back.
Imagine you get offered your dream job.
The startup is growing fast, and the press has been lauding it as a future
unicorn. The company offers you an equity package that works out to 0.15%.
Fantastic, right?
Well, how good that deal is or isn't
depends on the company's preference stack. If the startup is carrying a huge
preference overhang, then your 0.15% may be worth very little. Imagine the
company's funding history breaks down like the table below. This is a very
simple model, but you can see how the total amount of preference accumulates
from round to round:
To get a better sense of how preference
could affect employee payout, take a look at the table below. It tracks the
final value of your equity package depending on the startup's sale price:
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.
As Ilya Strebulaev, a professor at
Stanford, notes in a study,
“Some unicorns have made such generous promises to their preferred shareholders
that their common shares [the share's employees get] are nearly worthless.”
As an employee, there's not much you can
do to affect your startup's preference stack. You can, however, understand what
you're up against. When you're considering an offer, or even once you've been
hired, there are three questions you should ask your employer:
If your most recent valuation is close to
or exceeds the needed sale price, your equity offer has value. If the needed
sale price is much higher than the company's most recent valuation, though, you
have something to consider: Based on its current growth rate, how many years
would you need to stay before its value comes close to that needed sale price?
Are you comfortable investing that much
time?
Equity alone should not decide whether
you join a startup. A high salary, a great growth opportunity, or a mission you
feel passionate about can all make up for a modest equity package. The
important thing is to have realistic expectations about how much money your
equity could turn into.
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