The Conventional Wisdom of Equity Compensation
If there is an industry that thrives on upsetting unconventional wisdom, it’s tech. Don’t talk to strangers? How about hailing a ride — or renting a room — from someone you have never met. People will never buy things if they can’t hold them first. That sort of stuff.
So when someone pokes technology’s conventional wisdom right smack in the middle of the forehead, it makes an impression. Especially when that someone is Fred Wilson, who wrote a brief blog post questioning equity compensation for employees of startup companies, one of the foundational pillars of the technology industry.
Providing equity compensation when most employees have cash expenses — many of which are accelerating far faster than inflation, like student debt and housing costs (particularly near tech hubs) seems increasingly misaligned. As the average time to exit for a startup stretches further into the future (up to 6.2 years currently, from 5.0 years in 2008) waiting for options to turn into cash increasingly feels less like a privilege and more like a lottery ticket (as employees at Practice Fusion just discovered). And despite the technology industry’s belief in market efficiency, the inability to accurately quantify employee equity can distort decisions, particularly as the rank-and-file have far less visibility to valuation than senior management: how do you decide if you should leave for a new job with more responsibilities? Should you exercise options if you do? Accept the tax burden? Postpone having kids or owning a home since your personal balance sheet is illiquid?
There are substantial costs for startup companies as well: company dilution can raise the exit target for investors, often widening the gap between fund and founder as to what constitutes a meaningful exit. There are very real costs of stock options on the financial statements (as LinkedIn found out), not to mention the cash expenses (think of all the 409a valuations performed each year, as well as the associated legal costs) plus the sheer difficulty of tracking increasingly varied options as a company matures. However, as Wilson notes:
And yet we treat [equity compensation] like something that is non negotiable, like it is part of the ten commandments of tech companies handed down by God to the Hewlett Packard founders eighty years ago when they were starting their company.
As with most conventional wisdom, the initial ideas were good ones: granting equity compensation allowed startups to conserve cash and provide overall alignment for success. It’s a truism that startup company founders tend to come from wealthier backgrounds, and that this stability is part and parcel of the willingness to take risk. But as the startup ecosystem has evolved it makes sense to consider a variety of alternatives, particularly as the tech industry grapples with issues of diversity its worth rethinking if those same incentives should extend across a wider and wider employee pool where not everyone has the same financial profile. Equity compensation might well return to serving as the exception — or at least as an option (no pun) instead of doctrine.