Don't Compensate with Equity

Startups famously like to pay employees equity in lieu of part of their market-rate salary. Much has been said about why this is a bad deal for employees, but I think this is also usually a bad deal for startups.

Startups pay in equity for several reasons, of varying moral character:

• Aligning incentives
• Retaining early employees as valuation grows
• Conserving cash and extending runway
• Tax advantages to equity compensation
• Hoping that employees will over-value it
• Making their financials look better

But in most cases, these reasons don't make much sense:

• Aligning incentives makes sense for the earliest employees and for management, but most employees do not have much individual influence over the success of the company.
• Retaining early employees can be done with raises or bonuses^[0]—and if your equity has become valuable enough to matter in the counterfactual case, you can afford to do so. "Golden handcuffs" situations^[1] can be more effective than cash but are relatively rare these days.
• Extending runway can be done by selling the equity instead of compensating employees with it.
• All but the most junior employees have gotten wise to equity hype tricks.
• While investors might worry more about your spend, they will worry less about employees leaving post-vest if they aren't vesting.

The more fundamental issue is that startup equity is extremely risky and illiquid—terrible properties as a major investment for a middle-class individual. This vastly outweighs the only reliable advantage—tax efficiency—under any reasonable assumptions about risk adversion or marginal utility of money^[2]. Most employees will therefore significantly discount the value of their equity. There is a natural buyer for this kind of financial product who discount far less for risk and illiquidity: venture capitalists. Startups should therefore prefer to sell more equity to VCs and pay their employees with the cash they obtain.

Admittedly this is not always possible. Not every round is oversubscribed, and the dynamics of trying to put together a round make it difficult to sell more stock at a slightly higher price. But there are also SAFEs and other inter-round fundraising methods that startups can use to sell equity they would otherwise give to employees. Unfortunately, if your startup is neither oversubscribed nor able to find buyers for SAFEs in decent size, your odds are not good whether you manage to stretch your runway or not—better not to optimize for this case. Any advantage of equity compensation here is just a more complicated case of taking advantage of employees over-valuing equity (because they do not think through these contingencies).

There are exceptions. Your very first hires and senior executives do have enough influence on your success that they should have equity. And the most successful startups—with upcoming IPOs or tender offers—can reap the benefits of equity without most of the downside because their equity is more like cash. Unfortunately, I think these exceptions blind most startups to reality. Every startup has gone through the founding team stage, and every startup looks up to the late-stage successes, and they over-generalize from these situations. But they spend most of their lifetime in the valley between building their founding team and a liquidity event.

I once saw this dynamic play out up close when I received offers from a late-stage soon-to-be-liquid startup A and from a younger startup B. Both offers were equity-centric. B considered A its main rival for talent and had calibrated its offers to be similar to but more generous than A's. But the actual economic properties of the two offers couldn't be more different! In no world would the two roles end up paying a similar amount—either B would catch up to A and its equity would 10x before any liquidity event, or its equity would go to 0. B was very well-funded and fairly diluted—i.e. cash/equity was a live trade-off for them—and could have afforded to pay its employees a lot more cash. But instead they copied A's structure, which made their offer much less appealing given my diminishing marginal utility of money.

Could startups really get away with not offering equity, or is it too much of an expectation at this point? When I pitched this blog post to a friend and fellow founder, he turned out to have reached the same conclusion—he doesn't offer equity for most roles. Has it made hiring harder? Far easier, he tells me—by offering otherwise above-market salaries, he gets lots of good candidates who don't care much for equity. This suggests there is an under-exploited demand among candidates for cash compensation in lieu of equity. Whether this would be true at scale is unclear, although a mass move to non-equity compensation would likely change expectations.

0. ^

   There are some unfortunate tax disincentives to bonuses, so raises probably make more sense—although a temporary raise is more unusual.

1. ^

   Where an employee can't afford to exercise their vested options if they quit.

2. ^

   Economists generally define risk aversion as decreasing marginal utility of money, assuming people care only about expected utility but are otherwise indifferent to the shape of its distribution, but this is a simplifying assumption and is clearly false in extreme cases.