In this series of one-minute sound bites, Noam offers ways to avoid founding pitfalls . Click here to listen.
In this series of one-minute sound bites, Noam offers ways to avoid founding pitfalls . Click here to listen.
By: Noam Wasserman for Inc.com
Dead equity — equity held by employees and founders no longer working at the company — is a large and growing problem.
Facebook’s IPO minted many millionaires and even billionaires. One who attracted much attention is David Choe, the graffiti artist hired to paint the company’s first headquarters. Choe opted to forgo a cash payment “in the thousands” for the equity equivalent at the time. Thanks to that one decision, he owns nearly four million shares of stock, worth in excess of $100 million. Choe’s equity is a headline-grabbing example of “dead equity”: equity owned by people who are no longer actively working for the startup.
Every share of dead equity could have been redeployed as incentive for a current or future contributor to grow the value of the startup. Instead, the dead equity languishes on the cap table, weighing down the startup and making it harder to attract and motivate the people who could impact its growth.
Facebook’s situation is far from unique, even among recent tech IPOs. Mark Pincus of social gaming company Zynga recently confronted a similar problem when he tried to reclaim equity that he felt he had over-allocated to some early hires.
Imagine how much tougher a dead-equity dilemma becomes when co-founders, who tend to hold large equity stakes, are involved. Facebook co-founder Eduardo Saverin was able to hold onto a significant chunk of equity after his forced exit from the company; that equity is now worth billions. Other prominent examples of drop-out co-founders who held significant amounts of dead equity include those at car-sharing company Zipcar and at tech startup govWorks.com (made famous in the movie “Startup.com”).
Dead equity has always been a significant issue for startups. Founders and hires have always quit, after all, and their companies don’t always have a way to reclaim their equity. However, our CompStudy data show that the problem has been growing in recent years.
We analyzed the dead-equity data from a total of 733 tech startups: 257 from our 2008 survey and 476 from the 2011 survey. We took the percentage of equity held by former employees and founders and multiplied it by the startup’s valuation during its most-recent round of financing. The graph below compares the value of dead equity in 2008 and 2011.
On average, the value of dead equity in these technology startups tripled between 2008 and 2011, from $480,000 to more than $1.5 million. As shown above, the dead-equity problem increased across the full spectrum of company sizes, but is now a significant problem even for the youngest of startups, which saw the biggest increase in dead equity.
About three-quarters of this change in the value of dead equity is due to an increase in the percentage of dead equity; the rest is due to changes in company valuations.
Startups that anticipate dead-equity problems can structure their early equity allocations to increase the chances of protecting themselves. Within the founding team, the majority of startups split the equity without taking into consideration the unexpected bumps in the road ahead. They fail to include vesting terms (i.e., the progressive earning of equity stakes by remaining involved in the startup or by achieving predetermined milestones), buyback provisions, or other dynamic elements that would help them reclaim the equity stakes of drop-out founders. (For more about this, see Eric Ries’ blog post and excerpt from The Founder’s Dilemmas.)
It is more common that startups include vesting terms for their non-founding hires. However, those vesting periods often underestimate the time horizon over which key hires should be adding value to the startup. Startups overwhelmingly use “4 years of vesting” as a rule of thumb; as shown in Figure 8.8 of The Founder’s Dilemmas, 77% of non-founding senior executives have 4 years of vesting. This is true regardless of whether they were hired during downturns in the business cycle (when it will take longer to lead the startup to an exit), the startup’s industry segment, its stage of development, and many other factors.
Vesting can serve both as handcuffs that encourage important contributors to remain at the startup and as a way to preserve equity when those contributors leave. However, blindly applying the four-year rule, when a longer horizon is needed, weakens both the handcuffs and the ability to recover and redeploy equity. When a fully-vested person leaves prematurely, the startup will have added dead equity to its cap table instead of being able to dedicate the equity to a value-creating employee.
Startups need to evaluate their specific situations and craft appropriate vesting periods by asking (among other things):
Founders, board members, and senior executives should try to anticipate these dead-equity problems and avoid the often-costly pitfalls caused by them. Ignore this growing problem at your peril.
Original post can be found here.
Our annual “CompStudy” Entrepreneurship and Compensation surveys are under way right now. If you participate, you’ll get free access to detailed compensation data.
The CompStudy surveys focus on private companies in the Technology and Life Sciences industries. We have conducted these surveys annually since 2000. (I collaborate on the surveys with Ernst & Young, law firm WilmerHale, and executive-search firm Park Square.) Last year, more than 800 private startups participated, giving us an extremely detailed dataset to help you understand the market for executive talent. The first decade of CompStudy surveys – which included almost 10,000 founders from 3,600 startups – served as the data backbone of my book, The Founder’s Dilemmas: Anticipating and Avoiding the Pitfalls That Can Sink a Startup.
As in past years, survey participants will receive free access to our sophisticated reporting/analysis website, including salaries, bonuses, and equity holdings for C-level and VP-level executives. To qualify for the free access, please complete the questionnaire by June 30th, 2012. Click here to go to the survey site.
Investors (VC, angel, etc.) who get their portfolio companies to participate, earn free site access for themselves and their participating companies. Investors who get multiple portfolio companies to participate also receive access to additional tools, such as a portfolio-level compensation dashboard.
If you participated last year, we should be able to pre-fill some of the data that would not have changed, making it quicker for you to participate now. (If you did not participate in the past, participating now will make it quicker for you to do so next year!)
All survey submissions are kept completely confidential. Submitted information is seen only by me and the core research team. The analysis site will only show slices for which we have multiple data points, and we do not even list the names of participating companies.
Below is a screen snapshot of one part of the reporting site, showing some of the detailed data slicing you can do. Focusing on the left-side controls, you can slice the data using the following dimensions (going from top to bottom):
• Geographic region
• Position (the 11 most common C-level and VP-level positions)
• Founder status
• # of employees
• Company revenues
• # of financing rounds completed
• Industry segments
New features for 2012 include:
• 10% shorter survey; should take approximately 1 hour to complete.
• Instant access to the 2008-2011 reporting data (now including Board of Directors data!)
• Access to a Company Scorecard – a dashboard-style look at benchmarked compensation data across your executive team.
In this interview with the New York Times, Noam sheds light on “the common catastrophes that doom young ventures.” To Read More
“If you are a founder, or considering being a founder, a board member, or an investor, buy The Founder’s Dilemmas right now. One of your goals should be to do everything you can to maximize your chance of success. This book will help a lot and you won’t regret the time you invest in it.” To Read More
In this virtual panel, Noam answers FT readers’ questions on entrepreneurship. To Read More
Noam addresses what it takes to create and sustain an innovative business in this interview. Noam is joined by author Scott Anthony. To listen
Q & A with Noam about many topics explored in The Founder’s Dilemmas. To Read More
“If you’re starting a new company, you probably already know that a crazy variety of landmines await you. What if you had a map that showed exactly where they are and how to avoid them? Having seen these dilemmas derail countless startups, I wish every entrepreneur and prospective founder would read this book.” To Read More
By: Noam Wasserman for Inc.com
Mark Zuckerberg and his executive team have been extremely successful at retaining equity in their company. But how well do most other founders do? Even as Facebook prepares to go public, Mark Zuckerberg, the founder and CEO, still owns 28% of his company. As a whole, Zuckerberg, his co-founders, and his former and present employees, own about 55% of Facebook. How did they do this?
Fear vs. Greed
Each time founders seek capital they face what my colleague Bill Sahlman refers to as the fear versus greed tradeoff. On the one hand, founders fear that they will be forced to shut down their startup if they run out of money, which leads them to rush to raise new capital. On the other hand, they are also understandably greedy about maintaining a high equity stake, by minimizing their dilution. (Dilution is the progressive shrinking of each executive’s equity percentage as the startup raises each round of financing.) When founders delay raising each round, they are typically hoping to achieve certain milestones that will raise the startup’s valuation. That will reduce the percentage of stock they will have to cede to their financiers, and thus reduce their dilution.
In every round of financing, Zuckerberg and his Facebook team have impressively minimized their dilution. Our CompStudy data, which allows us to compare Facebook’s equity dilution against that of some 2,500 technology startups, shows how successful the team has been. To estimate how much the founders and other insiders owned after each of the startup’s first three rounds of financing, we used the two major factors that affect dilution: the capital raised by the startup and the pre-money valuation it received.
As shown in Figure 9.5 of my book, The Founder’s Dilemmas: Anticipating and Avoiding the Pitfalls That Can Sink a Startup, the averages for technology startups are as follows:
•First round: Raise $3 million, with a pre-money valuation of $5 million.
•Second round: Raise $5.5 million, with a valuation of $10 million.
•Third round: Raise $7 million, with a valuation of $15 million.
We then compared those numbers to Facebook’s numbers for its first three rounds:
•First round: Raise $500,000, with a pre-money valuation of about $5 million.
•Second round: Raise $12.7 million, with a valuation of about $100 million.
•Third round: Raise $27.5 million raised, valuation of about $525 million.
The resulting difference between the dilution experienced by the Facebook team versus that of the average technology startup is striking across all three rounds, as shown below.
After his first round of financing, Zuckerberg and the other Facebook insiders still owned about 91% of the equity. Insiders in the typical startup own only 63% after round one. As each round progressed, Zuckerberg widened the dilution gap, to the point where after the third round of financing, 77% of Facebook’s equity was owned by insiders, compared to only 27% in the typical startup.
One of a Kind
We then analyzed nearly 2,000 technology companies that submitted data to our CompStudy survey from 2008 through 2011, focusing on the software startups that had raised three or more rounds of financing. When they had finished raising their third rounds, in not a single startup did the founders still own 77%:
Minimizing dilution can come with a stiff price. Zuckerberg and his team faced tremendous fear-vs.-greed pressures. At the time of Facebook’s founding, the pressures to quickly raise a lot of money were heightened by the prominence of its major social-networking competitor, MySpace, which had a head start and was better funded. In the first of Zuckerberg’s decisions to resist the call to grow his company quickly (which would have necessitated raising a lot of capital), he consciously limited the site first to Harvard, then to a hand-picked group of schools, and then to a steadily widening net of potential users. Yet at the point where the typical startup with a pre-money valuation of $5 million is raising $3 million (and thus relinquishing 38.5% of the company to outsiders), Zuckerberg raised only $500,000, retaining a far higher percentage of his startup for himself and his team. In the quest to minimize dilution and maximize control, Facebook skated to the edge of the “fear” cliff multiple times in their early days.
An Underappreciated Dilutor: Founders’ Equity Splits
In truth, Zuckerberg was minimizing his dilution even before the first round of outside financing. A founder’s first real dilution – and often the most powerful – occurs when equity is split with cofounders. Compared to raising a typical round of outside financing, a founder is more diluted by adopting a 50/50 co-founding split instead of founding solo, or even taking 70% and giving a co-founder 30% (as Zuckerberg did, regretted, and sought to change).
By co-founding, a founder is betting that the value added by a co-founder will justify the relinquished equity. Throughout one’s entrepreneurial journey, there is a tension between amassing resources and wealth versus retaining control of the startup. I call this tension the “Rich vs. King” tradeoff– a topic to be explored in a future column.
This post originally appeared on Inc.com at http://www.inc.com/noam-wasserman/fear-vs-greed-at-facebook.html