Unfortunately, rational people may have very different risk tolerances. Founders often see it as I have a company and X money to work with. The next round means I have a company and X + Y money to work with. In that context having a 90% chance of 10 million is often better than a 80% chance of 20 million even if the expected value drops the difference between 0 and 10 million is vastly larger than 10 million vs 20 million. But, smaller stakeholders may not agree with this thinking.
What a typical employee thought:
- I have 1% of a 10M dollar company. We'll do well and in 2 years I will have 1% of a 100M dollar company.
What will happen in the best case:
- I had 1% of a 10M dollar company. They did well and now he has 1% of a 100M company (dilution in your face!).
He just lost 9M. They were actually never on the table, even thought the hiring department didn't hesitate to pretend they were.
You've meant to say "They did well and now he has 0.1% of a 100M company" I assume? Otherwise numbers don't add up. If all goes well the value of a smaller percentage after dilution should be higher than before the dilution, for example: 1% of 10M ($100k) -> 0.2% of 100M ($200k).
Everything else follows from that. The fact that employees get any shares at all is just a way to get better employees so that the company does well. Only employees of unicorns have any chance of getting wealthy from stock, and you're unlikely to be an early employee of a unicorn.
It's better to view the situation in absolute terms rather than relative terms. Instead of comparing the outcomes of founders/VCs vs employees, compare an employee of a startup to an employee of non-startups. At not-startups, the working environment is very different. Some people enjoy that, some prefer the opposite. Also, getting +$100k (or +$50k, or even just +$10k) is still nice, even if the founders and VCs get 800x more.
The only part I have serious concerns about is the fact that you can end up underwater when it comes time to exercise your options, i.e. your tax bill outweighs whatever profits you'd see. I don't know exactly how this situation arises, but it happened to a friend. It was something like: he could have exercised his shares and gotten several hundred thousand, but he would've needed to pay about $100k in taxes beforehand. Since he didn't have that money, he couldn't exercise the options.
I might be wrong about the specifics, but there are situations similar to that, and it's pretty unnerving knowing that you can jump into a situation where your +$100k somehow turns into -$50k.
But even your example wasn't that. Your examples was -100k and +300k (or more), but offset by time slightly. That's still a very large net positive, just gated by a period of net negative.
I suspect there are some details that you are missing as to the situation of your friend. I know little about investment vehicles, but I've filed taxes at one point and paid them at a later point many times. For income taxes the rules for this are clear, and the amount you pay in fees and interest is also very clear. For some investment vehicle, I would bet if there's some taxes that need to be paid prior they have automated processes set up to pay them for you and take the amount out of the later payout, for a fee. If not, I can't imagine getting a short term loan for that would be too hard, even if you have to use private money (a real investor, or even just a friend).
As someone who has been exactly there, this doesn't compensate for the lower salaries that are de rigeur in startups. Not to mention being an absolute insult compared to the employee's degree of contribution to the resulting event.
"Better than nothing, or being underwater" is pretty thin gruel in practice.
Does this mean that stock options are not a measure of risk taken by the employee into the company?
You mean the stock options are just like cash? I didn't think so. The employee is invited to take risks but without the protections.
I feel like at least a phone call to a bank would be in order at that point. If it's that simple, surely some sort of mutually agreeable loan could be worked out.
Surely if they're private shares that can't be sold the extrinsic value is zero, the private share value for tax purposes is no greater than the value of the option?
Define wealthy.
I have done quite well (not FU, 3-comma money, of course, but solidly 2-comma) from equity as an employee. In my current company, I joined a few months after the Series A (so nowhere near "early"), stayed through the IPO and many years of growth past that.
We were never a unicorn.
Amazon, Facebook, and Google are regularly turning SWEs into millionaires and a substantial part of that is from equity. Microsoft also had a good decade and a half of doing that. Netflix probably does as well. (OK, Facebook was a unicorn; the others probably weren't ever called that, though it may have fit.)
The point in the GP post that I was expanding upon,
> It's zero net gain at the point of dilution.
is focussing on the wrong instant in time.
You should be calculating the effect of the dilution on your exit event, when your equity actually becomes exchangeable for money.
But I suppose the idea is that a bigger pie is able to expand larger and faster than it would have been otherwise.
Let's say today I own 200 out of 10,000 shares (2%) of a company. Someone comes in and says we want to own 25% of your company and are willing to pay $100M for it. At that point (before any transactions happen) I assume that my company is worth ~$400M, and my shares are worth ~$8M ($400M * 0.02).
So the majority shareholders agree to the deal and dilute stock accordingly. Now there are 13,333 shares. The new buyer get 3,333 (25%) and I still have my 200 (now 1.5%). The company is worth that original $400M value plus the new $100M that was invested, for a total of $500M. My shares are worth ~$7.5M ($500M * 0.015).
Where did my half a million dollars of pie go?
Your slice of pie before the deal is (200/10000) * $300M = 6M
Your slice of pie after the deal is (200/13333) * $400M = 6M
Except that after the deal, your company has $100M more to spend, hopefully on investing in growing the business so that later on, you'll own 1.5% of much more than $400M.
This kind of thing is why management will sometimes try to steer employees away from discussions focused on percentages and toward ones focused on share prices. As an early employee who has been diluted a number of times, I certainly agree that it's more helpful to think in terms of my number of shares (which is unchanging) times a share price (announced at the time of the investment), rather than trying to compute my new percentage of the overall company value.
It was "pre-money $400M", "new investment $100M", "new investment gets 25%". Those can't all be held true.
You can change exactly one of them to remove the conflict, so it's either "pre money $300M", "new investment $133.33M", or "new investment gets 20%"
If the new people own 25% of the company, then the previous owners own 75%. That means that the new people should get one-third as many shares as previously existed (which you did correctly). But it also means that they should have to put up one-third as much money as the company was worth previously; that is, 133M, rather than the 100M you had them pay.
Your loss is your cut of the 33M loss that your company took by getting underpaid.
At the moment that an investment is made, a company should be worth just as much as it was before, but will have more liquid assets because it's traded equity for cash.
The question for employees and shareholders then becomes: "Do you believe management is capable of using the cash to build additional value, or will they waste it?"
"You own 1% of the company" vs "You own 1% of the angel round stock pool."
I think it's clear(er) what the second sentence means.
The point is all things are not equal. To restate a sibling comment, dilution means you own a smaller % of a more valuable company.
If it helps, think of "dilution == sell_equity". Dilution is the perspective of the sellers' side (x% - y%). Equity purchased is perspective of the buyer's side (investor's ownership goes from 0% to y%).
>To try to spin dilution in any other way is stretching the truth pretty far, and is rather manipulative IMHO.
Dilution explanation doesn't require "spin" nor mental trickery. It is the natural side effect of how companies sell equity to grow.
E.g. Larry Page's ownership of Google Inc got diluted from 50% in 1998 down to 16% in 2004. That smaller 16% was worth ~$3 billion around the time of the IPO[1]. If Larry insisted on "no dilution", no VC would invest money to help the search engine grow and therefore, he would own 50% of a worthless company.
So all things not being equal:
50% of $0 = $0
16% of $20 billion = ~$3 billion.
Let's imagine Larry Page had a different conversation with Sequoia Capital to match this misunderstood fixation over "anti dilution"
>1998: Larry owns 50% + Sergei owns 50% = 100%
>1999: Sequoia: "we'd like to buy 10% of Google Inc for $12.5 million"
>Larry responds: "Yes! Great! We need your $12.5 investment but keep in mind that both Sergei and I have anti-dilution clauses so our ownership both stays at 50%."
> Sequoia responds, "So you want me to buy 0% of the company for $12.5 million? Uh, you guys are idiots"
Somebody in that imaginary conversation doesn't understand "dilution" or "equity" or simple math.
[1] http://www.nbcnews.com/id/5033780/ns/business-stocks_and_eco...
If you have no say over how much you're diluted (like most employees), you could be diluted away to nothing. You have no control. So you must calculate worth accordingly.
Is everyone to get diluted equally. No? Well then, calculate worth accordingly.
In addition, I thought the pie getting bigger was the WHOLE POINT OF HAVING THE SHARES TO BEGIN WITH.
Show example math of how someone could get "diluted too far" resulting in less total value (shares x price) after an investment round that prices the company higher than before. If the total value was truly less, it means it was "down round" which is a different beast.
>, you could be diluted away to nothing.
Show how it is mathematically possible to dilute employee's 1% ownership in to 0% without illegal tricks.
When Mark Zuckerberg tried to dilute Eduardo (without also diluting the other owners), he tried to hide the reduced % via a newly created company. He got sued for the financial deception and lost.
Using his example, if you estimate the value of a company to be 100M and estimate 10 years until IPO, if the investment doesn't raise the value of the company at the time of the IPO in 10 years then the dilution is not good for the employee because the pie is the same size (100M) but his/her shares have been diluted.
Seems like it's pretty difficult to estimate the value of the company in 10 years or the IPO date though which is probably why people just use the amount invested to estimate the value of the company.
Well, it's a big risk to everyone that doesn't get voting rights, right? Not all investors get voting rights, do they?
In some way, an employee sits between a non-voting investor and a voting investor. They don't get to vote, but they do have some control over the outcome of the company (ranging from small to large, depending on the number of employees and responsibilities of the person in question).
If you look purely at the accounting, and ignoring voting rights and other complications, you are right. Dilution doesn't change anything.
IMHO this argument is a case of technically accurate, and completely useless.
It doesn't matter what the value of the company is at the moment of the dilutive event. It matters how that event affects the value of the company when the employee liquidates their stock.
The new round could be very good, but not necessarily. There is no guarantee a more well capitalized version of the company will end up growing faster or larger than the current cap table.
When the employee evaluated their original option grant they should have done an analysis of the business, its market, and future growth potential. Lets say the predicted value of the company is $100M in 10 years.
Lets look at two options: Option 1 - The company is continuing on its original trajectory. It is running low on runway and needs a cash injection to continue gaining market share for its quest for profitability. The company still looks like a $100M company, if successful.
The new round may not be good for the employee. When you look forward to the eventual liquidity event, the employee now has a smaller piece of the same sized pie. Maybe the company could still reach its goal by tightening its belt a bit.
Option 2 - The company has identified a new market opportunity. They are raising capital to spin up a new project and capitalize the opportunity. If successful, the company now looks like a $10B company in 10 years.
The new round is potentially good for the employee. On liquidation, they will have a little bit smaller piece of a much bigger pie.
>The new round may not be good for the employee. When you look forward to the eventual liquidity event, the employee now has a smaller piece of the same sized pie. Maybe the company could still reach its goal by tightening its belt a bit.
Sure, but not taking the extra round is also bad for the employee, right? If you don't take the round, and the company now looks like a $50M company, then you have the same piece, of a much smaller pie.
Actually, your statement of "All things being equal, owning more % of a company == more money." ... is what's misleading.
People are cargo-culting the meme that "dilution is bad" and it has the perverse effect of making them think that awareness of it is "financial sophistication."
Your other statement, "Mostly from people trying to sell the idea of a highly dilutive funding round." ... is also misleading.
It's not the "dilutive" effect that's the core issue. It's whether the company needs the funds. If the company needs the investment, it needs the investment. The dilution is a side effect.
If the new investors want too high of a percentage-of-ownership, then yes, it's "highly dilutive" which is tautology. This may also appear like a dilution problem but it's not. It's a financial literacy problem. The founders are supposed be smart and not sell too much of the company for too little a price! Therefore, I'm not talking about desperate situations of founders getting diluted down to 10% or less which then affects their motivation to run the company. In that case, the company is probably in financial trouble and the other option is to reject the investment which lets employees maintain a non-dilutive ownership of a bankrupt company.
>The new round could be very good, but not necessarily. There is no guarantee [...]
I agree but the backlash against dilution is about expectation of future events whereas your scenario is ex post facto judgement of past outcomes.
For a startup operating in the present moment, do the employees want the company to be able to raise equity financing to help navigate an unknowable future?!? If yes, it means everybody should expect some dilution in exchange for the outside investment.
>Lets look at two options: Option 1 [...] Option 2
Again, for both of your options, the easier and correct focus is shares multiplied by price. In the bad outcome of Option 1, the price went down. In the good outcome of Option 2, the price went up.
Focusing on dilution as some scary boogeyman is backwards since everybody else gets diluted (see Larry Page, Bill Gates, Mark Zuckerberg, etc)
Again, to reiterate the Larry Page example:
- Focus on the $3 billion vs $0. This is shares * price. The price is embedded in the "all other things being equal" part that you dismissed. The price is "not equal"!
- Don't focus on the dilution from 50% vs 16%. You can't play a mental game of "if Larry got 50% of $20 billion, that's $10 billion not $3 billion" because for him to keep 50% (dilution is bad), you have to replay history with him attempting to build Google with zero outside investment. It's more likely he'd have a bankrupt company instead of a $20B company since he can only buy a handful of servers by maxing out his credit-cards, and have no money to hire extra employees. This is the literal application of your "all things being equal". That's flawed ex post facto analysis which doesn't take into account the timeline and reasons people choose to dilute ownership / sell equity to capitalize the company at different stages.
If dilution is bad for the employee, then it is also bad for everyone else. If as you say, "the new round may not be good for the employee", then it also means it's not good for the founders and previous VCs. If the founders are not crooks, the intention for the investment round to help make the company better, not worse.
I still think the main source of outrage about dilution is that people think only the employees get diluted. They don't realize that every owner of the company including founders like Larry Page and VCs like Sequoia will get diluted too. All the sentiments of unfairness flow from that fundamental misunderstanding.
Agreed, but it might not. The fact that it is taking the investment does not mean it is needed, or that it is good for all stakeholders. Investors, founders, and employees all have different goals, motivations, and risk profiles. It is also very possible for the board to make a mistake and take funding that is a net negative for the company as a whole.
My problem is with this argument from your original post:
> In fact, dilution is a positive sign.
These are complex situations. Boiling them down to dilution is good, vs dilution is bad just leads to misunderstanding. Which, in my experience, can be the goal of the person making the argument.
I never said dilution is bad. My original comment was in response to your blanket statement that dilution should be assumed to be good.
I am just saying, "Hold on. It isn't so simple."
In the end, I think we are in violent agreement. People should not get hung up on dilution, it a natural part of the startup lifecycle. It is a factor in the equation, but only a factor. As I alluded to originally, it is much more important what the company is planning on doing with the funds.
Personally, I think the outrage about dilution is due to the fact that many new employees don't take the time to fully understand how it all works when they are hired. The single most important thing employees need to understand about dilution is that, if they join an early startup, it will probably happen at some point. Options for 1% of the company doesn't mean you will own 1% at the end.
> The point is all things are not equal. To restate a sibling comment, dilution means you own a smaller % of a more valuable company.
Right but if you aquired your shares under the assumption that you would own the same percent of a more valuable company, you are still being taken advantage of.
The employee shouldn't have that assumption. The correct default assumption is that the employees are diluted just like the founders when new equity is sold.
If the founders mislead the employees into thinking they got 1% -- and it would always stay 1% all the way to IPO, that's an issue with the ethics of the founder and not an issue with dilution. Dilution wasn't the problem. It's the dishonest entrepreneur that's the problem.
Put another way, if a founder told me I would be awarded 1% in stock and it would have anti-dilution protection for all subsequent rounds, I would not think to myself "wow, that's great!". Instead, that would be a signal that the founder is either 1) incompetent with math or 2) a crook.
> I started off once thinking "yay, X% means I get X% of the company!" and then I found out the shares can be diluted. Then I learned "non-dillutable".
Then I learned about vesting periods, windows for exercising options, and a whole slew of financial terms and devices; each one seemed to come with its own unique "gotcha" that, if you didn't know about, would cost you nearly everything.
Everyone I talk to about these always says "well, don't do that one thing, or if you do that one thing be sure you do it in this way and you're set". The cumulative knowledge you need becomes pretty high pretty quickly though, and the chances of me doing the right legal and financial incantation at the right moment becomes lower.
Nowadays I go with cash. I don't get 'golden handcuffs' that hold me to a job I don't like because it might pay off later. I can calculate the expected value and risks with cash without tons of research. I know my legal recourses if I get screwed out of cash.
You'll see that it was right all along.
Yes, I agree that we all go through an early period of ignorance and then we get more financially savvy as we learn more information. We don't know what we don't know.
However, when OP writes, "then I learned "non-dillutable", he/she is misinforming people with expectations that employees can get fixed-percentage ownership that stays at that fixed amount through subsequent investment rounds. The implication is that employees who didn't get such "non-dilutable shares" are getting screwed. This is not the case.[1] The normal situation is for _all_ ownership to dilute. It's not a nefarious trick on the employees.
If people think they are more "financially sophisticated" with knowledge of "no dilution" shares, they are wrong. Instead, if candidates try to negotiate "non-dilutable shares" with a founder as a condition of employment, they will look like clueless idiots. (Reading about mythical "non-dilutable employee shares" on HN made them dumber, not smarter.)
The expected mathematical mechanism for employees to get richer is for the share price to increase instead of the ownership % not to dilute.
[1] "Non-dilutable stock is impractical and unfair, and in some cases impossible.[...]" : https://www.quora.com/I-was-offered-non-dilutable-equity-by-...
In a typical startup a dilution means that the company run out of initial investments and has no way to get some form of a loan. So selling the ownership is the only way to continue. And if they succeeded with that it would not make the company more valuable. It just meant that owners were good at convincing investors. This is orthogonal to future value of the company.
What is the difference between each selling _existing_ shares they own up to the $12.5M valuation and 'diluting' the existing shares?
Dilution makes all this simpler.
Yes they do. In two senses. The obvious one is probably not what you meant to refute - the total value of the company post raise is, in the simple case, the value of the company before the raise plus the value of the new cash. The company is more valuable. What I think you meant to say was that your shares don't get more valuable.
That's more true, but they can be. If the raise was a good idea, the company's prospects are improved (and therefore the value of existing shares) by whatever uncertainty existed about its ability to raise that funding.
Sure, further rounds are a sign the company is doing well. The important word being "sign," they don't actually make the company more valuable (what the company does with the money they raise does). If you own a lot of stock, you probably already know if the company is doing well or not. In that respect, the round just puts a number on what you already know.
The math is simple. All things being equal, owning more % of a company == more money. To try to spin dilution in any other way is stretching the truth pretty far, and is rather manipulative IMHO.