Open guide to equity compensation

"Cooking the books" could mean many things but most people would interpret this as fraud. There are many exit scenarios that aren't fraud but rather stacks of preferential stock that get paid before common, who usually get paid last.

What happened in your exit scenario?

My read is that the poster felt that the accounting practices, which were likely legal and commonplace, violated implied contractual obligations.

It's technically legal -- the best kind of legal!

"Fraud" is a strong word, and there's nothing inherently wrong with having multiple share classes. But I really feel that preferred stock as implemented by most early stage startups is an intentional attempt to deceive employees. There's a lot of founders out there telling early engineers they're getting "0.5%" when they know full well that a $1B acquisition down the line is not going to put 5 million dollars in the engineer's pocket.

Playing both sides with this comment

That’s correct, I don’t believe anything illegal was done but certain things were done to dilute the employee share class which didn’t dilute founder shares. Just start reading about preferred stocks and you will realize they can basically be blank cheques to have any value and have voting rights to issue as much other common stock as they want.

Additionally there was some liberty on what “sale price” actually was in the contract. This may be common operation, but the sale price according to my contract was much lower than the amount of dollars which was exchanged for the company.

I don't intend to be on the founders' side at all, I'm just not quite sure I'd throw them in jail over it. I'd definitely call it "cooking the books" comfortably.

Can you explain? In most cases, preferences won’t come into play, assuming you raise at a standard 1x preference and sell for more than you have raised. In that case, owning 0.5% should roughly translate into $5M (modulo dilution).

See my comment further down. Im not going to go into any more details than that as the details of the sale are not public.

There's also just the case that a buyer is happy buying say 88% of the company and having 12% (usually non-voting) shares lie with employees/former employees. Stock options are only really, truly worth anything if they IPO.

That would be the naive mathematical interpretation and how the system would work if engineers designed it. Lawyers designed it, though, and they probably know some tricks to make that not happen.

There are plenty of valid scenarios where the company sells for a lot, but less than it raised. And 1x preferences are no longer standard post-ZIRP, afaik.

People are often not aware that the value of common is nonlinear, so the value of 0.5% in this case is zero. (For the ML fans out there, the common price per share has one or more ReLU activation layers. :) )

Not since... I'm not sure the regulatory change, but if employees are able to sell back to the company or to private investors, resulting in cold hard cash in employee bank accounts, without the company going public, I'd say they are worth something. We can argue about how, without an IPO, the price isn't fairly decided upon, but having cold hard cash in the bank is nonetheless real.

Even with 1x preferences, the company might have raised $2 billion but sells for $1 billion because the investors don't want to get any further losses.

The general rule of thumb is that acquisitions are bad for employees, and IPOs are good, especially if the share price is stable for 6 months.

Intentional misrepresentation is fraud, but I understand pragmatically how the line could become blurred. What I object to is the idea that blurring that line is intentional, even if that is not acknowledged.

No. Fuck that shit. When the spirit of the law and the letter of the law conflict, I want us as humans to be able to step back and say that, hey, it doesn't make sense when you put it that way, and ignore the rules and do what's actually right.

There’s also a lot of plain fraud in private tech companies.

Also for acquisitions, often you'll have to work at the acquiring company for some time to get money from your options. Or might get options in the acquiring company instead (which again are worth nothing until some future possible equity event which hopefully translates into cash).

Founders will almost always have common stock too, so they're in the same boat - it's only investors who will have preferred stock. If you don't spend 10 minutes to understand liquidation preferences before accepting a startup offer, that's kind of your problem.

As someone living in a country with common law and having taking business law 101 (so certainly NAL) this sometimes ends up being a bit of a guessing game as to how a judge will interpret jurisprudence.

There's a lot of room for improvement in legal systems and they move extremely slow due to the political nature of things.

totally, which is why we go to a jury of peers for things

Kinda? The underlying issue is someone you think you can trust not telling you the full details so they can fuck you later.

1. If the company is bootstrapped the founders can have preferred stocks with whatever clauses they want on it

2. Most (all?) companies will not show you their cap tables so it basically boils down to “trust me bro”

    > implied contractual obligations

What does this phrase mean? There is no way that any sound contract law will grant any weight to the term "implied". Either it is written (and agreed) or not. So, I would say anything that is not explicit is meaningless in term of contract law. (Again: I am only talking about jurisdictions with serious, mature contract law, not some banana republic.)

Like what? All the examples people have said are where either

1) the company has Nx preferences, for N >1, in which case the company has essentially failed to fundraise or

2) the company sells for less than they raised, which again, is a polite form of failure.

wouldn't you rather the 50/50 chance for some _seemingly_ impartial person to intepret a deal, than have to pay a lawyer more than somethings worth to enforce some complex 500 page word salad to keep a business run by a person whose dones this hundreds of times before?

lets no degrade lawyers more than necessary.

Business people hired lawyers to design means and methods to commit _implicit_ fraud and deceptive practices to improve the value of their capital assets.

Those lawyers then go on to sell this product to others.

I'm sure there's some lawyers out there that are going out there shopping this stuff around, but it's Capitalism and Business thats the active agent, not Lawyers.

If I say I'll give you 50% of the revenue we generate, and then the details of the contract allow me to bring on other people with the same deal of 50% of the revenue, and then you all share 50% it would likely feel unfair.

The underlying issue is trusting someone you should not trust, someone on the other side of the negotiating table who has interests opposite to yours.

The logical conclusion to #2 is valuing the equity compensation at zero, and foregoing it and asking for extra cash.

IPO is not the only way for employees to access liquidity

> There is no way that any sound contract law will grant any weight to the term "implied".

Nobody is suggesting that any law would.

> Either it is written (and agreed) or not.

Yet you managed to infer things that weren't in the post.

> So, I would say anything that is not explicit is meaningless in term of contract law.

Again, where is anybody saying anything to the contrary?

Sometimes what the contract says and what the contract _looks_ like it says to a layman can read very different.

- Granted $500k of stock on start, and then have it diluted as stock is added for new investors

- Hollywood accounting - net vs gross

There's lot of places where a contract can be represented as one thing, only to have it be far less than that.

True that stock _options_ are only worth something after an IPO, but vested and exercised stock options that get turned into equity is a different story.

Equity can be worth something via acquisition from private equity doing roll-ups, corporate buyers looking to fill strategic product niches, etc

Also, for the more heavily vc-funded late stage still pre-ipo plays, secondary market, which can be at a discount to the most recent vc round, or in some rare instances in a hot sector, premium.

One other thing - waiting for the IPO might be the worst thing to wait to do. The public markets are much more fickle than private markets. Once a company IPOs, there's usually a trading moratorium on insider shares, usually 180 days, so by then, the equity value may have completely imploded.

I’ve yet to work at a startup where liquidation preferences and investor participation is freely given or ever even mentioned. I only know about because I participated in TechStars. So, I guess we can blame employees for not hiring a lawyer to review their sign-on agreement (which, again, doesn’t have that info) or we can hold founders accountable for not sharing all relevant data needed to evaluate an offer. As a prospective candidate It’s one of those things you need to know about to even know to ask about.

I think founders are doing themselves a serious disservice. I loved working at startups but it’s just not worth it in most cases. The trade-off was always take lower salary for a chance at making big money and repeatedly investors and founders perform a rug pull.

Blaming employees for a change in the gentleman’s agreement is certainly one way to look at it. But, it sure feels exploitive, especially for younger folks that haven’t yet been burned by it. If founders keep doing it… well good luck finding anyone willing to work at their startup.

Then it is a poorly written contract, and the party that agreed to it was tricked or poorly advised. Plain and simple. We see this often with "fast and loose" term sheets for some corporate and sovereign bonds on less reliable names. There is a whole podcast (I forget the name at this very moment) that does nothing but discuss dubious bond contracts. Frequently, the co-hosts will ask: "Who in their right mind would agree to such a contract? This clause is totally unenforceable / provides no protection against event X/Y/Z." And, yet, these contracts still exist in the wild.

Dumb question: Do you think the average dev in Silicon Valley pays a third-party employment contract lawyer to review the terms and conditions before agreeing? Sadly, I feel the answer is "no". Speaking personally, I would never agree to such complex employment compensation terms without third-party advice. Yes, I know it is not cheap (maybe 500 USD per hour), but the alternative looks much worse, and most people here facing these contracts can afford it.

I've never heard of being able to sell back stock options. You don't own anything with an option. You just have the right to buy at a price in the future.

I didn't say stock options. There is a mechanism through which SpaceX employees have been able to cash out some sort of financial object that they received, despite the company not being public.

The comment you were replying to ended with this:

> Stock options are only really, truly worth anything if they IPO.

fair. the important thing here is that IPO is not the only way to liquidity for early employees

It is fraud to take advantage of the fact that your employees don't realise their stocks are not the same kind of stock that the VC and the founders have.

You think engineers never scam?

Yeah but I'm a programmer and don't innately understand that social power dynamics stuff. They're friendly and nice people and offer me drinks and snacks when I meet up with them. What do you mean they don't have my best interests at heart?

It sure fucking seems like it is! Have you tried to buy early stock in startups? You have to have 10K minimum in most cases.

I’d have bought huggingface, openAI, anthropic, unsloth, and many others stock right at this moment if I could get in for less than 10K.

Prove me wrong internet. I’m ready to buy in these companies this minute.

Not like lawyers, dentists, car salesmen, etc do!

Well, I'm not sure it is. People are pretty aware of salaries already for example. This was about stock options specifically.

Across the universe of accredited investors, I don’t think that a $10K minimum is a significant barrier.

We can argue whether the accredited investor process is good or bad (I think it’s more good than bad), but I don’t blame companies for not wanting a bunch of $872 high roller outsiders on the cap table.

My point still stands even if it's equity. PE/corp buyers may not care about buying out the very small minority stock holders, that is the point I 'm making.

Lets say you've got

Founder A 25% - Voting, Founder B 25% - Voting, Investor A 10% - Voting, Investor B 15% - Voting, Investor C 8% - Voting.

Former Employee A 0.5% - Non Voting, Former Employee B 0.4% - Non Voting, Employee C+ 0.2-0.3% each all Non Voting.

If say Big Co want's to buy the company why do they care about buying out former Employee B? If they can pickup the two founders and the three investors, thats enough for complete practical control.

I don't usually see minimums below 25K, which is fine and sensible.

You really need some kind of a proxy to aggregate anything less than that in practice - thinks like crowdcube or similar. Can you imagine having to draw up paperwork just to transact $1200 or something? Doesn't make much sense.

An outside individual purchasing shares is not the same as employees accessing liquidity.

As one example, SpaceX is privately held but routinely does funding rounds with large investors so employees can sell shares and access liquidity[1][2]. A $10,000 minimum purchase amount is trivial for those investors.

[1] https://www.reuters.com/markets/us/elon-musks-spacex-raises-...

[2] https://www.reuters.com/business/aerospace-defense/spacex-fu...

I'd say that phrase means 'consideration' in some cases, and in any case something like 'reasonable expectation', which would enter into the 'meeting of minds' prerequisite of contract law.

Banana republics like almost all countries with Civil Law rather than Common Law? And also, you know, some US states and the UCC?

The doctrine that anything not explicit is meaningless in contract law is also referred to as 'the four corners' referring to where you look to interpret the contract; this is considerably relaxed in many jurisdictions (and some situations in the US) where there is considerable information asymmetry and/or power imbalance between parties. With employment contracts in particular; to be a good coder for instance, why would you need to know how dilution of options works? Only to avoid being mislead by your prospective employer?

Conversely, in Civil Law jurisdictions, you see that corporations (rather than employees/consumers and sometimes small businesses) are mostly held to the four corners of the contract as they are professional parties that have legal departments and should be presumed to do their due diligence.

I'm generally pretty against paternalism in markets, but when you get to the more "finance-y" stuff like this the opportunity for large scale fraud is just so prevalent and there are so many people just looking for their next mark.

If $10k or $25k is an amount of money you have to pause to think about at all you have zero business investing in early stage startups. Simply by the way the math works out you are better off buying lottery tickets because at least then you'll get to scratch something off before going bankrupt.

Ah yes the cornerstone of any stable judiciary - "ignore the rules and do [what I want]."

Have 1x preferences become standard? When I worked in startups early investors often has 2x or 3x liquidation preferences, especially at seed.

Sorry, but I DO have business investing in early stage startups. I called huggingface being this big back in 2019. And given your first sentence, I'm going to 100% call this out as projection on your part.

Folks who work in AI/ML know how to invest in the space! You're welcome to ignore the fact that Unsloth is objectively going to pop off (likely be acquired by huggingface) and anyone who invests in it will come out ahead.

The Venn diagram of people who are sophisticated enough to make these kinds of investments with better odds than gambling and people for whom $10k is hard to scrape together is indistinguishable from two circles. I'm sure there are some in the intersection but it's such a small piece of the pie we can effectively call it zero.

If you want to gamble that's your right I'm sure there is a roulette table somewhere near you. But the social harm caused by allowing dentists and grandmothers to invest in seed stage startups greatly outweighs any social good caused by letting that near-zero overlap get rich a little easier.

morally, yes

legally, no

I am under the impression that an oversized cap table is pretty much standard. Am I wrong?

People here get u on their high horse about investment minimums and the like. Sure, they get real excited about some startup and they may turn out to even be right. I also know people who do angel and seed investing who are beating the bushes for capital or are just holding tight. Startup investing isn’t some magic money tree reserved for the well off. Heck, I’m pretty selective about even purchases of even individual public companies.

In 2019 they didn’t need your $10k of funding. If you contacted them within the 6 months they were starting they would have said yes. In 2019 it was more time consuming than it was worth. So they encourage you to go through a pool of investors which you are scoffing at.

In reality, my project needs funding now. If i bootstrap and get customers, I don’t need to worry about your lunch money. I need someone (or customers) who can fund that same amount for a year.

That hasn't been my experience. I've never had the experience of BigCo only acquiring just enough for 50.1% ownership. There's also clauses in the equity plans for participation on change of control (assuming that BigCo taking 50.1% constitutes change of control)

it's a particular issue with PE, who aren't really doing it for strategic reasons, but really are just there to make money.

Right so for options, when the employee leaves the company, they can convert them to shares, and then there are ways for them to sell those shares somehow, and it results in cash money somewhere down the road that isn't just the salary.

Seriously - the whole point of giving your early employees equity is so that you can attract talent without blowing your budget.

It seems like most founders love pretending that there are armies of top-tier engineers rushing to work at their startup in exchange for pay that's well below market and stock that still won't be worth very much even if the company has a wildly successful IPO.

I really wonder why this happens - is it just greed from the founders? The VCs? Do early employees value stock like shit regardless of how transparent the company is?

Different stock classes SHOULD be illegal. I have yet to hear a single good argument for it that isn't obviously self-serving.

And ownership stake in the company should be a simple thing to understand, not some byzantine mess designed to fuck over the engineers.

I don't know where you live but in my country going to some old person and trick them into signing stuff they don't understand is illegal.

Banks aren't even allowed to suggest buying high risk stuff.

> Then it is a poorly written contract, and the party that agreed to it was tricked or poorly advised.

Well, yes? I mean, we're talking about a situation where one of the parties involved in the contract isn't acting in good faith. And people frequently can't understand contracts. Is there anything surprising about the fact that someone was misled or "tricked" in such a situation?