Posts Tagged With: Silicon Valley

Preferred Stock and Common Stock Aren’t The Same

When you get an offer from a tech company it will usually be some combination of cash and stock. Small companies give out stock because it's hard to compete, cash-wise, with bigger companies, and a grant of stock or options offers the chance at a large payday down the road.

Valuing the cash part of an offer is pretty simple. How should you value the stock? Well, one answer is whatever someone's willing to pay you for it.

To that end recruiters will sometimes give you information like, "our last round closed at $4.80 per share, so, if you get X shares per year, your stock compensation is worth $4.80 * X." Sometimes recruiters will send a fancy tables showing the value if the company doubles or 10X's its value.

This is a classic bait and switch. When a company raises a round from, say, Sequoia, Sequoia wires money to the company and gets preferred shares. When you are granted stock options as an employee, you are getting common shares. The differences will vary from company to company, but commonly:

  • Holders of preferred shares get paid out before common shareholders (ie you). Bankruptcy is not intuitive. If you get in a traffic accident, the insurers will usually say something like, the other party is X% at fault, and you were Y% at fault, so this is what you owe. Bankruptcy is not like traffic court. All the rights holders ahead of you will get paid out 100% before you see a cent. If the company is sold or liquidated, the preferred shareholders will likely be paid in full before any holder of common stock sees a dollar. Because of this, preferred shares are more valuable.

  • Preferred shares have different voting rights than common shares. A preferred share might get five or ten (or zero) votes, to one for a common share.

  • Preferred shares may have other downside protection in the event an IPO or sale does not reach a target price.

So preferred shares are worth more than common shares. It is a mistake to look at the preferred share price and multiply by the number of shares and use that as the current value of your common shares. Your shares are worth much less than that.

One reason this happens is that preferred shares are easier to value, because there are regular funding rounds, insider sales. Common stock doesn't trade hands that often before an IPO because stock sales often require board approval. But that doesn't excuse anyone from giving you common shares and pretending they are worth as much as preferred shares.

The recruiters and VC's next trick is to pretend that you shouldn't be concerned about the difference between common and preferred stock, because in an IPO preferred stock is usually converted to common stock. That's true. But this is sort of like saying a home without fire insurance and a home with fire insurance are worth the same as long as they don't burn down. If you have common stock, you don't have fire insurance. And a startup is significantly more likely to fail than a home is to burn down.

If anyone tries to convince you that the difference doesn't matter, ask them if they'd like to swap their preferred shares one-for-one with your common shares.

If you are being recruited and someone tries this on you, please point out the difference and explain that you don't appreciate being condescended to. You should also think less of the company. Every one of your coworkers went through the same process of being lied to about their potential share value.

If you are an employer and you want to do this honestly, quote the most recent share price you have, and then explain that that's the preferred share price, but you are not giving out preferred shares. Explain that recruits should value their shares lower than the preferred share price you quoted - exactly how much is difficult to say, but the preferred share number should be an upper bound on that value. If your common stock is traded, or any of your shareholders are forced to mark their shares to market (Fidelity holds them in a mutual fund, for example), you should disclose that.

(You could also let your employees sell their equity more often, maybe to insiders.)

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Let employees sell their equity

Sometimes people choose to work for one company over another for reasons related to the work environment, for example what the company does, and whether the other employees create a place that's pleasant to work at. But a major factor is compensation. If Company A and Company B are largely comparable, but Company A offers $30,000 more in base pay per year more than Company B, most people will choose Company A.

At tech companies, compensation usually breaks down into four components: company stock, benefits, cash salary, and bonus. When you get an offer from a company, these are the four areas that the recruiter will walk you through. The equity component is a key part of the compensation at startups. Small startups hope that the potential for a large payoff is worth sacrificing a few years of smaller base pay.

If you join a small startup and you get stock, you generally can't sell it until an "exit event" - an IPO or acquisition - even if your entire stock grant has vested. Generally, any stock sale before an exit event will require approval of the board, and the boards generally frown on stock sales, for reasons I will get into. So while you may own something that is worth a lot of money, you can't convert it into cash you can actually spend for a half decade or more.

By contrast, if you join a public company, your compensation includes equity that you can sell basically immediately after it vests, because it trades on a public exchange. There are hundreds of people who will compete to offer the best price for your shares every day between 9am and 4:30pm.

As an employee, how should you think about the equity component of your offer? One reason to take a big equity stake is to bet on yourself. If you have a great idea about how you can make the company 10%, 50%, or 200% more valuable, and you think you can execute it, you should take an equity stake! After you implement the changes, your equity will be massively more valuable. Broadly speaking this is what "activist investors" try to do; they have a theory about how to improve companies, they buy a stake and hope the value changes in line with the theory.

One problem with this is that you are much likely to be in a position to make these changes if you are someone important like a C-level executive or a distinguished engineer. However, most tech employees are not C-level executives. If you are an engineer on the fraud team, and you try really, really hard at your job for a year, maybe you can increase the value of the company by 1% or 2%. You are just not in a position, scope wise, to drastically alter the trajectory of the company by yourself.

Rationally speaking, it does not make much sense for you, an engineer on the fraud team, to double or triple your effort just to make your equity stake worth 1% more. There might be other reasons to do it - you could really buy into the mission, or you hate being yelled at or whatever - but just looking at the compensation, whether you, personally, work really hard or slack off, your stock is probably going to be worth about the same. Unless you are the CEO or other C-level executive, at which point you have a big enough lever that your level of effort matters.

Another way to think about it is, imagine you have invested your money in a broad range of stocks and bonds, and then someone asked you to sell 30% of it and place it all in a single tech stock. Modern portfolio theory would suggest that that is a bad thing to do. You could gain a lot if the stock does well, but on the other hand, if the company's accountant was embezzling funds, or the company lost a lawsuit, or the company lost a database or had the factory struck by lightning or something, you could lose a ton of money that you wouldn't if you were better diversified. It's not worth the risk.

All this goes to say that employees should value their equity substantially less than an equivalent amount of cash. Outside of the C-level, you can't do much to make the equity more valuable, and an extra dollar worth of equity takes your portfolio further away from an ideal portfolio that you could buy if you just had cash. (For more on this topic you should read Lisa Meulbroek (hi, Professor Meulbroek), whose CV is criminally underrated.)

(On the flip side, if your company is small and valuable, it may have its pick of investors to take money from, and be able to dictate investment terms. Holding equity in a company like this is a way to approximate the "deal flow" of a good Silicon Valley investor - as an employee you are getting the chance to buy and hold stock in a company at prices that would not be accessible to you otherwise. This may be true of small, hot startups but it gets less and less true the bigger a company gets and the more fundraising rounds it goes through.)

One implication is that you should prefer to work at public companies. At a public company, you can take your equity compensation and immediately sell it and buy VT (or even QQQ) or whatever and be much better off because you are diversified. You can't do that at a private startup.

Another problem is that public companies tend to have better equity packages. I went through a round of interviews recently and I was stunned at how paltry the equity offers were from private, Series A-C companies. For most of the offers I received, the company valuation would need to increase by 8-20x for the yearly compensation to achieve parity with the first-year offer from a public SF-based company, let alone to exceed it. Even if they did achieve 4 doublings of their valuation, you might not be able to sell the private company stock, so you're still behind the public company.

I expect larger companies to have better compensation, it's part of the deal, but that large of a differential, plus the cash premium to be able to sell instantly, makes it foolish to turn down the public company offer. 1

So how can you compete if you're a smaller company? The obvious answers are what they've always been: recruit people with backgrounds that bigger companies overlook, give people wild amounts of responsibility, sell people on the vision, commit to "not being evil" and actually follow through on it.

But you can also try to eliminate an advantage that public companies have by letting your employees sell their equity. Not just, like, one time, at a huge discount before you go public, or when you get to Stripe's size and want to appease your employees. But routinely; because your employees want to boost their cash base, or buy the stock market, or buy a vacation, or whatever.

There are some objections. Having more than 500 shareholders triggers SEC disclosure requirements, which can be a pain to deal with. So require employees to sell to other employees or existing investors. Cashing out entirely might send the wrong signals, so limit sales to 10-20% of your stake per calendar year. A liquid market might require repricing stock options constantly. So implement quarterly trading windows.

Executives might not want to see what the market value of your stock is at a given time. That's tougher. But a high day-to-day price might convince people to join when they otherwise wouldn't. A low price might convince you to change direction faster than waiting for the next fundraising round.

There are also huge benefits. Employees can cash in earlier in ways that are generally only available to executives. They can take some risk off the table. People who want to double up on their equity position can do so.

Finally, you might be able to attract employees you might not otherwise be able to. A lot of folks who are turned off by the illiquidity of an equity offer might turn their heads when you describe how they can sell a portion at market value every year.

Big companies have big moats. One of them - the ability to convert stock to cash instantly - doesn't need to be one.

Thanks to Dan Luu and Alan Shreve for reading drafts of this post.

You may think they were lowballing me, but this was after negotiation with each. Another possibility is that I did differently on the interviews for each, and the smaller companies offered me lower packages because they thought I did worse. I think I did about equally well on the interviews for each.

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