How does your company milestones effect your equity compensation?

As you know we are huge advocates for employee equity programs as a way of retaining employees, but it's also a very valuable tool to create alignment with the mission and vision of the company. If more stakeholders are aligned with the mission and vision, they should also be aligned with the business outcomes. Now, what do we mean by this?

First, a basic overview of equity and options differ here. Simply, if you own equity in a company you have underlying ownership in this business - a slice of the pie - and that slice has a prescribed value. An employee equity program gives you options to acquire equity. This slice of the pie will grow (or shrink) depending on how the business performs. Therefore everyone who has a slice of equity will want the business to perform better, and thus grow in value.

Now here is where it gets interesting, and sometimes misunderstood. What does business performance mean in a start-up? This isn't like the stock market. In the stock market, the business value changes every day based upon the share price. The market participants, both retail investors such as you and I, and professional investors such as pension funds and hedge funds, are actively looking at business performance and trying to translate that into a value. They can then translate this into an investment decision, but because there are so many participants in the market the current share price is a proxy of the current value of the business.  With start-up companies they are often private companies, where the value is determined less frequently, normally when the company goes through a financing round. Therefore it's usually a smaller set of investors who decide what the company is worth, and what business performance means.

What? You maybe thinking. Investors have that much control? Well, yes, they do. But don't worry, it's not that scary. Your current investors already have equity (like you, if you have an employee equity program) therefore they have the same interests as you - to increase the value of the business. Therefore they want you to succeed also, and are also very interested in the business performance.

Business performance means many different things to different companies depending what you are doing and what stage you are in. Ultimately, though, they are looking for meaningful steps towards you validating your business model and becoming profitable. If you are a SaaS business, this could be things such as early signups, conversion rates, or customer growth. If you are a deep technology business, this could be around filing intellectual property, forming licensing agreements, or signing joint development agreements. With these things validated, then the value of the business can become more certain, and in most instances more enticing for public markets or as a takeover from another company.

The job of navigating what investors are looking for in terms of validation, and setting business performance targets with what is possible with the current resources the company has access to or owns, is the role of the CEO. Their job is telling the story of what you hope to achieve with the resources you currently have available, and what that means if you invest now versus later. This means when your CEO is setting business performance targets, they better be achievable because they ultimately will translate into the expectations of the investors, and thus the value of the business. If the CEO over promises and the company under delivers, then when you need to raise money this will be reflected in the valuation and could result in a down round. If they underpromise and over deliver, this also will be reflected in the valuation (higher!).

Why is this important to an employee? A good CEO should be constantly checking what is possible with the team and what they need to deliver on these targets. Therefore communication to the CEO is critical here. If you are in an environment where there are always impossible deadlines that are never met, and the CEO never responds to your cries of pain, then this should be a major warning sign. If you have equity in the company, then this should be an even larger warning sign, because now your equity based compensation could become worth less, or in some cases even nothing!

What, nothing? How come?

Let's quickly think about how equity based compensation works. If you want a basic overview of the terms then click here, but basically there is an option strike price that is usually set around some sort of valuation event, such as a fundraising round. For the sake of argument, let's say you have a strike price of $1.00 per share. Therefore you want the value of the company to increase higher than $1.00. If you hit your targets, and your CEO is communicating a strong strategy that sits well with investors, then your next funding round could be at $5 a share. Therefore the options you receive have just 5x in value - that is a great bonus!

But let's now think about your CEO under delivering on what's promised. They said they would deliver a finished product in November, but by November it wasn't even possible to get the MVP working. When you go to raise funding, the company can only raise at $0.75 now. Now your options may not be worth anything, because you will have to strike your options for $1 for something that is only worth $0.75 - a $0.25 loss per share - OUCH!

The good thing about options is you have the right but not the obligation to strike these options, but you can quickly see how a nice big allocation of shares in your employee share programme can quickly become not so great with poor goal setting and bad communication in the team.

Therefore it's critical to understand that when you have equity in the business, you are now hoping the business outcomes are better. Therefore when your CEO comes to discuss things, it's better to be honest so they can paint a clearer picture to investors, create more tangible targets, and actually get to the place you want to be as a business. Fail to do so, and you could be losing loads!