Are we all on the same team?
It should be obvious that when you join a company you are implicitly making a very large bet on the founders. Whether it be an early stage company or even a late stage one, venture companies are based on the premise that the founders have the ability to perform magic and suspend disbelief. Accordingly, they’re given a significant amount of control over the company, far more than what is allowed and typical. Instead of giving investors the ability to affirmatively decide on certain actions, the venture capital construct relies on what is called protective provisions or “blocking rights”. Combined with softer dynamics like the natural cheerleading that occurs or straight up founder’s shares having 20x voting rights type constructs, venture company founders more often than not very much have “control”. So, unsurprisingly, if you decide to join a company you must get to a point where you trust the founders.
While I believe strongly in trust, I think incentive alignment is an essential building block in building that trust. It’s great to work towards the same general goal but when you don’t have certainty that your utility function is proportional (or at least directionally the same), it’s hard to concentrate on doing the best you can. I think this was probably less problematic back when venture capital was less well funded but seems rampant today given the competitive dynamics of the industry.
The first thing I want to highlight is founder share sales. This is when founders sell their shares to investors prior to a liquidity event. To be clear, I don’t have a philosophical opposition towards it — there are founders who have student loans to pay off, founders who’ve invested all of their personal savings, etc. However, there are a couple of dynamics that when combined create misalignment of incentives.
- Founders often sell their shares without offering their employees the ability to tag along.
- Founders have the ability to control the price and the terms of the subsequent round of financing.
- Venture boards, while not controlled by founders, often blindly support founders. In other circumstances, the founders were able to negotiate sufficient control at the board level (see Uber, WeWork, etc).
- The market has become extremely competitive which means capital providers are more willing than ever to bend to founder demands and at earlier stages of the company than ever.
Why do these three added together create a problem? This means the founders can choose the round that offers them the most favorable terms to get themselves liquidity. In a normal world, the board is there to veto and be the check in the check and balances, but instead, may simply encourage this behavior. Paired with market demand, the net result is you have founders who sold their hyped up company shares 2 years into the company and have de-risked themselves on the backs of the employees they convinced to bet their careers on the company.
There is a sensical way to do this — namely, provide full transparency to your team and allow them to join in on this type of deal. While I personally think keeping a founder hungry is crucial, this at least allows the people who’ve bet on you and the company to know what’s going on.
The second thing to highlight is what happens on a “change of control” or generally, a liquidity event. Before we get into the details, lets first establish same basic concepts. When you get equity in the company, it has a vesting schedule (usually a four year monthly/quarterly vesting with a one year cliff). While this clarifies your compensation structure in most scenarios, it does not explain what happens if the company is sold or undergoes what is called a “change of control” event (control being control of the company here).
Some companies like to tout that under those circumstances they’ll fully accelerate employee vesting meaning you fully vest all of the unvested stock at the point this occurs. In general, I believe that this is the right idea, especially for early stage employees. They’re making their bet on the company based on the full equity package granted to them. However, in reality, it’s far more nuanced. For example, if the acquiring entity wants the company to continue to operate, they can’t have the employees leaving right after an acquisition. So, it’s pretty normal under those circumstances for equity to not accelerate and instead, just continue based on where the vesting schedule was. Moreover, if necessary, the board could always argue to amend the equity plan or build that into the terms of the sale.
In any case, where it gets more complicated is when the founder doesn’t have vesting (because they negotiated it upfront) or if they have a trigger event which causes their shares to fully vest upon something like a change of control. Under that construct, the founder now has an incentive to sell the company earlier, perhaps before the company has fully realized its value or to an unfavorable acquirer, because they wouldn’t be stuck at that company vesting.
While there is no obvious answer, it is more standard to have what’s called a “double-trigger vesting acceleration” which means two events have to both happen for their stock to fully vest (i.e. change of control and termination not for cause). Regardless, it’s important to make sure that the founder (again, who controls the situation) is on the same side as the employees.
Finally, the third thing (but definitely not the least) is to make sure that the equity plan (while amendable) is fair. There are terms that people debate about including:
Option expiry being 90 days after leaving the company (Segment popularized removing the expiration entirely)
- For what it’s worth, I think this is less of a concern if you have a significantly low enough 409A valuation
- However, it is undeniable that in other situations it discriminates against people of little means. One method is to do what Segment did — that is extend it beyond the 90 day window though the conversion from an ISO to an NSO makes it far less attractive. Another approach taken (which is probably the most favorable) is to grant employees (or at least some of them) the ability to take non-recourse low interest rate loans against the strike price. This allows the employee to capture the benefits at a pretty minimal cost + reap tax benefits.
Repurchase upon any separation from company (not just termination for cause)
- I was made aware recently (actually by Allen before he joined) that our equity plan had a repurchase right at “fair market value” for vested shares following an employee’s separation from the company for any reason, and that it was 50% standard in equity plans. This means that the company could buy back shares at what may be considered rather arbitrary prices once someone leaves, even if it’s been fully vested.
- We have since removed it from our equity plan, because while we would never use it nefariously as a management team, it still feels uncomfortable as an employee and you never know who ends up running the company.
Definition of “for cause”
- Not to get too into the details but upon a “for cause” termination, there are a lot of serious remedies the company can take. Therefore, make sure that for cause termination is something fully in your own control and a sufficiently high standard.
- “for cause” as a legal term of art has a relatively well-established common law definition, but the definition can be tweaked / clarified by defining it explicitly in a document (which is usually accompanied by capitalizing the term such that it is obvious it’s referring to the in-contract definition, usually becoming “for Cause” or “For Cause”). 99% of the time the definition is just a clarification of what is already established in case law, but it could not be so, so it’s always good to check precisely what the definition is
I can go on and on about this but hopefully this post illustrates how much control founders have and therefore how much trust you should (or shouldn’t) have in them. As someone who worked in the financial industry prior to Valon, part of my desire to build Valon was to build a place where you had transparency and could trust management to do right by you. While this post may be or seem self-serving, I hope people will take this as an honest effort by us to do what’s fair and right and if not, at least take the learnings along with them on their next journey.