19 Feb 2016

Fairer Startup Pay

As startups go public for lower valuations than were valued earlier, people are losing money. Especially employees, who are often paid only after outside investors are paid. Sometimes investors are guaranteed twice as much as their investment before anyone sees a single rupee. This is unfair, on multiple levels.

First, investors are transferring risk onto other parties. They keep the reward, and others take the risk. If a company goes public for less than the investors invested, everyone should proportionately share the losses. But what happens is that investors push the losses onto founders and employees, while keeping the profits for themselves. This is unfair. The minimum I’d expect from investors is to take a proportional share of the risk.

Second, people working in a startup don’t have the benefit of diversification. Investors, whether angels or VCs, invest in many startups, so even if one fails, they are not hurt much. They care only about the average return. Founders and employees, on the other hand, don’t have that benefit — they pour a few years of their lives, and their money, in just one startup. They should therefore take less risk than diversified investors, not a proportional share of the risk, to say nothing of taking all the risk.

Third, employees are often young and financially vulnerable compared to venture capitalists. They may not have yet achieved financial security in their lives, or built up lot of assets. That’s another reason for them to take less risk.

Fourth, how many fresh-faced twenty something employees at a startup understand the fine print — things like liquidation preferences (optional, participating, stacked, etc), ratchets, valuation caps, and so on? When pay is hard to understand, unsuspecting employees are led to believe that they’ll make a lot of money, but may not. Offering an agreement that the other party doesn’t understand is outright fraud. An agreement is valid only if both sides fully understand what they’re signing. Even if it’s not legally wrong, it’s ethically wrong and downright shameful to take advantage of young, naive, financially insecure people. Let’s set a higher standard.

To fix this, founders and employees should all get paid before outside investors see a single rupee. In other words, founders and employees should be highest in the capital structure. If I were a founder, I’d want to make enough money to retire, say ₹20 crores. I don’t mind as much how the remaining money is shared after I make my 20 crores. The investors can invest at whatever valuation they want, for example.

This can be structured as debt or equity. In other words, the company may agree to owe me 20 crores. In that case, I’ll never get more than that amount, even if my company becomes the next Facebook. Or it could be equity, with a clause guaranteeing a minimum payment of 20 crores. The critical part is that I make my 20 crores before investors see a rupee.

Employees would get the same deal, but a smaller number than 20 crores. Maybe 5 crores, for example. But no matter the amount, founders and employees all get paid before outside investors see a rupee.

Why would venture capitalists invest in such a company? Because, in compensation for taking greater risk, they’d get a higher upside, which is that if the company becomes the next Facebook, they’ll make more. So, in this proposal, investors have more risk and more return, while founders and employees have less risk and marginally less return — they may not become a billionaire, but they are more likely to make enough to never have to work again. I’d take that tradeoff any day.

This would be a fairer world.

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