Tech Transfer eNews Blog

Beware of employee equity, the credit cards of the venture community

By Jesse Schwartz
Published: November 13th, 2019

The following is excerpted from a guest column by Dror Futter, partner with Rimon Law, and Natasha Azar, senior manager of university relations with Osage University Partners. The complete article appears in the October issue of Technology Transfer TacticsCLICK HERE for subscription information.

When hiring venture executives and employees in the early stages of a university start-up, the buzz centers around equity. For successful ventures, these equity rights, often issued when the equity is worth pennies a share, hold the potential of delivering great wealth to those fortunate enough to receive them. However, there is an often ignored drawback to equity compensation — simply stated, it is the credit card of the venture world. As opposed to salaries that directly impact budgets, equity grants are “painless” and only upon exit of the venture does the true cost of the grants become apparent.

The painlessness of equity grants makes it a very tempting compensation tool for cash-strapped early-stage start-ups. But these ventures often risk making outsize equity grants to employees who, while important in the short term, will not have a significant long-term impact on the company. Many ventures fail to recognize that equity needs to be budgeted and, as a result, “spend” too much too early, leaving less available for additional grants to round out the leadership team and make other critical hires.

For university spinouts that often need to hire a large part of their future executive teams, mistakes in early equity grants can unnecessarily dilute founders’ and university’s common stock positions.

To understand the impact of dilution on a founder’s stake, Figure 1 below shows a hypothetical ownership summary that reflects typical ownership through financing rounds and how the dilution plays out.

As the figure shows, while the nominal value of the founder’s stock is increasing, even in a successful venture, the founder’s ownership percentage declines steeply as a result of dilution. In the hypothetical, the company has raised a total of $41 million in four funding rounds. Each of the funding rounds represented an “up round” where the pre-money represented a significant increase from the post-money valuation of the prior round. Yet the founders’ share dropped from 30% to 12% — in other words, a smaller piece of a larger pie.

The average successful tech start-up exits for $240M after a series of raises totaling approximately $40M of capital. This amount of capital is typical of the industry, and it is distinct from the need to refresh the start-up’s option pool across each financing.

Fueling growth with investment capital is the tool that allows companies to expand their team, footprint, facilitation, and marketing. In the typical funding and exit described in the hypothetical, the founders, founding team, and employees were diluted over time. While 12% of a $240M exit is definitively a life-changing event, the path to even larger personal upside can only be achieved by reducing dilution and increasing valuation.

The dilution equation is simple ($-raised/$-valuation), but the implications of driving the numerator to $0 or the denominator to unicorn status is much more nuanced. When founders are building their cap tables, they should think about how taking more dilution will ultimately create a bigger pie to take a slice of down the road. For founders and their university tech transfer partners, this dilution can be exacerbated by poor choices in equity grants to employees.

The entire detailed column excerpted above, outlining specific examples, data, and strategies for minimizing the impact of dilution, is published in the October issue of Technology Transfer Tactics. For subscription information, CLICK HERE

Posted under: Tech Transfer e-News

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