The Startup Equity Illusion
Exposing the misaligned incentives, hidden math, preference stacks, and founder buyouts.
When you take VC money - especially a lot of it - you implicitly sign up to 100x your company. For a VC, the worst outcome is if your startups is somewhat profitable, but not profitable enough to return the money + opportunity cost + the multiplier.
They’d rather you have a small chance of having an outsized exit, than be sustainable enough of pay your employees well, and ship a good product.
VCs are not at fault here, after all, it’s the founders that take the money. I’ve seen some egregious examples of this where VCs would inject a ton of cash, but base it on “a preference stack” - making sure that in an exit, they’d get paid back ~3x.
Which means, if you raise $10M, and sell the company for $30M, you have to return that 3x of that initial $10M - essentially the whole $30M to the VC, leaving the founders with essentially nothing. [0]
Therefore, they ask you to go big or go home. This is a good reminder of that.
Now you might wonder how the founders even agree to these terms. Well, VCs have found a way to have the founders incentivised by “buying them out” early on. For example, they might say - take $2M out of that $10M and that’s for the founding team. It’s a “payout” for the work that you’ve put in so far. This doesn’t happen always, but it’s also nearly impossible to figure out when it has. Neither party is incentivised to disclose it.
Now that the founding team has essentially “made money”, they’re in cahoots with the VCs to essentially look for an outsized exit - a 100x one. Why? They’d given up a lot of equity, to the point that a small exit doesn’t appeal to them. In particularly egregious cases, they might have given up control of the company via board seats as well.
If the founders took some cash off the top of that $10M funding round, in return for a ton of equity, in a company of 2 Co-founders, they might be left with less than 20% each. (40% total founder ownership)
Let’s say there’s a deal on the table - this time, for $60M. After paying off the VCs, there’s $30M.
A founder having an ownership of 20%, will get $6M back. $6M is good, but not good enough for setting them up for the rest of their lives after taxes, especially after grinding it for ~10 years, 10 years of their most productive years.
So, they align with the VCs to essentially look for that 100x outcome.
This is not necessarily a bad thing for the founders, per se. They’ve made their money early on, and are paid a salary. It’s not bad for VCs as well. They’d have a small chance of the startup returning the fund, or being able to write off the loss, without keeping it in the books perpetually.
Same can’t be said for the employees though. You generally join a startup for a substantially low salary, longer hours, and a small chance of making it out with a lot of money. But there’s a distinct difference between the company doing well at an exit, a founder doing well at an exit, and an employee doing well at an exit.
The conventional wisdom might say that the founder outcome is closely mirrored with the employee outcome. But you’d be mistaken. A quick scroll on Reddit or HN will tell you how everything is essentially stacked against the employee. In fact, in most startups, founders do well regardless of whether the employees do well.
Company doing well > Founder doing well >>> Employee doing well.
You’re generally at the whims of an investor who is incentivised to dilute you to oblivion, and a founder who can be incentivised to play along. Founders don’t have any incentive to advertise adverse terms (if any) to potential employees. Carta might say “you have a 0.01%” of company ownership, but unless you know the fine print of non-standard terms, your upside is very closely mirrored with the trust you place in the parties who control the board. [1]
As an employee, there’s very little transparency into these terms, or what a potential exit scenario looks like. Therefore, I’m of the opinion that most early stage employees are better off optimising for a market rate salary, and subsiding it for having a chance to do something meaningful and fun [2].
However, if you think of this in terms of first principles, you can generally draw a good picture by looking at how invested the founding team is on the trajectory of the company.
Does the founding team look as invested as you are? Are they grinding with you in the office every day, or having beers on rented yachts?
How much are they paid? Are they on high enough non-performance based salaries?
What’s the average tenure of the people who might know this information other than the founders? Do they stick around, or do they churn?
[0] This is an oversimplified calculation. Most calculations here, are oversimplified,
[1] We haven’t even talked about dilution in the later funding rounds, or terms protecting the investor downside.
[2] You either get a good experience, or a good story. Startups give you a lot of good stories.