Post Category → Employees

Early Startup Employee Compensation

Background reading:

Given how deeply involved we are with early-stage startups hiring their first key employees, I figured it would be helpful to outline a few key principles to help entrepreneurs navigate the topic.

Make sure they are actually employees, and if they are, at least minimum wage.

States vary in how strict they enforce the line between contractors and employees. California is way harsher than elsewhere in the country.

In general, employees are under your control as to how they work and when they work. Contractors, on the other hand, are required to deliver a service/end-product, but have more control over how it gets done, and they usually are working less than full-time hours and have multiple ‘clients.’ Those are very rough guidelines, and you should work with lawyers to ensure you stay on the right side of your state’s (and federal) specific rules.

The employee v. contractor classification is very important, because contractors can be engaged for free from a cash perspective (equity only). Employees, however, need to be paid at least minimum wage, and may be entitled to benefits. The legal and tax requirements for engaging (and terminating) contractors v. employees are also very different.

Every startup lawyer knows stories of startups that treated someone as a contractor in order to keep costs low, then the relationship went south, and the person ended up filing complaints and getting the startup into hot water. On top of following the rules, your best protection is to be careful with whom you hire, and be respectful/thoughtful if you have to terminate them.

All else being equal, more equity means less cash, and visa versa.

Generally speaking, if someone is getting paid significantly less than what’s “market” for their position, they will expect to receive more equity in order to make up for the difference. Very early employees are generally working at below-market (often substantially below market) cash compensation, and therefore receive much larger portions of equity than someone hired post-Series A or Series B.

And the converse is true as well. If someone, for whatever reason, needs to make $X, even if it’s a serious stretch at the startup’s current budget, then their equity should be proportionately lower. And it should go without saying, all employee equity should have a vesting schedule. 

All of that being said, the early employees will of course expect their compensation to move closer to market as the startup raises funds and hits revenue milestones.

In the very early days, employees are often paid more than founders / senior executives.

The further you move away from the founder team, the greater the dilution of a person’s commitment to the “mission” of the startup; and that means more cash to keep them committed.  For that reason, at pre-seed and seed stage, it is not uncommon for *true* employee hires to actually be earning more, from a cash perspective, than the founder CEO; obviously with substantially lower equity ownership.

After a decent-sized seed round (and certainly Series A), it becomes a lot rarer for the CEO to not be the highest cash earner on the roster.

For more info on what founders are typically able to pay themselves at the various stages, see: Founder Compensation: Cash, Equity, Liquidity.

Don’t over-optimize for market data.

When you reach post-Series A or Series B, it can be helpful when hiring people to obtain hard data on what’s “market” for a certain position, and use that data in negotiations. There are some good services to help with that.

But at very early stages, everything is highly contextual. I’ve seen teams where everyone is making almost nothing. I’ve seen situations where the founder CEO is making nothing, and their lead developer is making six figures. I also see everything in-between. It all depends on the relationships and context. Maybe ask around if you need to, or do some AngelList Jobs perusing, but don’t put too much faith in the value of broad market data for your pre-seed or seed stage startup’s hiring needs.

Employment laws and taxes are not a place to move fast and break things.

Finally, as much as I appreciate keeping things lean, moving fast, and skirting the rules where the costs are low, realize that violating laws around employee compensation and hiring/firing can burn you, badly.

In some contexts, unpaid employee compensation is even recoverable against the Board or executives, outside of the Company. Did you catch that? Let me repeat it for you: failing to pay employees compensation you promise them, or taxes for that compensation, can in some contexts result in personal liability for you, even if the company itself files for bankruptcy.

Take. This. Sh**. Seriously. While I’ve seen more than my fair share of nuclear wars between founders – see: How Founders (Should) Break Up – the deep relationships among founders often allow for more leeway in terms of following/not following the letter of the law. Employees are usually different, and will hesitate significantly less to use every weapon against you if you cross them. Make sure you’re well-advised from the moment you bring on your first *true* hire. 

Non-Competes and Startups

TL;DR: Post-employment non-competes are generally not enforceable in California. Given how much content around tech entrepreneurship originates from California, you might get the impression that not having non-competes in startup employment agreements is the norm across the country. You’d be wrong.

The whole non-compete debate in tech circles is fun to watch. Certain people try to paint it in simplistic “good v. bad” terms. The champions of innovation who believe “talent should move freely,” v. the traditionalist ogres representing entrenched BigCo’s. But as you’ll hear me repeatedly say on this blog: watch incentives. Where you stand depends on where you sit. 

Ecosystem v. Individual Incentives

The debate over non-competes has a few core elements to it. First, it pits ecosystem v. individual incentives, which I’ve discussed in a few places on this blog. I’m fairly confident that if you remove the ability for employers and employees to agree (voluntarily) to have non-competes in their employment docs, the end-result is more companies and more bargaining power for employees (obviously); which is to say, it probably does net-out to faster ecosystem growth.

But if I’m an entrepreneur who has already started a company, I give far far more shits about the specific company I’ve sunk my sweat and tears into than about your “ecosystem.” Your ecosystem is not going to produce an ROI on my “one shot” investment.

However, if I’m a venture capitalist, angel investor, or run an accelerator, my ROI is tied to the ecosystem; I have portfolio, not “one shot” incentives. I benefit from incentivizing hyper-competition and the creation of new companies, even if it threatens the existence of those who are currently working on their “one shot.”

ps, it also increases the need for capital to fund talent wars. No non-competes -> Talent wars -> Demand for more capital -> VCs make more money. Watch incentives.

From an evolutionary perspective, you better believe it would help the human species if people died sooner and reproduced more. You also better believe the people currently alive might have a slightly different perspective on the matter, and would prefer for their own individual interests to be considered too.

So putting aside moralizing judgments, everyone discussing the non-compete issue needs to first acknowledge the reality of their misaligned incentives.

Grandstanding

Secondly, because so many people on the entrepreneurial/employer side, particularly in Silicon Valley (where there is an extremely^2 competitive labor market), are so concerned about being seen as “that awesome person/company that just LOVES employees and you really really really should want to work for,” there is very much a reluctance to speak honestly on this issue. You’ve got companies offering doggy daycare and daily massages to try to hold onto their roster. They sure as hell aren’t going to go on the record saying “yeah, it would be nice if we could have non-competes.”

So it doesn’t surprise me that most of the public content on the issue involves people grandstanding about the values of innovation, disruption, free talent flow, etc., and how they support outright bans on non-competes. The law (in California) is already there – they can’t have non-competes, and that’s not changing – so why on earth would I counter its logic publicly, when deviating from the script will hurt my recruiting efforts?

There’s a very similar dynamic going on here with the 90-day exercise period on employee options. Putting aside the legal and tax nuances around it, so much of the public content coming out of SV on it paints it as total BS and just a way for employers to “screw” employees.

Summary:

  1. Asking employees to commit to a 1-year non-compete is just employers “screwing” employees. Nothing more.
  2. Asking employees to exercise their options within 90 days of leaving the company, or forgo the equity, is also employers “screwing” employees. Nothing more.

Is not offering doggy day care “screwing” employees as well? Asking for a friend, in California.

“Non-competes and employee option expiration are outrageous! We’d NEVER do that to employees!”

Translation: “We’re hiring! Chef-prepared veganic meals daily. All you can drink Soylent.”

Employers (including current entrepreneurs) have wants and needs. Employees have wants and needs. Startup investors have wants and needs. And many of them conflict. Acknowledging it, instead of finger-pointing and grandstanding, makes debate possible.

Humanize the Issue

I’m very much a fan of humanizing complex business issues; which to me means distilling them down to basic norms and ethics of human interaction. It’s easy to get caught up in cold business calculus when you talk about “employers” and “employees,” instead of reducing the issue down to people simply bargaining with each other.

Say I’ve spent years building up a family restaurant, with all of my special recipes, business contacts, processes, etc., and I invite you to come work with me. I’m going to teach you everything about the business; all of my secrets. But to ensure I can trust that you aren’t just going to take everything I teach you and use it somewhere else, I ask you to agree not to compete with us for a year if you leave.

Am I an asshole? Or am I simply protecting myself somewhat from betrayal? I can think of lots of human scenarios in which this kind of bargain is perfectly acceptable and reasonable. And with my free-market tendencies, I don’t feel comfortable with the government dictating that me and my prospective employee can’t simply agree among ourselves what the right bargain is.

And now we’ll have the necessary rebuttals.

But this isn’t about family restaurants, Jose. This is about Google and Apple trying to keep powerless employees from choosing where they want to work.

Is it really? You think the Pre-Series A entrepreneur with 10 employees isn’t exposed to a key employee walking with everything she’s learned and taking it somewhere else?  There are valid arguments for why non-competes need to be right-sized for the circumstances, and why perhaps very large corporations shouldn’t get the same benefits from them as smaller businesses. And also that lower-level staff should get more freedom than employees closer to core IP/trade secrets. Courts already think about them this way.

And let’s also stop playing the violins for a second. Are today’s tech employees, especially in startup ecosystems, really powerless?

But confidentiality provisions and other IP protections still protect companies, even without non-competes.

Trust me, it is 100x as expensive to prove in court that someone stole your trade secrets than it is to point to a paragraph in an employment agreement and be done with it. Google and Apple have the resources to fully enforce their IP confidentiality. Most small companies / startups do not. Today, total banning of non-competes may help Goliaths more than Davids.

There may even be a feedback loop in which total banning of non-competes increases trade secret poaching by large corps who can throw millions at key employees and pay for armies of lawyers, which over time reduces incentives for entrepreneurship in those industries that require long-term trade secret nurturing to compete with incumbents. I can see evidence of this in certain kinds of hardware startups where talent is subject to poaching by Apple, Google, etc. and for which the lack of non-competes makes it impossible to stop.

But removing non-competes requires employers to hold onto their employees in other ways.

I get it. Government reduces the power of an employer, so the employee now has more leverage. Employee therefore gets better treatment. Wonderful. But the point of this post is that employees aren’t the only people in the business ecosystem that matter, and there are valid arguments on the other side that are worth hearing. Acting as if everything in an economy should be biased toward employees, and against employers, is how you get European-levels of stagnation and unemployment.

Non-Competes are the Norm. 

Outside of California, non-competes are the norm, and they can be valuable among the many other bargaining mechanisms between employers and employees. They can help provide a foundation of trust, which allows employers to invest in their employees for the long-term.

Maybe you’re so gung-ho on the total free flow of talent and “ecosystems” that you absolutely want to forgo non-competes. That’s perfectly fine. Every company is different, and has its own culture. But at least understand why your counterparts at other companies may think differently about the situation, and offer alternatives. That’s how healthy labor markets are built.

The right answer on non-competes probably lies somewhere in the middle of the two polarized sides. On the one hand, it is definitely unfair for a powerful 20,000 employee behemoth to be able to restrict even a secretary from working at a competitor. I think we can all agree on that, and the courts already do. But that doesn’t mean the same rules should be applied to the key employee at a 10-employee startup.

On the other hand, there is a valid argument that the level of hyper competition in Silicon Valley is not something other ecosystems should try to totally replicate. It may lead to talent wars, which waste resources on frivolous perks, and require larger rounds of capital. It may also hurt the ability of companies to invest in their talent for the long-term, because they’re constantly worried about that talent being bought out by a better capitalized competitor.

We should all agree that there are valid points to be made on both sides, and valid disagreement as to what a “healthy” startup ecosystem really looks like. The grandstanding and obfuscation of misaligned incentives is the problem.

Common Stock v. Preferred Stock

TL;DR: Beyond the technical differences between Preferred Stock and Common Stock, there are deeper differences in their composition, incentives, and risk exposure that play out in the course of a company’s history. Understanding the tension between those differences is important.

Very quick vocabulary lesson:

Common Stock is the default equity security of a corporation. It’s what founders, employees, advisors, and other service providers get.

Preferred Stock (Series A, Series B, etc.) is “preferred” because it has extra privileges / rights layered on top of it relative to the Common Stock, including a liquidation preference, rights to block certain things, etc. Preferred Stockholders are almost always investors.

Why don’t investors (usually) buy Common Stock? Short answer: why be common when you can be “preferred”?

Longer answer: they want the downside protection that a liquidation preference provides (they get their money back before anyone else), and they want various contractual privileges that separate them from the “common” holders; like the right to elect certain directors. Also, another argument often made is that by having investors buy Preferred Stock, the “strike price” of options (which buy common stock) used as service compensation can be lower (when a valuation occurs). The logic is that common stock at the time is less valuable due to its lower rights and status on the liquidation waterfall.

So if your investors pay $1 for Preferred Stock with a liquidation preference and other rights, you can still issue your employees options at 20 cents per share (or whatever your valuation reflects) without busting tax/equity compensation rules. The options are for Common Stock, which lacks the bells and whistles of Preferred Stock, and therefore the “fair market value” exercise price is lower. If the investors had paid $1 for Common Stock, your employee options would’ve been much more expensive.

Interesting corporate law factoid: between the Common Stock (founders, employees, etc.) and the Preferred Stock (investors), which group does the Board of Directors owe greater fiduciary duties to in the event of a conflict?

Answer: the Common Stock. And yes, that means even the directors elected by preferred stockholders, even if the director is a VC. Ask your corporate lawyer if you don’t believe me. The Delaware case law is pretty clear.  All the more reason to avoid “captive” company counsel, to help the Board actually do its job.

Kind of ironic. The investors get “Preferred” stock, but the Board is actually legally required to “prefer” (in a way) the Common Stock.

Apart from the technical differences between Common Stock and Preferred Stock, it’s important to keep in mind the different characteristics of the people who make up the two groups.

A. Common Stockholders are much less “diversified” than Preferred Stockholders. This is their “one shot.” 

As I wrote in Not Building a Unicorn, venture capitalists and founders/management often have very different incentives when it comes to setting out a growth and exit strategy for a company; especially when the VCs are the type that look for “unicorns” (larger funds).

Most startup investors (preferred stockholders) have a portfolio of investments. If a few go bust, their hope is to more than make up for it with a grand slam from another. For a less diversified common stockholder, like a first time founder: going bust is really going bust.

Imagine, for simplicity, you have 2 potential growth/exit strategies: Option A and Option B. Option A has a 50% chance of success, and would result in the Company exiting at a $80MM valuation. Option B has a 10% chance of success, but would result in a $1B exit.

Now imagine a portfolio of 10 companies, each with an Option A and an Option B. The Preferred Stock are invested in all 10 of those companies, but the Common Stock are exclusive to each company.

Do you think the Common Stock and Preferred Stock are always going to see eye to eye on which option to take? Hell no. With downside protection (liquidation preference) and diversification, preferred stockholders are far more incentivized to take much bigger risks than common stockholders are.

The Common Stock v. Preferred Stock divide is very real, and that matters from a corporate governance perspective.

B. Common Stockholders are typically less “sophisticated,” and don’t have their own lawyers. 

Part of the idea of fiduciary duties is that someone more sophisticated, informed, or influential is given responsibility to look out for the best interests of someone who is less sophisticated, informed, and influential. That’s why the Board of Directors, which has the most power in the corporation, has fiduciary duties to all the smaller stockholders who can’t see everything that’s going on.

Naturally, because many institutional investors are diversified, they are by definition “repeat players,” which makes them more sophisticated at the complexities of financing, corporate governance, etc. In negotiating transactions with the Company (like financings), they also often have their own lawyers to negotiate directly on their behalf.

Common Stockholders rarely involve their own lawyers when they are getting their equity from the Company. They rely much more on the norms of how the Company treats all of its equity recipients. And, frankly, they just have to trust that they will be treated fairly.

It’s worth noting that, at least in this regard, individual angels are a lot more like common stockholders than institutional venture capitalists. They too often sign standardized docs, with little negotiation or personal lawyer involvement, and they also often don’t have visibility into Board decisions. They are usually more trust driven in their dealings with their investments. This is why founders will often feel more “aligned” with angels than with VCs. That’s because they are usually more aligned.

Even founders, with much bigger stakes than a typical employee, often do not involve personal lawyers in dealings with the Company; not until the later stages when the cap table and board composition are very different. They rely much more on company counsel to advise on what’s best for the Company as a whole, which indirectly means what’s best for the common stock.

In short: Common Stockholders, broadly, (i) are less diversified, and therefore more exposed to risk in this specific company, (ii) have less downside protection, (iii) are less wealthy and sophisticated, and (iv) usually don’t have their own lawyers to review and negotiate things on their behalf. This is, to a large degree, why the case law puts such an emphasis on fiduciary duties to common stockholders.  Because the bigger Preferred Stock players can negotiate contractually for their rights and protections, Corporate Law says officers and directors should focus on what’s best for the Company as a whole, with special care toward the interests of the common stock.

ps: should Company Counsel own equity in the Company? Usually they don’t, but sometimes they do. After reading the above, it should be crystal clear what type of security they should own, and why letting your lawyers buy preferred stock can, in many circumstances, be a very bad idea.