On Equity

Henry Ward’s post:

Work @ Carta, get liquidity

Has been on my mental back-burner for a few months now.

I’m not sure that I’m fully bought into Ward’s prediction that the market will tip towards liquidity being the norm at some point in the near future, but it did make me reflect on the problem-solution fit that is equity grants.

At the core of the decision to grant employees equity, is a noble intent to give employees an upside in the future of success of the company. If the company does well — your equity stake appreciates in value. If the company doesn’t do well — your equity stake depreciates in value, all the way to the point where it may be worth nothing. I’m a strong proponent of this noble intent.

But equity also seems like an unnecessarily complex solution to accomplish said intent. Part of it has to do with the financial vehicle itself (Incentive Stock Options, or ISOs, for the purposes of this thread), and part of it has to do with the particular way that it’s being granted, which implicitly makes some assumptions on the lifecycle of the typical company which no longer seems to hold true.

Here’s a partial list of some odd “externalities” of using equity:

  • An arbitrary period of time during which equity is granted (“4-year vest”)
  • An arbitrary eligibility period (“1-year cliff”)
  • Complex tax treatment — taxes are often due before the upside can be realized
  • Cashflow constraints — options must be “exercised”, which requires a cash outflow, often times before a cash inflow is possible
  • Challenging handling of employee departure/termination (“exercise window” which further amplifies the cashflow constraint)
  • Irrelevant rights — being a shareholder grants shareholder rights that go beyond the cash value of the shares and are irrelevant to the intent stated above
  • Questionable “company success” proxy — a company’s market value is also impacted by many external factors that have little to do with the actual success or even financial health of the company
  • Limited liquidity — the ability to materialize any of the financial upside often depends on the company stock trading in a public market. An event that seems to happen later in a company’s lifecycle compared to when it used to take place, and has its own overhead and undesirable “externalities”

Maybe equity is simply the “best worst” solution. And maybe it’s time for a better solution?

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On Equity

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