Brave New Equity World
By Avi Deitcher
Poor founders and CEOs; we really should have some sympathy for them. The sheer amount of information they need to know is mind-boggling. Everyone starts out with one area of expertise. For most startup founders, it is technology; for some, it is product or marketing. You quickly need to learn sales, and technology, and marketing. Then comes HR - since you need people to grow - and finance becomes important very quickly. Add in legal for contracts, not to mention all of the odd compliance rules in all of the jurisdictions in which you operate - employee relations rules, company operating regulations, incorporation rules, the list goes on - and it seems nearly impossible.
Even if you have a great consultant to keep on top of all of that and find out what you don't know (ask us if you need one), every day new information comes along.
And now, company equity structures are changing. Historically, startups have been relatively straightforward (although sometimes creating accurate cap tables can make quantum mechanics seem simple).
You started a company, you issued common stock to the founders. As you grew, you set aside shares for Employee Stock Option Plans (ESOP), and sold series of preferred shares to investors. The investors might also get warrants or other structures, but overall, it is a structure investors and most founders have understood for decades.
Until it doesn't work.
In the last decade, between the growth in litigation towards public companies and the sheer explosion in compliance costs, more and more companies choose to remain private as long as possible.
Of course, this has had a deleterious effect on public market investors. You used to be able to buy shares in a public company with a valuation of $50-100MM. It was risky, but most of a successful company's growth was ahead of it. The common investor could partake.
Now, companies go public when they have no choice, often because regulations have forced the company to go public. Companies prefer to remain private as long as possible. Thus, while Apple went public at $1.7BN in 1980, and Microsoft at ~$780MM, nowadays Facebook went public at over $100BN, and Twitter at ~$24BN.
A few weeks ago, Uber was raising money at a $62.5 billion dollar valuation... privately. This is over 36x Apple's valuation at IPO and 80x Microsoft's. Even accounting for inflation (of which many writers appear to be ignorant), it still is 12.8x Apple and 28x Microsoft... and Uber still is private.
The problem is, in order to grow a company that big and still remain private, you need an equity structure that allows you to maintain control.
This fascinating article from Business Insider shows what Uber has done to maintain control. It includes:
- Taking advantage of the JOBS Act's expanded thresholds
- Keeping employees out of actual shareholding - and possibly benefiting them by avoiding their shares' being "out of the money" or "under water" - by providing Restricted Stock Units (RSUs) instead of ESOP options
- Placing tight restrictions on equity transfers
Some of these are doable only because Uber is in such a strong position. Nonetheless, Uber's willingness to experiment with different structures may be opening the door for other companies to work with new structures.
The regulatory, litigation, public market requirements and public investment opportunities all have changed. It was inevitable that the equity structures that evolved in a different era for all four of those major structures need investigating and someone willing to try different ones.
Which will last? It is hard to know. I suspect that five years from now, even the earliest stage startups will have equity structures at least somewhat different from what we have seen for the last thirty to forty years.
Pity the founders and CEOs, though. Ever more for them to learn.