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3:42 am By Arnold Kling Stock Options, Start-ups, and Venture Capital In the start-up sector, stock options enable venture capitalists to confuse entrepreneurs so that they willingly give up a larger share of their companies. There is a Winnie-the-Pooh story in which Pooh and Piglet set out to trap a Heffalump. Piglet suggests that it would be better to use honey than haycorns as bait for the trap, even though he does not believe it. What he realizes is that if they use haycorns, he will have to supply them, but if they use honey, then that will be Pooh's responsibility. Similarly, when venture capitalists suggest that start-ups use stock as bait for employees, it is not necessarily because they believe that stock is more attractive than cash. It is because if the company uses cash, venture capitalists will have to supply it; but stock can be provided by the entrepreneur. A Tale of Two Term SheetsSuppose that you are one of the founding partners in a start-up, and you are given the choice between two term sheets from venture capitalists.
Which deal is better for you as a partner? The way I look at it, term sheet number 1 is better. We get more money, and we keep more of the company. However, an alternative is to look at "valuation." With term sheet number 1, the venture capitalist is paying $4.5 million for half the company. This means that the whole company is valued at $9 million. By that same formulation, term sheet number 2 has the venture capitalist paying $4.0 million for 40 percent of the company, so that the whole company must be worth $10 million. From a "valuation" perspective, term sheet number 2 looks better. In this case, it is the "valuation" perspective that is misleading. The partners truly are better off with the first deal, even though the second deal leads to a higher "valuation." Exhaustion and EgoWhen you see the two deals side by side, it's not hard to see through the "valuation" fallacy. However, the venture capitalist does not show you the two deals side by side. All through the negotiation, they talk about putting in $X at a valuation of $Y. They negotiate until you are emotionally exhausted and out of cash. Finally, you are worn down until you are prepared to accept a discouragingly low valuation. THEN, they throw in the kicker about stock options. By this time, you would never argue for something like term sheet number 1, because the valuation is already so low as to be humiliating. Your ego cannot take anything lower. So you go with term sheet number 2. Employee Compensation and IncentivesAnother way to look at term sheet number 2 is that the venture capitalist obtains 60 percent of the company for $4 million, and then puts up 20 percent of the company toward a stock option compensation pool. This compensation pool has value, but that value will be reduced by the risk premium that employees attach to stock options. With term sheet number 2, the partners have an additional $500,000 which they could use to obtain employees. Because employees place a sizable risk premium on non-cash compensation, we should be able to attract more talent with $500,000 in cash than with a 20 percent stock option pool. The "party line" from Silicon Valley is that stock options are used to create a loyal work force at low cost. However, for that purpose you can design more effective compensation schemes that tie bonuses to individual and corporate objectives. Stock options are not the most effective way of achieving the objective of employee loyalty. Instead, I believe that in the start-up arena, stock options serve as a way to reconcile the fragile egos of entrepreneurs with their desperation for money. Setting aside a large share of the company for stock options provides a face-saving way for partners to sacrifice a heftier part of their company for relatively little cash. Copyright 2002 Corante. All rights reserved. Terms of use |
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