Equity and Risk at Startups

Friday, March 19, 2021 by Louie Bacaj

The rewards in a fast-moving venture-backed Startup are tied to risk, not to contributions. If there is a successful exit, the question of fairness sticks out because employee number 20 may contribute no less to a venture's success than employee number 10 does; in fact, they may contribute even more, yet the rewards will be disproportionate.

The risk in startups follows a logarithmic curve. There is a large chance of failure at the beginning of any business, and that chance of failure begins to smooth out over time.

Example startup risk curve over time.

This logarithmic curve of risk is important because that risk is directly correlated to the equity you get. Equity is, of course, ownership, and it is a critical component to building wealth. This relationship between equity and risk is somewhat understood by most of us, but the scales they follow trip many of us up.

Most debates about founders having so much more equity than their early employees, or early employees having exponentially more than later employees, focus on fairness and end up missing the point of how these two things - risk and equity - work.

There is nothing fair about risk.

Through my failures, I have learned that we humans are terrible at understanding exponential growth and just as bad at understanding the opposite of that growth, logarithmic deceleration. This is all critical to making good decisions about joining a startup, starting a business, or obtaining ownership in any venture.

Equity multiples are hard to grasp.

I will present some numbers from a very successful venture-funded startup I was a part of and how things panned out to illustrate the point.

The founder of the company made about a billion dollars after the successful exit.

His co-founders, who didn't put money in at that early stage, risked their time and quit their jobs reasonably early to help him start it and made them 100 million each.

The first few employees made anywhere between 1 to 10 million each in equity.

I was the 20th engineer, around the 45th hire; I made around 160k for myself. I was an individual contributor and not incredibly senior at the time of my hiring. However, I grew fast and received more equity through every promotion.

The difference between the founder and his co-founders was 10x; the difference between the co-founders and the early hires was 10x. The difference between my exit and the founder is 6,249x.

Risk is logarithmic but the Equity difference is exponential (Notice how this maps out to the above Graph)

Many people, myself included, felt this was somewhat unfair. But by the time my peers and I joined this Startup, we had to put no money in, and we had near-market rate salaries. The company was as well-capitalized as most medium-sized fortune 1000 companies; the risk was low, so the equity was low.

I remember having a conversation with a friend, and colleague at this Startup, who told me that the lesson he learned from the first Startup exit he was a part of was that you needed to have equity. He had none at that first one. This time though, he told me that he learned it's not enough to have equity; you have to be early enough to make real money. Both he and I worked hard at this Startup. His story stuck with me, and it's influenced my thought process about startups over the years.

Equity is proportional to risk, but not all risk is the same.

Before a new venture has taken off and before there is product-market fit, that early risk is exponentially larger than the risk that exists after a company has customers, is making money, or has lots of users. That risk further levels off with each stage of the company or venture.

For startups, the risk is such that it might all be worthless and that the initial team might lose everything they put in, including all of their time, and get zero in return—no salary, no money, nothing whatsoever back. Depending on how much money, what they had to give up, an early team putting in this risk could be losing so much that it could be ruinous for them. I had a friend who started a business, lost all his savings, and went into debt; it took him years to recover. The trauma from that failure has changed his whole outlook on life.

Taking on the risk of zero, maybe even ruin, ends up getting valued and rewarded with exponentially larger equity than the risk others take who come in later on. On the debate of equity awards, this is where things start getting "unfair."

For example, after a company raises capital, the risk for later employees is reduced. Even if their equity is worth zero, they would be receiving a salary for the entire time there while the Startup has capital. Yes, they could run out of capital, but that risk is much lower because, for one, you can see it coming and can do something about it, like try to get another job, and that kind of risk is far lower than the first stage.

While all of this seems obvious, again, it's the scales that trip us up. It used to trip me up. For example, if a company has three founders at that first stage, each founder may have 30% of the company and allocate 10% to a pool for early employees and executives. By the time founders hire someone, they've either capitalized the company themselves or through investors. By that time, the first stage of risk is gone, and as such, we end up with a situation where employee 1 has one a few percentage points of the company. In contrast, the founder has 30x more. This may seem "unfair," I used to think it was, now after trying many things and failing, I see that it's not unfair. It is tied to the relationship between risk and equity; if the risk is lower on the logarithmic curve, the risk is never gone, you'll get exponentially less equity.

I have received CTO offers at early-stage startups with a few employees. One offered me 1-3% of their company as part of the equity compensation; I was offended at the time. Because I know how much I would have to work at a company with so few people and how much value I would add to a company at that early stage. However, I never put the relationship between equity and risk on the scale to weigh them.

In Conclusion

You only start to understand and appreciate risk and reward after going through it a few times and after a few failures. After seeing how difficult the early phases of any venture are and why the outcomes become so outsized. The rewards in the venture are more strongly correlated to risk than they are to contribution.

This relationship that risk has to equity is worth understanding because these things will influence our outcomes far more than anything else we do. It is the main reason why Jeff Bezos is worth a hundred billion, or more, while someone that may work even harder than him is not worth even a hundred grand.

If you want outsized returns from your work, you will have to take outsized risks; it is not enough to be good or to work hard. You will have to be a founder or early enough where your equity is meaningful, and even then, it's a toss-up.