Assessing the equity portion of a package in start-ups or pre IPO businesses

Published: 5 September 2014

Any employment offer always has two key components - salary and benefits. A less common and mostly misunderstood part is the much vaunted ‘equity’. Equity is the carrot that draws many executives away from top roles with global blue-chips to start-ups, turnarounds and dare I say it, basket cases.

The phrase ‘I am looking for something pre IPO’ is as ubiquitous as ‘I’ve done the start-up thing and want to get back to corporate life’.  The driving force behind both these statements is equity; initially the great hope but what regularly becomes a source of frustration and a driver for people to take the wrong job.

In my experience this stems from the fact that ‘equity’ is often viewed on a binary and short term basis when it should be viewed through the lens of probability and time.

There are many influencing factors on the success of any business and the variance created by luck in any individual scenario should not be underestimated. Even the very best and brightest global VCs have a relatively low expectation in terms of their individual portfolio companies success; their profits being created, by a couple of home runs in a portfolio of many companies. Fortunately for the VCs they are able to repeatedly and simultaneously invest capital to smooth out the variance.

As employees with finite careers and only so many hours in the day, we do not have this luxury. This is not to say we shouldn’t pursue life changing wealth creation opportunities, more that we should be methodical in assessing those opportunities.

The reality

Start-ups fail. It may be the employees fault, the market conditions or an externality that couldn’t be predicted. If you are a senior executive you may for example have 20 years in your career left for ‘wealth creation’ opportunities. If an average pre IPO business takes five years to bring to maturity you essentially have four rolls of the dice. If for example, the opportunities you are considering have a 50% chance of a ‘successful exit’ (which is reasonably high) it is well within the realms of possibility that all four businesses fail. Remember, you personally may do a fantastic job and be left with nothing.

If this is your first foray into the start-up world it may be worth joining a business that is late in its maturity cycle and likely to IPO/sell in the coming one to two years. Even if the reward is not life changing the experience will be invaluable and people inevitably associate success with success. For the next opportunity it may be better to consider a relatively high risk opportunity that has a significantly higher reward.

Understand the numbers

Equity offers are usually complex and have multiple moving parts. For those of us who are not highly numerate, it can be daunting. However when assessing an equity opportunity, some of the key factors you should be considering are:

·  The expected return and the likelihood of success - what is the management’s best estimate of valuation upon exit? That number is an educated guess at best but it may be useful to dig into what would be ‘acceptable’ as opposed to what they want in a best case.

·  Some investors require a multiple of their money to be returned to them before management. Once money has been returned the value of further success for the management team can grow exponentially. It is critical to understand this metric.

·  The time scales involved; a realistic view of how long it is going to take for a successful exit should be a major determining factor in valuing equity. When assessing this, it is useful to understand how long the investors usually hold their investments. It is a broad rule of thumb but often quite accurate.

·  What is the vesting schedule? Is equity dilution a possibility? Is the strike price fair? If these types of terms are currently alien, I would strongly suggest undertaking personal research and securing high quality advice to ensure you truly understand the value of the offer. 

·  If offered and you have the liquidity, would you invest a significant amount of money yourself?

I learnt very early on that as a head-hunter it is not my place or responsibility to attempt to explain the intricacies of an equity plan or indeed  what it is likely to pay out (be wary of those who do). My stock response when asked about equity is to set up a conversation with the relevant internal stakeholder, usually the CFO, who should be able to explain in intimate detail the various moving parts. I would strongly advise a candidate to take this information to an independent adviser (lawyer/accountant) who can advise you appropriately.

Inevitably people generally overestimate the value of their equity and don’t factor in the time it takes to achieve a pay-out. Given human nature and the inherent complexity of equity this is understandable but it can lead to the aforementioned frustrations. I have read many commentators who suggest that equity should be an added bonus that should not influence your decision to take a role. I believe this is incorrect; equity should be a significant factor in whether you do or do not accept a role. The key is to assign an educated range to the value of the equity and use those numbers to assess whether in the context of your career, financial position, aspirations, family life etc. it is on balance a good move. 

I am a huge supporter of start-up and pre-IPO businesses and would encourage many (although not all) to experience life in the fast lane. I would also thoroughly support people ‘taking a chance’ and looking for life changing wealth creation opportunities. I would only urge candidates to undertake what they may consider extreme due diligence and understand the true metrics underlying the offer.

Callum Wallace is a Consultant in the Technology Practice at Berwick Partners. He specialises in recruiting commercial talent in the Technology industry

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