I have brokered over 100 compensation negotiations between senior executives and hiring managers (often the CEO or CFO) and their Board of Directors. It’s a fascinating process, and one where information asymmetry and opaqueness can lead to unpleasant surprises, in part because compensation programs markedly differ across public companies, venture backed start-ups and mature companies owned by LBO sponsors.
Trust and transparency are critical to both “sealing the deal” and avoiding buyer’s remorse (on either side). Grounding the “discovery process” and eventual compensation negotiation around what is both important to the candidate and within market ranges for the role, industry, enterprise scale, valuation and maturity of the business can help establish base line compensation ranges and provide a framework for principled negotiation.
As a senior executive recruiter who has worked with many disruptive startups and established companies, I know enough to make some generalizations based on experience – but also enough to welcome your input. Here goes:
View private stock/options as a down payment on retirement and don’t model it into your current lifestyle
Employees of many venture-backed companies are typically granted stock options at the company’s most recent 409 (a) valuation. In many cases, this valuation is lower than the company’s latest private market valuation because 409 (a) valuation applies a liquidity discount.
Unlike stock at a public company, which typically vests over four years, you need two things to happen as an employee of a private company: 1) the company must grow its valuation and 2) the CEO and Board need to both receive AND accept an “attractive offer”. As a former investment banker, I can tell you that most M&A deals fall apart for a variety of reasons: valuation, who is going to run the combined company, the business is self-financing, or quite simply because the CEO/largest shareholder simply does not want to sell for any price.
Capital structure matters
If you are lucky enough to have a friend in the VC business, have them explain to you in detail how preference stacks work. For compensation negotiations, just know that big valuations often come with big preference stacks that may protect investors at the expense of management and employees if the company fails to meet certain valuation hurdles. In the Valley, we are habituated to follow the “headline valuation.” As a potential recipient of private and illiquid stock, I’d rather know that a company has been able to create a ton of value without having to sell too much of the upside.
Companies like Stitch Fix are a good lesson: the company raised less than $50M of equity capital before its $1.6Bn IPO. Stitch Fix represents the rare combination of rapid growth and capital/operating efficiency which results in massive returns to investors and employees. Unfortunately, there are far more examples of “upside down” capital structures where employees toil for years earning under-market cash compensation, but then don’t make anything on their private stock.
Private Equity / Buy-Outs Work Differently Than Venture Deals
Private equity (or leveraged buy-outs) tend to concentrate equity ownership with the most senior executives, and in some cases may not extend any equity to the rank-and-file employees. In contrast, venture-backed start-ups tend to distribute equity deeper into the organization. Some PE firms will reserve a percentage of the upside or deal value at exit for senior management and will work with the CEO and VP HR to determine how much of the equity program is spread across and down in the organization. I have found that private equity boards tend to be more 80/20 oriented – they believe that 20% of the team drives at least 80% of the value, partly explaining the concentration of equity with senior management.
My point is not to judge either approach, but to simply advise that candidates and hiring teams have a fact-based discussion about how these program work. Avoid trying to sell the equity as a life changer. It could do just that for everyone at the table, but there are no guarantees and all parties need to recognize the risk/reward relationship and illiquidity of shares.
A framework to think about long-term equity compensation at a private company
As a numbers guy and leveraging my prior career selling and taking companies public, I work with clients to develop an excel sheet which shows the value of one’s option grant based on a range of company valuations at exit. Often the exercise involves defining an achievable base case company growth plan over the next 3-5 years that supports a range of potential valuation ranges. CFOs and other financial types tend to build their own models and may discount “management” forecasts, but the modeling exercise between future business executive and hiring manager generates two positive effects:
1) It orients the conversation towards value creation, and adept leaders can build from the compensation conversation and build management objectives for this key hire over the next 12-18 months.
2) It can shift the conversation from how much do I get to how can we grow the pie
In the end, compensation is only one factor…and normally it’s not the most important reason when deciding to take on a new challenge.
With over a decade of placing senior executives, I’ve gotten a pretty good sense when a candidate wants the job. It’s then my role to calibrate the compensation conversation so that the candidate and hiring team can come to a meeting of the minds. In the heat of a compensation negotiation, I like to take the candidate back in time to the core reasons for why he/she took the call in the first place. We also revisit first principals: are you excited about the people, the mission, the role and the opportunity? Normally, if the answer is YES, YES, YES, and YES, then negotiating compensation becomes an exercise in arriving at a market rate that both sides feel is within the range of fairness. To help all parties make the decision less personal and more data driven, I work with clients to gather independent compensation surveys while also sharing my judgment based on the most current comparable placements. I’ve found that when both the hiring manager and candidate ground the conversation on data then both parties are more likely to seal the deal.