When you join a company, you may have to decide between equity o cash compensation. Usually, the equity or cash compensation is split more heavily towards cash. However, at a startup, you may elect to have lower cash compensation for more equity compensation.
As a veteran worker who has received cash and equity compensation over the past 22 years, let me share you my thoughts on how to choose.
I've lived in San Francisco since 2001 and the desire to take on more equity compensation is strong. We all want to win the equity startup lottery ticket. However, most lottery tickets never pay out!
Equity Or Cash Compensation
The only way someone can truly get rich is through equity. Think about all the billionaires in the world. Almost all of their net worth comes from their equity stakes in huge businesses such as Microsoft, Google, Facebook, and Berkshire Hathaway.
The only people who are going to get rich making a salary are perhaps investment bankers, hedge fund managers, strategy consultants, doctors, and big lawyers. But even those guys aren't going to crush it with their six figure salaries unless they become partners in their respective firms or practices. They always have equity compensation.
Every once in a while I go jogging along the mansions in Pacific Heights on Broadway and Lyon St in San Francisco. I specifically choose this area because it's inspirational to see beautiful homes. All of the homes are valued between $10-$25 million dollars. And guess what? Every single one of the owners is an entrepreneur.
There's the Getty family (Getty Oil), the Ellison family (Oracle), the Haas family (Levi's), and the Sachs family (Yammer), to name a few of the owners who are clustered in these few blocks of extreme wealth. Even if I made a million dollars a year, I'll still never be able to afford a $20 million dollar home. Just the property tax alone costs $220,000 a year.
Ownership is the key to building outsized wealth. And ownership is one of the main reasons why I've chosen to pursue entrepreneurship. It is truly a fantastic feeling to build something out of nothing and create an asset that is potentially worth a great deal.
Even if someone offered $10 million for Financial Samurai, I'm not sure I'd sell my baby. Only really evil people sell babies right? Besides, the government would get half. Besides, in a low interest rate environment, selling a cash cow online business is foolish! I know several people who sold their sites for millions and regretted it.
Cash And Equity Compensation In Investment Banking Job
When I worked in investment banking, roughly 25%-150% of your base salary comprised of a bonus (e.g. $100,000 base + $100,000 bonus). The bonus was then split up into a cash portion which was paid out to you immediately, and a stock portion that vested over three years. The higher your bonus, the higher percentage you would receive in stock. You have to slave away to make your six figures!
To own stock is to be an owner of the company. When you are an owner of the company, you tend to think in ways that are more beneficial to the firm. Perhaps you'll be more inclined to pick up the trash that someone left in the hallway. Maybe you'll be more vociferous in defending the merits of your CEO's actions. Or perhaps your mind will go into overdrive to think of better ways to cut costs or generate more revenue.
Many firms offer both a cash and equity compensation mix for employees who've demonstrated their loyalty. I was at my old firm for 11 years. I amassed three years worth of deferred compensation that I would lose if I quit. Not quitting, but finding an amicable way to get laid off was key to retaining my deferred compensation as I embarked on my entrepreneurial journey.
Bonuses Are Always Paid In Deferred Comp
The deferred cash and equity compensation plus my severance was enough to provide for six years worth of living expenses at my current rate. With such a safety net, I felt I could take my time to do what's right. I did't have to work just for the sake of money.
If all I received was a pay check from work, I'm not sure if I would have given more than 100% of my effort on a constant basis. Maybe I'd feel more inclined to leave once the clock struck 5 pm. Instead of working until 7 or 8pm to make sure all my client requests were handled.
If the pay raise scale was fixed at a single percentage annual increase based on a rigid number years of service, I definitely wouldn't have been motivated to try harder. Perhaps this is why there's such malaise in the government or amongst folks who are in unions.
Cash Compensation As A Consultant
From 2014-2015, I worked as a consultant at Personal Capital. It was fun and something new to do in the financial tech startup world. I made a difference building their brand online through content as a Chief Content Officer.
I truly believe the wealth management industry is in for a big shakeup over the next 5-10 years. Technology will start being leveraged to help people get better control of their financial lives. To be a part of such change is exciting.
In an incredible show of flexibility and goodwill, Personal Capital gave me the offer of earning 100% cash compensation, a 50/50 mixture of cash and equity compensation, or 100% equity compensation in the form of options. The only time I've ever heard of a consultant or contractor receive equity compensation for their work is when that one artist painted a mural for Facebook years before they went public. Great move on his part!
One of the benefits of being financially independent is flexibility. I don't need cash compensation to survive because I've got passive income and online income currently flowing in. A fair market compensation is all I ask.
I'm pretty allergic to cash as you may have noticed in the post “Pay Down Debt Or Leverage Up?” The more cash I have, the more I've got to figure out what to do with it. I'd much rather invest it for 10 years, not think about the money, and hopefully let the investment compound at a 10% IRR.
Getting Me Some Equity!
Receiving options is clearly a gamble because nobody knows the future. Who would have thought that WhatsApp is now worth $2 billion dollars more than LinkedIn? Crazy, I say. Or what about Tesla today?
Or, maybe we're still only 10% of the way through an incredible multi-decade long growth story. Maybe Personal Capital becomes the dominant digital wealth advisor of the future. With its smart combination of free online financial tools and financial advisory offices, it could be huge.
If Personal Capital becomes a runaway success, I will attempt to kick myself in the face with an inflexible right leg if I go the 100% cash compensation route. Of course I can use the cash to invest in some home run company. But those are hard to find, especially in the private stage.
On the other hand, if Personal Capital fails, I will have ended up spending all that time with zero monetary return. But you know what? As I wrote in my About page, money stopped being a big driver for me a long time ago. It would certainly be nice to get a financial windfall. But I'm most interested in learning new things and experiencing an interesting life. I've learned a tremendous amount about online marketing already. Furthermore, I'm having fun.
Given such thoughts and circumstances, going at least the combination choice of cash and equity makes sense.
How To Determine How Much Equity Compensation To Receive
If I was the CEO of a startup, I would be impressed if a potential employee believed in my company so much as to decide on getting compensated 100% in equity options. If all my employee had was options that could not be monetized unless there was a liquidity event, I would feel comfortable knowing s/he would do everything possible and then some to help make our company a success. Interests are perfectly aligned.
At the same time, I'd probably be protective of how much equity I would give out if I believed the equity will grow by tremendous amounts. There's only so many options I could give, unless I issued new shares and diluted myself and the existing shareholder base. Then again, I'd enjoy sharing the wealth for all those who helped make the company a success. Winning on your own feels lonely.
Given I strongly believe in Personal Capital and I don't need more cash to pay the bills, I've decided to roll the dice and go for 100% equity compensation. I think Personal Capital can be a five bagger (return 500%) over the next five years if we properly execute our strategy. When it comes to larger investments, I'm always thinking long term – five years minimum, ten years preferable.
In fact, after buying $10,000 of my equity options, five years later in 2020, Personal Capital sold to Empower for at least $850 million. My $10,000 tuned into $49,500. Not bad! I wish I had more equity compensation!
Deciding Between Options Or Cash
1) Make an honest assessment of cash flow needs. Calculate an income level that covers all your basic needs at the very least. Living paycheck-to-paycheck is stressful and will hurt your quality of life. But, you might also be inspired to work even harder if you don't have anything to spare.
2) How strongly do you believe in management? Does the C-level team have relevant industry experience with a long track record for successful execution? Or are they recent college graduates who just have a great idea, but no experience executing a vision? Management can be young and inexperienced. But they better have someone who's been there and done that to guide them through the land mines.
3) How big is the market opportunity? Every startup sees a huge market opportunity, otherwise they wouldn't launch their business in the first place. The better question is, what is the real market opportunity? Overestimating the potential customer base is an egregious error that will severely affect the business model.
4) How much income and net worth is enough to make you feel satisfied? I understand it's hard to know until you get there, but you've got to make some assumptions.
5) Do the Venture Capitalists have some preferential clause? In case of a liquidity event, some VCs stipulate a 2X or greater minimum return before shareholders get paid. For example, let's say a VC invests $10 million for a 10% stake with a guaranteed 2X minimum return, valuing the company at $100 million. The company sells for $200 million. The VC's stake leaves only $160 million to be divided by the remaining shareholders. This a 60% return instead of a 100% return for employees.
More Things To Think About
6) What is the cliff and vesting schedule? A one year cliff and four year vest means that you must work at the company for one year before getting your first year's options. If you get fired or leave a day before the one year cliff, you get nothing. With a four year vesting schedule, your 40,000 options are granted over four years at 10,000 a year. Most companies vest every month after the initial one year cliff.
7) How many shares outstanding are there? 40,000 shares sounds nice, but if there are 1 billion shares outstanding, 40,000 is just 0.00004%. How much equity you receive depends upon how early you start at the company and your negotiations skills.
8) What is the current value of each option worth? There are a couple values to consider. The value as reported to the IRS for regulatory purposes and the value management believes the company is worth to outside investors.
9) What happens to your options if your company gets acquired? Let's say you're one year in and the company gets acquired. Do your options immediately vest, or do you lose the remaining three years of a four year vest? Everything is negotiable. If the acquiring company wants you to stay they'll do whatever it takes to make you whole or perhaps give you more incentive to stay.
10) What is the ultimate monetary goal of the company? Is senior management planning on selling to a bigger fish while public, or going IPO? Figure out what the grand vision is by speaking to management and the time frame they think it will take to get there.
Treat equity options compensation as money you're willing to lose. If you don't have a choice, then treat your options as simply funny money that has no value except for when it does. Don't ever assume your options will be worth something, and certainly don't ever spend money that you haven't yet received.
No Guarantees With Equity Compensation
Choosing between cash and equity is a personal decision based on your individual cash flow needs. Ownership is one of the best ways to create wealth. I'm excited to not only be an owner in a new company. But an owner who has the ability to help create more value.
You could own options with a strike price way above the current share price. Your business could go under. Cash is a sure thing. Equity compensation is not. In general, I'm willing to take up to a 50% discount on cash compensation to get more equity compensation. After all, if I'm willing to wok for the company, I believe in its upside!
Related post about cash or equity compensation:
Readers, have you ever had to decide between cash or equity option compensation? If so, how did you choose? Please share some of the pitfalls of owning options if you can.
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Photo: Lt. Governor Gavin Newsom texting on his phone in front of Larry Ellison's Mega Yacht, 2017, FS.