In my last post, I wrote about early stage businesses operating with losses while they scale. I suggested the need for a capital plan to reach cashflow breakeven as soon as possible, and warned of dire consequences if the investors suddenly turn off the flow of capital before the business is self-sustaining. A friend and former colleague suggested that early stage companies are not for the faint of heart, and unfortunately, not everyone is aware of the financial condition of their employer, or even considers it when they decide to join a new company.
I remember joining an existing company as the new CEO some years ago. In one of my early town hall meetings to introduce myself and describe the state of the business, I commented that the company had plenty of cash to get to breakeven. A hand went up in the audience, and the person asked in horror, “are you saying we are losing money?” The question took me by surprise, as I thought that was pretty common knowledge. It turned out that quite a number of the employees had no idea that this early stage business had not reached profitability and was burning cash. My effort to be transparent triggered somewhat of a panic that required a lesson in how early stage investors fund companies and the “normal” financial progression of our stage of business. For some of the employees this was shocking and way beyond their personal risk tolerance. For others, it was refreshing to hear the quiet parts said out loud, and they became even more engaged in the success of the business.
Some of the members of the ‘old guard’ management team were surprised that I was so open and candid about our financial position. Conversely, I was surprised that they had not been transparent in the past. As my friend said, joining an early stage company is not for the faint of heart, and I believe it is the responsibility of the CEO to be honest with individuals and help them to make informed decisions about their risk tolerance when joining a new company.
A related topic is being candid about the value of employee equity grants. Everyone likes the idea of receiving options as a part of their compensation package, but very few people truly understand how to value their options, and most employees significantly over-value their grants. They receive a grant with what looks like a big number of shares, but they never ask how that number relates to the total outstanding fully-diluted number of shares, or what debt or preferences are higher in the stack before common shares receive any value. The result is a false sense of value that often leads to a disappointing outcome. When employees see the company sold for a big number, they are surprised that their options have little or no value because they did not understand the context of their grant..
I have seen CEOs and leaders ‘sell’ employees on the potential value of their equity grants. They pitch a story about how much these shares ‘could’ be worth in some utopian future, and for the financially naive employee it creates an expectation of a future jackpot. I have always believed the CEO has an obligation to be intellectually honest about employee equity grants. I prefer the adage to ‘under promise and over deliver.’ My guidance when asked about the value of equity grants has always been that the employee should be happy with their base salary and any variable compensation they are contractually entitled to receive. They should treat the options as a remote potential bonus way in the future, but do not consider their value when deciding to accept an offer. I have also tried to put the potential value of the options into a context such as ‘a nice dinner out’ or ‘a nice vacation’ or ‘a new car’ or some other tangible thought that helps frame the expectations.
Clearly, in successful companies that have undergone successful exits or public offerings, some employees with stock options have made a lot of money. However, at the time of the grant the strike price is equal to the fair market value, and employees should have a clear understanding of what has to happen for the options to become valuable. This is just another element they deserve to understand along with the operating financial picture and risk profile of the business. Employees that join an early stage company with their eyes open understand what they are getting into, and are excited about building something great together. In my experience, these are the most valuable team members that are aware of the risks and are willing to do what it takes to succeed. It starts with the CEO being open and candid, and acknowledging that employees deserve to know their employer.