Sramana Mitra: The sad thing is when you’re going for job interviews and negotiating job packages, the companies will not tell you all these details.
Heidi Roizen: By the way, I now have to say the disclaimer. I am not currently representing DFJ or my partners. I just had an argument with somebody yesterday about this. I said, “I believe that companies should be transparent about that. When you get hired, someone should sit you down because your equity package in a startup is a meaningful part of your future plan.”
I think someone should say to you, “This could go to zero. Here’s the overhang sitting over you. Here’s the waterfall chart.” Anyone coming into a company should actually understand what it takes for their shares to be worth something. There are companies in the Valley for which this is transparent and there are others that obfuscate this and actually think it’s criminal when you disclose this. I just think this is crazy stuff.
When you’re an entrepreneur or an employee and you’re going to invest years of your life into something, you should understand what the payout likelihoods are. That said, I think most people grossly overestimate the probability of their payouts. I think this is also a disease here in the Valley. Just because you worked for a startup for four years doesn’t mean you should become a millionaire. Why does that entitle you to be fabulously wealthy from having done so?
I still think there is a huge element of luck and timing to which companies actually succeed. The flip side is you should also realize that it’s a little bit like buying a lottery ticket. You should be at peace with whatever your regular compensation package is. If you’re willing to trade ordinary income for this additional equity, more power to you, but recognize the probabilities. I think there is a lot of survivor bias in the Valley.
I tell my students, “That’s why they publicize the people who win the lottery so you can identify with the person who wins.” I just think people need to be informed.
Sramana Mitra: To summarize, what are the top terms that people should be watching for and fully understanding?
Heidi Roizen: The simplest term is preferred. There are preferred shares and there are common shares. Which would you rather be? I’d rather be preferred. Preferred is pretty much the industry standard. If I’m going to invest money in your company, my stock is preferred which means I’m going to get my money out first. That’s the first term.
Participating is another one. It’s the idea that once I get my money out, is anyone else made whole first? Do I get to participate in the proceeds or do I have to wait around until everybody is evened up. These are like first-grade interpretations. Any entrepreneur who’s doing this stuff, they should get a lawyer who does this. Don’t use your uncle Joe who’s a divorce attorney. There’s a specific language and terms for early stage investing.
There’s a fabulous book by Brad Feld and Jason Mendelson called Venture Deals. Everyone should read that. If you’re gong to sell pieces of your company, take two days to read this book and understand. This is another pet peeve of mine. Entrepreneurs who absolutely want to control every single thing about their product and their company, but then they don’t even know what these terms mean. You’re going to live and die by these terms, so you better know them.
The other big one is stack preferences versus pari passu preferences. Think of stack preference as an inverted wedding cake. If I’m going to eat that wedding cake – have a liquidity event – I’m going to start eating at the top and move to the bottom. The people at the top get to eat every piece of that cake before the next layer gets to have a bite as opposed to pari passu where we’re going to slice the cake and everybody is going to get a piece of that.
When you have stack preferences, what you’ve created is a situation where every person has a very different financial incentive. People at the top are going to make their money no matter what as long as you sell for a certain amount. The people at the bottom are not going to make anything until you eat that entire cake. For pari passu, they may come in paying a different price for every subsequent round. Their shares may be more expensive, but ultimately the liquidity is going to flow more equally to everyone which is a much better construct if you can get it. It’s a negotiation.
Why doesn’t everyone do it this way? If I’m the last money coming in and you have not necessarily made a lot of progress – I say this, “The good news is, you’ve built a nice $10 million company. The bad news is you burned through $50 million to do it.” If that’s you and I’m the next money in that’s going to help you get to profitability, I don’t want pari passu. I’m going to say, “You wasted their money. I don’t care if they get their money back or not. I’m going to give you more money but it sits on top of everything else.”
These terms were all invented for reasons of downside protection for the investor. It’s a negotiation. It’s downside protection for investors versus as entrepreneur-friendly as it can be for the entrepreneur who’s negotiating the other side.