A handful of trends are causing the historical Silicon Valley model of compensation to fail employers and employees. I am not entirely sure how to fix it. But I believe that at least part of the solution will be a move away from equity compensation and toward a heavier reliance on cash bonuses.
As is widely understood, traditional startups compensate employees in two parts. People are generally paid a cash base salary and some equity participation that vests over time. The second piece is usually in the form of options for early employees and RSUs for later ones.
In an ideal world, this makes a lot of sense. Unlike transactional businesses like banking or consulting, technology startups bind their human capital together and create a valuable and durable asset. The equity component of their compensation is effectively a stake in the asset they are building.
That said, in practice things get a lot more complicated, and this compensation model has been criticized as out of touch with reality on a few fronts.
First, the dollar value of employee stock options in private companies is extremely hard to make sense of. Layers of preferred equity and an illiquid market mean that the equity component is completely non-transparent. Complicated distinctions between RSUs and options with different tax treatments, strike prices and acceleration clauses only complicate the picture.
Second, the critical details of how equity is granted seem increasingly arbitrary. For instance, the four-year vesting schedule was roughly timed to the idea that it would take that long for a company to go public. Now that companies are taking far longer, it doesn’t make as much sense.
How much equity people are granted is usually tied to some calculation of a 409a valuation, the value of the common stock. The valuation flows from a discount to the preferred price VCs are paying for shares, which has as much or more to do with availability of capital and competition over the deal than the innate value of a company.
A couple factors are making the situation worse. As outcomes are becoming even more binary and enormous, early employee equity grants are starting to feel truly like super-charged lottery tickets with extreme jackpots and very long odds. That makes compensation more probabilistic and less rational.
Another point: The technology industry is now basically everything, which means employers are trying to apply this broken equity models to an ever more heterogeneous set of companies. These companies are valued differently, have different future financing needs, different volatility signatures and the like. This makes comparing comp packages across companies, even those that appear to be similarly successful, even tougher.
No One Wins
All this non-transparency and complexity creates a lot of added overhead and skewed incentives for companies and employees.
Companies have to spend a lot of time explaining the tradeoffs between different offers. For example, startups tend to have larger initial grants while larger companies tend to give less upfront but make up for it with refresher grants and performance bonuses. Expressing the nature of these valuable retention packages to new recruits can be difficult.
Because of this, companies end up attracting talent on the basis of the problem they are solving and a general trust in the management team. I believe this stunts creation of several types of great businesses that are valuable but don’t have grandiose mission statements, typified by things like enterprise software. I think it also at least partially explains why Silicon Valley is so obsessed with this concept of “impact.” And that obsession in turn attracts a disproportionate number of gamblers and those that buy into higher callings; it excludes others, including those who tend to be older and cannot afford the same risk.
Compensation confusion also makes people more flighty than might be rational for companies or employees. Since people really don’t know what they are getting paid, for those that can afford the risk, there is an added attraction to companies where the theoretical upside looks like it might be “enormous.” If a company feels like it is going to hit some turbulence, in the absence of understanding and being able to evaluate compensation, employees tend to be more flighty.
Probably the least painful problem, but a problem nonetheless, is that in the case of enormous “wins,” companies end up accidentally massively over-compensating their employees. This is obviously expensive. If you accidentally pay someone tens or hundreds of millions of dollars above market, you are not only wasting money but you have also dealt yourself an almost un-winnable retention problem. You will end up either losing a lot of talent or paying out hugely costly retention packages over a very long time.
I would also argue that this isn’t healthy for the employees. Obviously it is great to make a lot of money, especially while young. But many people in the Valley argue that turning engineers into lottery winners has been wrecking a whole generation of productive talent in the U.S. by making them too rich too soon, and therefore, less motivated to work on traditional teams.
Solutions
One solution that sometimes gets joked about is that graduating classes from tech-heavy schools like Stanford should all pool their equity grants. Since the value outcome of the currency in which young engineers are being paid is of unknown value, this approach would let everyone just revert to a “fair” mean. Of course this doesn’t make much sense because it would create incentives, like staying at a company you should leave just to stay in the pool. But the fact that this is an idea sometimes floated shows the problem is real.
Another more realistic and sophisticated solution often discussed is the “studio” model, which gives people stakes in multiple projects under one umbrella. This is the second coming of incubators which give participants equity across a set of companies as opposed to equity in just the one in which the individual is working. It is still equity-based but isn’t as clearly a single-ticket lottery.
The other Hollywood-inspired idea that comes up is that engineers should hire agents to scout projects and negotiate their comp. Then the worker gives the agent a cut.
I am skeptical of both these approaches. They may work for divvying up ownership in a project that has a clear start and end, like a film. But they don’t work well for assets where the equity value must be maintained continuously over many years.
The primary solution I see is shifting more compensation to cash, giving people a far easier way to compare opportunities.
A basic cash and annual bonus model makes more sense as it is getting easier for more technology businesses to immediately generate revenue—and even profit. And with far greater access to capital, even for young startups compensation can realistically be more cash-based and transparent for all sorts of companies, effectively shifting the burden of valuing equity from individual employees to professional investors.
Switching towards cash in no way means that people will be paid less or that their compensation won’t be performance-driven. Annual bonuses can provide very similar and more clearly understandable incentives.
Equity compensation won’t go away. There is something romantic and downright good about equity for several types of businesses; however, I think we will look back at this period of outsized equity comp as a compensation anomaly and ultimately see that more cash compensation is better for more businesses and people.