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Why Employee Equity is an Investment like Any Other: Entrepreneurship and ethics

There’s been a flurry of articles and a Hacker News Poll, highlighting entrepreneurs who despite, or maybe because of their success, turn around and screw their employees, collaborators, partners. Just look at the last few big deals this year:

Zynga and its CEO (personally worth billions at the expected IPO) is forcing employees to either reduce their incentive stock allocation or be fired (and, per the apparent language of their contract, lose even more of their stock in addition to their job).

Skype and its private equity investor/operator Silver Lake (beneficiary of the lion’s share of the $8B acquisition by Microsoft) fired lots of its employees right before the transaction and used a nasty little clause in the incentive agreement to claw back all of their stock options.

Groupon and its CEO (personally worth a shrinking billion of their IPO) didn’t fire anybody, but raised $1B in “financing” shortly before the IPO, then paid out $890M of that “financing” to preferred shareholders (read: CEO, Chairman and a few early investors).

Skilled, successful people standing to make a lot of money in these transactions simply had their CEOs turn around and screw them.  The methods vary but the outcome (and goal) is the same: use the information and power asymmetry in the organisation to disproportionally shift wealth from employees to insiders. It’s usually not just the CEO, but the investors and other shareholders that encourage or apply pressure for the CEOs to behave this way.  Amazingly, these deals are even defended publicly. Zynga and others argue that some early or junior people in the company are getting “too much money” for their contribution. They hold up the Google Chef as an example (he was employee 53 and made $20M in the IPO). Lots of people on Hacker News jumped on that example, arguing that the Chef “deserves” the money because he was a great chef, because he was critical to company moral, because he is part of the labour class which should get an equal share of wealth, etc. As well-meaning as those comments are, they are all rubbish (and dangerous rubbish at that).

The problem with these arguments is that they implicitly buy into a faulty framework and turn the debate into “deserving” vs. “not deserving”. The Google Chef didn’t make $20M because he was a great chef, a loyal socialist worker, or a nice guy – he made $20M because he invested into an early stage company that happened to achieve a mega-billion dollar IPO. That’s right, he *invested*!

Employee equity is an investment like any other. You contribute your time at a lower than market rate or work harder than the average person while getting average pay. It is only a fluke of tax law that the company pays you a salary and then some stock options. What is really happening, is that they are paying you at a higher salary and you then purchase company shares with some of that salary (like any investor, just at usually smaller amounts and at a regular schedule). Tell a VC that he doesn’t “deserve” some of his upside and you get a lawsuit. Treat employees any differently and you fundamentally misunderstand the concept of incentive compensation.

I don’t know the inner dynamics of any of these deals, but clearly there is an attitude that pegs leadership and power holders against employees and others who have no individual power in the transaction.  It certainly raises the interesting question of how to ensure ethics in entrepreneurship.

One of the issues is that the character traits you need to be a successful entrepreneur may actually make it more likely for this kind of unethical behaviour to occur.  Entrepreneurship requires a fair bit of arrogance, a high sense of self-competence, tenaciousness, the ability to maneuver and cut corners on the spot, and get results.  It also means believing that you can do something that most people can’t do.  When you have a successful company, of course these character traits are going to lead you to a sense of entitlement.  And the more successful you are, the more that belief gets supported, and the more likely you may be to accept these kinds of unethical deals with the intention of weeding out the ‘undeserving.’ Presumably, when Mark Pincus gave all of his employees equity instead of salary, he consciously decided at the time that it was a good deal for his fledging company. It’s only now that they’re heading into a multi-billion dollar IPO that he would start thinking, “I built this, I deserve this.” I’m putting words into his mouth, of course, but I wouldn’t be surprised if this scenario were behind a lot of these kinds of deals. 

So how do you prevent this from happening? Not easily. Senior leadership and investors will always have more power and information at their disposal than employees. That said, there are ways to make it much harder to screw around with the Cap Table just before the exit.

One way to protect employees (and everyone else) is to give them actual shares rather than options (if possible of the same class as the “current” investment round) and reverse-vest them on a linear schedule (i.e. every week or month, not quarter or year). This gives them minority protection under the law and moves the burden of last-minute change to the shareholder system rather than the much easier hurdle of changing internal policies. It makes things a bit harder to explain, a bit more expensive to maintain, and a bit more difficult to negotiate, but it will ensure the fair treatment of all parties involved. The desire to do so is, in many ways, a measure of ethics in your organisation.

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