On Employees Investing In Their Startups

Like many others in tech, last week I saw a story in New York Times about a startup whose financial exit did not quite meet its employees’ expectations. There is also a good follow-up by @StartupLJackson, which I recommend.

There are several things that I think are important to understand in the context of this situation.

Side note and a disclaimer. I am not trying to convince you to make any investment decision one way or another - my goal is to merely illustrate some aspects of investment analysis thought process that I strongly feel you should be considering. Times article clearly tells me not everybody pays attention to these, which is unfortunate.

No matter what anybody says, the final decision is yours and yours alone - in tech ops we say “you own your availability,” in the investment world “you own your investment decisions” carries the same weight.

On private company valuations

I frequently come across comparisons of privately held company valuations with those of publicly traded companies. While I understand that sometimes people use such charts to add color to the point they are making in which case these comparisons are just illustractions roughly approximating reality, I suggest you be careful taking them literally.

Stock of a publicly traded company has many technical characteristics that make it significantly more transparent to a trader or investor than stock of a startup. There are SEC filings that are public information (interestingly, as an investor you don’t need to read them all - the fact that they are published and there is a legal framework that ensures the filings are very likely to be true, mean that information will be priced in the shares when you are going to buy), there is daily trading volume supported by liquidity, there are short sellers keeping stock price honest, often there are publicly traded derivatives - all these factors combined make it easier to understand and value (assign price to) public stock.

All of these things are either missing or very limited for private companies. In extreme case, I could negotiate purchase of a single share of a startup directly with management at a sky-high valuation. The price I will pay is a result of only 2 opinions about how much a company is worth now - mine and management’s, and valuation from last transaction could be used as basis for future stock sales.

Also, keep in mind overall stock structure and share classes. With publicly traded company, stock structure is simpler (fewer classes) and better documented - if a most sophisticated investor in the world and I own a share of AAPL, we hold absolutely the same thing with equal rights. (Yes, I am aware of dual-class share structures in public companies, etc).

In private companies, multiple share classes could exist with very different terms which significantly impact how much each share of each class is worth depending on a lot of variables (think liquidation preferences, for example).

The fewer classes company stock has, the easier it is to come up with market cap number using simple math. For a startup, calculating market cap is harder (sometimes significantly) - if a company issues preferred stock during last round of financing, it doesn’t mean you can automatically take that price and apply it to common stock.

Sum up: comparing valuations of publicly traded companies and private companies is often (or at least frequently) the same as comparing apples to oranges. If you want to know what you are doing when investing, you should analyze such comparisons with great deal of caution.

On investing hard cash in the startup where you work

Like with any investment decision, it’s impossible to give a general recommendation in this case without knowing company details, your personal financial situation and your appetite for risk. But nevertheless, the thought process you should follow when deciding whether to invest or not is universal.

Mathematically expected value of your equity grant most often starts out as strictly positive - there is a set of outcomes when it’s 0 and there is a set of outcomes when it could be worth something, so overall it’s greater than 0. In other words, you may not win but you will not lose. If you add to your position and pay cash for it, understand that this statement is no longer true - there is now a chance you can lose real money.

When investing in your startup, just like when you make any other investment, you should consider several aspects:

• expected return on the investment relative to other investments in your portfolio and other asset classes available to you (is the risk justified? is this the best use of your investment dollars on risk adjusted basis?)
• opporunity cost (what else could you do with the money you are about to invest if you decided not to go ahead with this investment?)
• total loss (how severely will you be impacted if you lost all of your investment?)
• diversification (if this investment goes through, what will it do to your portfolio diversification?)
• time horizon (how is the expected time horizon of this investment affects timings of your future financial goals?)
• liquidity risk (it may be very hard to convert your investment to cash when you need it - do you have enough cushion in your portfolio?)

Furthermore, contrary to popular belief that an investment decision is either “yes, invest” or “no, don’t invest,” in reality you can not decide whether to invest or not without knowing the price you will pay and terms of your investment. As a general rule, almost always there exists a price at which even the worst company in the world could be a reasonable investment.

When you are buying shares of a publicly trading company, you usually first determine whether you like the company and want to own its shares, then figure out a good price (or set of prices) at which you’d be willing to buy, and then execute your plan.

Unfortunately, coming up with the price you should pay for shares of your privately held startup is the hardest task of them all. It’s very possible that you are at a significant information disadvantage relative to sophisticated investors (which in case of tech startups are angels and VCs), founders and management. You have to find ways to compensate for it.

Sum up: Investing in anything (startups, stock market, real estate, bonds, gold, tulips, etc) without having a very clear idea why you are doing it and how various plausible outcomes could affect your finances, is a slippery slope. Not only are you deciding whether to invest, you also need to pay attention to price you will need to pay and terms associated with your investment.

On JOBS Act

This section is US specific. One of the parts of JOBS Act focuses on establishing a legal framework for startups to raise money from individuals who are not sophisticated investors.

I have been skeptical of this idea for a long time, and the Times article once again reaffirmed my skepticism. It’s a free country, and the fact that something is legal does not necessarily mean that you should do it.

I remain super convinced that it’s nearly impossible for an outside unsophisticated investor to overcome information disadvantage when investing in equity of a tech startup. And if I am a tag-along (attach my investment dollars to those of a sophisticated investor), I don’t see why founders would ever want to give me terms they are giving angels who are bringing their Rolodex, expertise and experience.

I do see how unsophisticated investors could loan money to startups (it would be a bond, which is senior to all equity investors - bond holders are paid first), but I am not sure whether it will work for founders (and existing angels).

Sum up: In my opinion, NY Times article is a very strong empirical argument why unsophisticated individual investors should not make equity investments in startups, even if it becomes legal under JOBS Act.