Startups have typically shared very little cap table information with employees outside the core management team, but a trend toward greater transparency has been gaining momentum. Should you jump on the bandwagon? What implications would this have for your company?
Like it or not, employees at startups are becoming significantly smarter about their equity grants. A quick web search returns hundreds of articles educating potential hires on basic questions to ask about their stock options.
As employees ask more questions, and as stories surface about disgruntled option holders, people are starting to look at equity compensation in a new light. Startup workers are realizing that without more information, they really have no idea how to think about the value of their stock options.
Lately, however, we’ve seen some interesting new approaches to cap table openness.
A year ago, Buffer announced that they would open up their cap table to everybody. Separately, Andrew Mason, the founder of Groupon, recently released a thought-provoking concept called progressive equity. His approach limits the amount of cash that shareholders can receive so that more cash is available for everyone, and he clearly outlines how equity will be distributed from the very beginning.
Given the current environment, it’s fair to say that many option holders are going to push for some kind of equity information. They might even become resentful if you don’t provide anything. This is especially true for the first hires who take the biggest risks in the startup’s early days. But it is also true for any employees you hope will work long hours at below-market salaries. These employees should have the chance to better understand what their option grants could be worth.
But there are some obvious and not-so-obvious risks to freely sharing cap table information. Miscommunication, mismatched expectations, disgruntled employees and even lawsuits are all possible negative outcomes.
So, what approach is best for your startup?
There is no one set of standards and policies that every startup should adopt. What we can offer is our experience at Shareworks Startup Edition – both our internal experience, and what we have learned by helping thousands of startups manage their cap tables.
Levels of Transparency
For simplicity’s sake, we generally think about 5 increasing levels of cap table (or equity) transparency as shown in the graph below. The levels represent information that you share with your employees or new hires.
From our experience, most companies fall under Level 1. This means that the only information employees have is whatever is provided in the legal paperwork for the option grant. Generally, this information includes number of shares, vesting plan details, vesting trigger information, exercise details, and expiration dates.
While this information is clearly useful and important, it gives the employee virtually no information to assess the value of the grant.
Increasingly, many companies are sharing Level 2 information. Level 2 discloses the fully-diluted ownership percentage of the shares at the time of the grant. With a little guesswork and a rough sense of the company’s total value, clever employees can use this information to estimate the value of their shares.
A few companies systematically share Level 3 information, which involves telling employees their fully-diluted ownership percentage any time they want. This means that as the cap table changes, employees can always have a sense of where they fit in.
Even fewer companies provide more than this, but we generally provide high-level waterfall and valuation information to our employees.
The term “waterfall” refers to the way value gets distributed to all of the various shareholders of a company. An employee’s ownership percentage multiplied by the company’s total value often provides an incorrect estimate of the value of the employee’s shares. This happens because some securities on the cap table have have liquidation preference rights. This means they receive cash before anyone else, which complicates the calculation of value for other shareholders on the cap table .
Helping employees understand what their shares might be worth in different scenarios involves helping them to understand the company’s waterfall. Waterfall analysis can get tricky, but you can read my article in Forbes or a similar article by my co-founder that provide additional details.
These days, most companies are required to obtain a 409a valuation if they want to issue stock options. Some may debate the accuracy of these valuations, but they at least provide a method-based estimate of value. Furthermore, since they take into account liquidation preferences and other rights, the estimated value per common share is often more reliable than the per share price from the most recent round.
At any rate, you can provide this information to employees with the caveat that the results are purely theoretical and should not be used as any sort of investment advice. Our company often provides valuation data to employees with these types of disclaimers. The information we selectively share includes the following:
- Valuation ratios for our industry
- Pre- and post-money valuations from rounds we have raised
- 409a valuation information
Risks of Transparency
Unlike public companies, private companies are not legally required to reveal equity and valuation data in a broad and systematic way. In fact, most private companies are fiercely protective of the key information necessary to estimating the company’s value.
Some people assume that private companies do not share information simply because they don’t have to. In reality, sharing detailed equity and valuation information with employees poses significant risks. These risks include:
- Possibly creating false (positive or negative) expectations among employees
- Incurring liability because an employee makes a bad decision based on the information provided (sells shares too early, doesn’t exercise shares, etc.)
- Leaking sensitive data out of the company (and possibility to competitors)
- Indirectly facilitating unauthorized buying and selling of the company’s shares
Benefits of Transparency
Despite the risks, transparency also offers some pretty compelling benefits:
- Building trust and confidence with your employees
- Giving your employees a real sense of the potential value of their shares
- Helping employees understand what drives increases in your company’s valuation
- Motivating employees to create more value
- Creating a culture of openness and honesty throughout the whole startup
The overall goal of cap table transparency is to help employees feel more valued and respected. Startups have been known to abuse equity compensation by throwing up smoke and mirrors to woo potential hires. By helping employees better understand the potential value and the mechanics of their option grants, everybody feels more secure.
This can prove to be a great strategy even if the company goes through hard times. You’re likely to receive greater loyalty from employees who feel like they’ve been treated with fairness and honesty. If everyone understands the risks and benefits up front, you will encounter less resentment and mismatched expectations down the road.
In the end, we can’t tell you what level of transparency will work best for your startup. Because our company is so small, it is relatively easy for us to embrace a high degree of openness. Among the thousands of clients we have, we have concluded that sharing a few key pieces of equity information (Level 2 or 3 on the chart above) can allow many startups to get most of the benefits of cap table transparency without many risks.