Why Do Startups Offer Equity Compensation Instead of Salaries, and How Do Employees Live On It?

When a startup offers stock options or equity instead of a traditional salary, it often leaves employees wondering how they will survive financially without immediate cash flow. It is a risky move, but for the right individuals, it can lead to substantial rewards.

The Nature of Startups

Startups are fundamentally different from traditional jobs. They are an investment in capital, specifically in the form of equity. The value of equity is not guaranteed and depends on the startup's success. Unlike a fixed salary offered by a stable company, a startup’s rewards are contingent upon the company's performance, making it an inherently high-risk, high-reward situation.

Why Equity Compensation?

Entrepreneurs and early-stage employees who receive equity are not given a job as traditional employees would understand it. Instead, they are offered partnerships, where their success is directly tied to the startup's success. These equity-based compensation plans are ideal for individuals who have a financial cushion or another source of income and are willing to take the risk for the potential returns.

Living on Equity Compensation

Living on equity compensation alone is not feasible for most people. Employees who join startups without an alternative source of income are exposing themselves to a severe financial risk. Successful long-term projects include:

tHaving a parallel source of income from another job, side gigs, or investments. tHaving enough savings or a stable family source of income to support themselves until the startup's success. tBeing entrepreneurial and creating their own side income streams while working at the startup.

Entrepreneurs willing to take the leap with equity compensation understand the importance of diversifying their financial sources and do not rely on the startup for their sole income.

Examples of Success Stories

One such example is the Flipkart story. In 2007, Flipkart had a valuation of around $1 million. By 2017, the company was valued at over $10 billion. Early employees who received equity grants likely ended up with significant wealth, far more than if they had joined a traditional job. For instance, if an employee received an equity grant worth $100,000, they could end up with over 100 crores (hundreds of millions of dollars) if the company was successful.

Let’s compare this to someone joining a multinational corporation (MNC) with a CTC of Rs 50 lakhs (5 million) and saving all their income. With a 10% annual increment, this individual would have saved only about 9 crores (around 9 million) by 2017. This stark contrast highlights the power of equity compensation in potentially leading to much greater financial success.

Other Success Stories

AskMeBazzar, a startup that had a valuation of more than $100 million at one point, has since fallen and is now worth nothing. This underscores the importance of a company’s success in determining the payoff of equity grants. Employees of companies like Flipkart who chose equity over traditional salaries have a much higher chance of financial success.

Conclusion

Equity-based compensation in startups is a risky but potentially rewarding strategy. To succeed, entrepreneurs and employees need to have a solid understanding of the risks involved and a plan to manage their finances. While it isn’t suitable for everyone, for those who are willing to take the risk, the potential rewards can be phenomenal.

Ultimately, the choice to join a startup with equity compensation requires careful consideration of one’s financial situation and risk tolerance. For those who have the right mindset and resources, equity compensation can be a path to significant financial gain.