As we’ve seen in the first part dedicated to incentives in startups, equity should be the main driver for both founders and early employees. Yet, you can’t buy food or pay your rent with equity. So wages can’t be omitted in the compensation package. The goal of wages in these situations is to allow people to live without stress, while being under market practice.
So the general principles of equity are the following:
- Cover the downside: schematically, equity should cover at least the opportunity cost taken by founders and employees when they accept a discount on the salary and take a bigger risk,
- Ensure huge rewards (and thus, incentive) for the upside. Founders and early employees never get rich with salary. They (sometimes) get rich through capital.
So in that sense equity rewards risks & performance for founders and employees.
It is a very great means to offer a proportion of the value people actually create, aligning their rewards with the value they help create. When you have a stock option granted, your payoff is the difference between the price of the option (the value of the company when you joined it, where you didn’t contribute) and the price of the selling (the value created in-between, once you’ve started to participate).
Also, equity has another objective: ensure loyalty. Stocks aren’t offered as wages. When you are offered a stock option pool, they are attached to a specific mechanism.
In general, equity is associated with vesting and cliff. The typical formula is “four-year vesting with one year cliff”.
Vesting is a way to give ownership of a specific asset over time. For instance, a four-year vesting means that the employee gets 25% of his rights every year. If he leaves on the first day of his third year, he will have 50% of the stocks offered. To be precise, the rate at which stocks are vested varies. It is generally on a quarterly basis (around 6%). But sometimes, the frequency is monthly (around 2%), biannually (around 12%) or annually (around 25%).
Cliff represents the period that must elapse before starting the vesting. It is associated with a catch-up so you don’t just postpone the vesting schedule, but hinder people from leaving during the cliff period (where they would lose everything). For instance, in the later example, if the vesting is granted on a monthly basis with a one year cliff, the employee leaving the day before the first year, he wouldn’t have any stock (and not the first eleven months of vesting he would get without cliff), but the day after the first year he would indeed get the 25%.
How much equity should you give?
The equity package is depending on several variables, but it is mostly linked to the attractivity of your company, how strategic a position is, how hard a candidate is to attract and to retain.
Basically, if you are very early stage, looking for a CTO, not being able to pay market price and having a call from an exceptionally talented technical person, in a market where there is a shortage of tech talents, you’d better be ready to give a significative stock plan.
Also, there is a component that needs to be considered: how much is your culture performance-driven vs egalitarian. If you want to build a company where the individual performance takes a significative role and make very high differences of compensation between the least and the most performing, you can have a very asymmetrical stock offering (offering lots of stocks to few stars and very little if not nothing to the others). If you want to have a more egalitarian company to balance individual performance and team spirit, you might want to offer stock in a more balanced way.
It is important to distinguish between hiring and on-going pool. You shouldn’t offer a very different package for a comparable position, because you cannot know how well someone will perform in the long run (don’t offer more than you need to attract someone). You can offer additional equity to retain your best employees later on if you feel there is too much of a gap between what he has in your company and what he could get outside.
Bottom line: equity offering needs to be adapted to your market, the profiles and company culture.
Now let’s go into the details: how much should you offer precisely?
The Layers Framework
A very good framework is given by Joel Spolsky, co-founder of StackExchange:
“For simplicity sake, I’m going to start by assuming that you are not going to raise venture capital and you are not going to have outside investors. Later, I’ll explain how to deal with venture capital, but for now, assume no investor.
Also for simplicity sake, let’s temporarily assume that the founders all quit their jobs and start working on the new company full time at the same time. Later, I’ll explain how to deal with founders who do not start at the same time.
Here’s the principle. As your company grows, you tend to add people in “layers”.
- The top layer is the first founder or founders. There may be 1, 2, 3, or more of you, but you all start working at the same time, and you all take the same risk… quitting your jobs to go work for a new and unproven company.
- The second layer is the first real employees. By the time you hire this layer, you’ve got cash coming in from somewhere (investors or customers — doesn’t matter). These people didn’t take as much risk because they got a salary from day one, and honestly, they didn’t start the company, they joined it as a job.
- The third layer is later employees. By the time they joined the company, it was going pretty well.
For many companies, each “layer” will be approximately one year long. By the time your company is big enough to sell to Google or go public or whatever, you probably have about 6 layers: the founders and roughly five layers of employees. Each successive layer is larger. There might be two founders, five early employees in layer 2, 25 employees in layer 3, and 200 employees in layer 4. The later layers took less risk.
The founders should end up with about 50% of the company, total. Each of the next five layers should end up with about 10% of the company, split equally among everyone in the layer.
- Two founders start the company. They each take 2500 shares. There are 5000 shares outstanding, so each founder owns half. [50%-50%]
- They hire four employees in year one. These four employees each take 250 shares. There are 6000 shares outstanding. [So each employee have 2.5% (and the founders diluted)]
- They hire another 20 employees in year two. Each one takes 50 shares. They get fewer shares because they took less risk, and they get 50 shares because we’re giving each layer 1000 shares to divide up. [So each of these 20 employees has 0.5% (and the founders and first four employees are diluted).]
- By the time the company has six layers, you have given out 10,000 shares. Each founder ends up owning 25%. Each employee layer owns 10% collectively. The earliest employees who took the most risk own the most shares.”
Of course, you don’t have to divide the 10 points of each layer by the number of people, you can offer more equity for more senior people.
This framework is very simple and good especially for the early days of the company. As the company grow, people tend to use another framework: making a conversion between the salary and the option granted.
The Salary Framework
The initial grant can also be expressed as a percentage of the base salary (taking the price per share of the last round).
According to the study Rewarding Talents by Index Ventures, the percentage is on average between 15% and 33% of the salary, but can be as low as 5% (junior people in sales or customer success) and up to 75% (director in product, engineering or business development).
Another study, done by The Galion Project, suggests to grant at least one the equivalent of one extra month per year of vesting, ie: 4 months of salary for the typical 4 year vesting period, said another way giving at least 25% of the annual salary.
Factoring Risk & Contribution to the Salary Framework
It’s also possible to combinate these two approaches. The philosophy is to keep it simple using the salary framework while adjusting for risk and contribution. A good proxy for that is using the number of months after the previous fundraising (where the valuation picture is taken).
For instance, if you would have 10,000 shares (ie: 10% of the salary) as you join the month the fundraising is done, you may have only 5,000 shares 15 months after the previous fundraising.
To have a linear function, you need to take the number of expected months before the next fundraising (eg: 18 months on average) that you multiply by an intensity factor (the higher, the lower the risk/contribution will impact the package). In my example, I used 18 months as an expectation and multiplied it by a factor of 1.666 (like the period would be in fact 30 months).
The model would be: the new hire is a senior sales, and given my stock option pool, my hiring plan and my compensation grid (these three variables help you know how many stock options you can give to a given candidate), I will offer for that position 10,000 stocks, which represent 10% of his salary.
Yet, since he arrived 12 months after the previous round, his risk and contribution will be lower than someone that would have arrived just at the time of fundraising. Thus, the package would be: 10,000 * 15/(18*(1+2/3)) = 5,000. That approach can be found here.
Rule of thumb:
- the first few hires will get on average points of equity (ie 1%, 2%, 5%…),
- C-level are given between 1 and 3 points (it is true for early stages but also afterwards since the later the company, the more experienced will be the key people you hire),
- a board member should get between 0.25 and 1%,
- the distribution of stock option is almost always more concentrated than the distribution of salary across the positions (ie: the proportion of stock will increase faster than salary as you go up into the grids), which mean that eventually, the more strategic a position is, the more the incentive should be done through capital, and not salary,
- it’s not only a question of how strategic a position is (or how rare a profile is), it is also a question of designing a coherent incentive package (salary + variable + stock) and making it compatible with market practices. For instance, your Head of sales might be very strategic, yet the market practice design a strong short term incentive with variable salary, which will result to a lower grant of stock (all things being equal) than their peer in R&D where the incentive will be mostly through stock,
- you don’t give as much equity to internal promotion than external nomination because you give people the opportunity to access the position,
- if you factor in risk/contribution, a good intensity factor is between 1.11 and 1.66.
Equity in a dynamic perspective
Marie Ekeland, co-founder of daphni says that on average a public company has offered circa 5% of employee stock plan every year in the US.
You can find the data from a benchmark of the Tech 120 below (look at the new shares as%):
In private companies, the founders can offer stocks as they wish before their fundraising. When they raise funds, business angels and VCs usually add a pool of equity for the founders and employees so they can attract great talents. Since fundraising usually occurs every 18 months, you can design your layers with this timeframe (or with a shorter timeframe, like every 6 months, dividing the stock pool by the number of periods before the next fundraising).
Question To Ask Yourself
- What is your split between your welcome & retention plans?
- Do you give equity to everyone (everyone wants some in the US, so if you are operating at least partly in the US you need to)?
- Is the unvested value of the stock an incentive big enough to retain the employee? Either you refresh everyone or you refresh people with the biggest potential & performance (equity is a way to retain the best and to make the other leave). It is particularly the case: (1) for people who stepped up (the initial package doesn’t match their current position), (2) for those who are there for a long time (shares unvested) and that you want to retain.
- Are you giving very unbalance package (very high package for the best performers, lower for other)? At the beginning the package is only related to the position, after that you can adapt it to the actual performance.
- Is your policy adapted to local market practices? (your competitors are fixing the minimum compensation package and equity is either very important (eg: US) or not that well understood in others (eg: France))
- Is your equity plan enough to attract talents? You can change the incentive structure for a specific role if you have trouble attracting it (can be different between the different market)
- Did you build triggering for the achievement of certain objectives? This makes it possible to emulate an incentive structure of a startup inside a tech company already big (or for special strategic projects such as internationalization)
This article has been written by Willy Braun.