Early-stage hiring / How to determine equity for early stage employees

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We’re now looking at the last piece of figuring out the total compensation package for early stage startup employees: equity. This is what many people come to the startup world specifically for—well, that and the lofty hope of “changing the world”, one piece of software at a time. They’ll take the risk of working for a company without a lot of clout for the possible reward of a major payout. They’ve seen the success stories, the unicorns that started from nothing to become billion dollar plus companies (when Facebook first went public, its first 3000 employees enjoyed a collective stock option payout of $23 billion), bringing early employees along for the ride to the tune of if not vast riches then at least a very comfortable windfall. And whether or not you have an exit plan, regardless of how committed you are to the vision, at least a small part (and maybe a big part) of why you’re here as a founder, and why the investors that believe in you are too, is for that pay-off, too. Equity is almost a given for early stage startup employees, some actually way past early stage. In fact, in the U.S. particularly, equity has been a common part of compensation packages for executives since the 1950s. So should you offer equity? Yeah, probably.Offering equity helps you attract high quality candidates while freeing up cash flow for your startup that may otherwise be very tightly allocated to salaries. Working at a relatively unknown, and in some cases an entirely unknown startup, is a big bet but one that some people are willing to take, as long as they are paid something above whatever their personal threshold is. That personal threshold varies from person to person, situation to situation. It could be the market rate in their geographic area (which, depending on whether you’re hiring remotely, could be higher or lower than what’s considered market rate in your area, or in your industry, especially if you are in close proximity, geographic and otherwise, to Silicon Valley and other tech hubs). Or, it could be whatever they’ve calculated will pay for their living expenses, a personal exchange they’re willing to make in lieu for the chance to work at a startup for a product they’re interested in, for the chance to make an impact. That impact, they’re hoping, is tied to equity. When you have that combo, someone who you really want on your team, who believes in the company, and who is willing to take on some risk for the reward of equity, it can be a powerful win-win situation to align incentives with a bullseye on growth. You want that kind of person on your team.Let’s get acquainted with some general terms associated with startup equity: A glossary of startup equity termsFirstly, to clear up some potential confusion about what equity is, it’s just a percentage of ownership of the company which is typically tied to shares in the company, granting its owners the role of shareholder. When you started the company, you (along with any co-founders) had all the equity with a sum of 100% ownership. Any investors that invest into the company typically get equity in exchange for their investment, an amount that’s negotiated between the two parties and then contractually bound. Sometimes advisors who offer mentorship but not investment may also get equity in exchange for their time and insights. When it comes to offering equity for early stage employees, think of it as non-cash compensation allocated as ownership. The amount of equity allocated to employees depends on the role and stage of the company, usually up to 2.5%. Equity can take on many forms. In general, it’s most commonly stock (which startups don’t have). Startups, however, can grant stock options, which is the most common way early stage startups grant equity. Stock options allow (but don’t force) employees to buy shares allocated to them, but must be exercised. Exercising a stock option means purchasing the stock at its grant price, regardless of the stock's price at the time that the option is exercised. (So, if a stock option’s value increases, the employee benefits from being able to buy it at its former, lower-value price.) Restricted stock awards (or simply stock awards or grants) are stocks awarded as compensation with restrictions on it. They’re different from RSUs (restricted stock units), which are agreements to issue shares to employees at later dates, and typically aren’t recommended for startups because of the complex tax implications and impact on cash flow. Vesting is the process of gaining full rights to the equity granted, and usually comes in the form of a vesting schedule so that equity is granted over time and not all at once, with the intent to prevent employees from obtaining equity without a long term commitment to the company. A cliff is the amount of time someone must work before the vesting period even begins. For example, the cliff may be one year from the hire’s start date. If the employee quits before the year, their stock options don’t vest at all and they get nothing. However, if they stay for a year and then quit, vesting begins and their equity will be granted incrementally over a 4 year period. As a company raises capital, more shares are issued so that more people (a.k.a investors) can become shareholders and equity holders. As this happens, existing shareholders then own proportionately less of the company. This is called dilution and happens often in startups as they move through funding rounds from seed to series A and beyond. But it doesn’t mean that the value of shares necessarily decreases. Though not always the case, the intent of raising capital is to increase valuation and with an increasing valuation, a smaller piece of the pie may actually end up representing more monetary value. And importantly, each stage of funding, though certainly never a guarantee, represents that the business is becoming less risky and is usually making more money.An option pool or employee pool is a percentage of shares that’s reserved just for employees to distribute equity as part of compensation packages. This usually ranges from 10-20% and is decided upon between founders and investors. A cap table (short for capitalization table) is a spreadsheet or record that shows ownership stakes in the company, and is updated as equity is granted. Founders, investors, advisors, employees—anyone who’s a shareholder in the company—is on its cap table. How to determine equityIf you’re a venture capital funded company, you typically will be having conversations and making decisions about equity allocation with your investors. In fact, equity can’t be granted usually without the approval of your board and investors. Bootstrapped and self-funded startups can also issue equity, though if equity isn’t quite right for your company, there are other ways to incentivize employees without making them shareholders. Here are some things to consider when determining equity for employees: Type of equityThough equity comes in various forms, most likely as an early stage startup you’ll be looking at offering stock options.Candidate preferenceWhile you may not be able to negotiate much in the way of salary, you may have a candidate who prefers a bit more equity and will take a lower salary. This kind of flexibility can be well-utilized in the very early stages of a startup to free up cash flow and incentivize highly-motivated candidates. For example:Base Salary: 75k Equity: 1.25%vs.Base Salary: 95kEquity: 0.75%Cliff and vesting scheduleYou’ll want to ensure that there is a cliff and a vesting schedule to property align the equity as an incentive for long term contribution. A 1-year cliff and 4-year vesting period is common for startups. % of equityReward anyone being paid below market rate with equity until your startup can sustain itself and pay at or above market rates. When your startup can sustain pay at or above market rates, you can still offer equity to remain competitive though % allocated will decrease over time.Here’s some general guidance on how equity is calculated, though of course you should always consult an expert:Role seniority: Early stage startups should have 3 compensation levels, increasing as the team grows. These 3 levels can be executive, senior, and junior, each with a varying % of equity. Example: 1% for founding/early engineers, 0.45% for senior engineers, 0.15% for junior engineers. (To learn more about hiring an engineering team, check out our article here [LINK NEEDED]). Type of role: As a general benchmark, engineering hires and technical roles tend to be allocated the most equity compared to non-technical roles. Example: 1% for founding/early engineers, 0.9% for founding/early marketing hire. However, this could be dependent on your own strengths as a founder, the needs of your business, and your business’s competitive advantage . Just keep in mind that people may be comparing equity between startups, who often use industry benchmarks. Hiring date (risk premium): Earliest employees, particularly the first 1-3 employees, are rewarded higher equity because risk is higher (the “risk premium”). As a company proves itself through growth and funding rounds, the risk lowers over time and equity typically decreases proportionally, too. Employees so early on they become co-founders can get anywhere from 49.9% to 5%, much higher than other early employees. Performance milestonesYou have the option of tying equity to performance milestones, but this is typically not recommended as it doubles the risk profile attached to equity compensation. Lastly, don’t forget that there are other parts to total compensation beyond salary and equity. Read more in our article on creating an attractive compensation model and package for your startup here .

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How to determine equity for early stage employees

We’re now looking at the last piece of figuring out the total compensation package for early stage startup employees: equity. This is what many people come to the startup world specifically for—well, that and the lofty hope of “changing the world”, one piece of software at a time. They’ll take the risk of working for a company without a lot of clout for the possible reward of a major payout. They’ve seen the success stories, the unicorns that started from nothing to become billion dollar plus companies (when Facebook first went public, its first 3000 employees enjoyed a collective stock option payout of $23 billion), bringing early employees along for the ride to the tune of if not vast riches then at least a very comfortable windfall.

And whether or not you have an exit plan, regardless of how committed you are to the vision, at least a small part (and maybe a big part) of why you’re here as a founder, and why the investors that believe in you are too, is for that pay-off, too. Equity is almost a given for early stage startup employees, some actually way past early stage. In fact, in the U.S. particularly, equity has been a common part of compensation packages for executives since the 1950s. So should you offer equity? Yeah, probably.

Offering equity helps you attract high quality candidates while freeing up cash flow for your startup that may otherwise be very tightly allocated to salaries. Working at a relatively unknown, and in some cases an entirely unknown startup, is a big bet but one that some people are willing to take, as long as they are paid something above whatever their personal threshold is. That personal threshold varies from person to person, situation to situation. It could be the market rate in their geographic area (which, depending on whether you’re hiring remotely, could be higher or lower than what’s considered market rate in your area, or in your industry, especially if you are in close proximity, geographic and otherwise, to Silicon Valley and other tech hubs). Or, it could be whatever they’ve calculated will pay for their living expenses, a personal exchange they’re willing to make in lieu for the chance to work at a startup for a product they’re interested in, for the chance to make an impact. That impact, they’re hoping, is tied to equity. When you have that combo, someone who you really want on your team, who believes in the company, and who is willing to take on some risk for the reward of equity, it can be a powerful win-win situation to align incentives with a bullseye on growth. You want that kind of person on your team.

Let’s get acquainted with some general terms associated with startup equity:

A glossary of startup equity terms

Firstly, to clear up some potential confusion about what equity is, it’s just a percentage of ownership of the company which is typically tied to shares in the company, granting its owners the role of shareholder. When you started the company, you (along with any co-founders) had all the equity with a sum of 100% ownership. Any investors that invest into the company typically get equity in exchange for their investment, an amount that’s negotiated between the two parties and then contractually bound. Sometimes advisors who offer mentorship but not investment may also get equity in exchange for their time and insights. When it comes to offering equity for early stage employees, think of it as non-cash compensation allocated as ownership. The amount of equity allocated to employees depends on the role and stage of the company, usually up to 2.5%.

Equity can take on many forms. In general, it’s most commonly stock (which startups don’t have). Startups, however, can grant stock options, which is the most common way early stage startups grant equity. Stock options allow (but don’t force) employees to buy shares allocated to them, but must be exercised. Exercising a stock option means purchasing the stock at its grant price, regardless of the stock's price at the time that the option is exercised. (So, if a stock option’s value increases, the employee benefits from being able to buy it at its former, lower-value price.) Restricted stock awards (or simply stock awards or grants) are stocks awarded as compensation with restrictions on it. They’re different from RSUs (restricted stock units), which are agreements to issue shares to employees at later dates, and typically aren’t recommended for startups because of the complex tax implications and impact on cash flow.

Vesting is the process of gaining full rights to the equity granted, and usually comes in the form of a vesting schedule so that equity is granted over time and not all at once, with the intent to prevent employees from obtaining equity without a long term commitment to the company. A cliff is the amount of time someone must work before the vesting period even begins. For example, the cliff may be one year from the hire’s start date. If the employee quits before the year, their stock options don’t vest at all and they get nothing. However, if they stay for a year and then quit, vesting begins and their equity will be granted incrementally over a 4 year period.

As a company raises capital, more shares are issued so that more people (a.k.a investors) can become shareholders and equity holders. As this happens, existing shareholders then own proportionately less of the company. This is called dilution and happens often in startups as they move through funding rounds from seed to series A and beyond. But it doesn’t mean that the value of shares necessarily decreases. Though not always the case, the intent of raising capital is to increase valuation and with an increasing valuation, a smaller piece of the pie may actually end up representing more monetary value. And importantly, each stage of funding, though certainly never a guarantee, represents that the business is becoming less risky and is usually making more money.

An option pool or employee pool is a percentage of shares that’s reserved just for employees to distribute equity as part of compensation packages. This usually ranges from 10-20% and is decided upon between founders and investors.

A cap table (short for capitalization table) is a spreadsheet or record that shows ownership stakes in the company, and is updated as equity is granted. Founders, investors, advisors, employees—anyone who’s a shareholder in the company—is on its cap table.

How to determine equity

If you’re a venture capital funded company, you typically will be having conversations and making decisions about equity allocation with your investors. In fact, equity can’t be granted usually without the approval of your board and investors. Bootstrapped and self-funded startups can also issue equity, though if equity isn’t quite right for your company, there are other ways to incentivize employees without making them shareholders.

Here are some things to consider when determining equity for employees:

Type of equity

Though equity comes in various forms, most likely as an early stage startup you’ll be looking at offering stock options.

Candidate preference

While you may not be able to negotiate much in the way of salary, you may have a candidate who prefers a bit more equity and will take a lower salary. This kind of flexibility can be well-utilized in the very early stages of a startup to free up cash flow and incentivize highly-motivated candidates. For example:

Base Salary: 75k

Equity: 1.25%

vs.

Base Salary: 95k

Equity: 0.75%

Cliff and vesting schedule

You’ll want to ensure that there is a cliff and a vesting schedule to property align the equity as an incentive for long term contribution. A 1-year cliff and 4-year vesting period is common for startups.

% of equity

Reward anyone being paid below market rate with equity until your startup can sustain itself and pay at or above market rates. When your startup can sustain pay at or above market rates, you can still offer equity to remain competitive though % allocated will decrease over time.

Here’s some general guidance on how equity is calculated, though of course you should always consult an expert:

Role seniority:

Early stage startups should have 3 compensation levels, increasing as the team grows. These 3 levels can be executive, senior, and junior, each with a varying % of equity.
Example: 1% for founding/early engineers, 0.45% for senior engineers, 0.15% for junior engineers. (To learn more about hiring an engineering team, check out our article here [LINK NEEDED]).

Type of role:

As a general benchmark, engineering hires and technical roles tend to be allocated the most equity compared to non-technical roles.
Example: 1% for founding/early engineers, 0.9% for founding/early marketing hire.
However, this could be dependent on your own strengths as a founder, the needs of your business, and your business’s competitive advantage . Just keep in mind that people may be comparing equity between startups, who often use industry benchmarks.

Hiring date (risk premium):

Earliest employees, particularly the first 1-3 employees, are rewarded higher equity because risk is higher (the “risk premium”). As a company proves itself through growth and funding rounds, the risk lowers over time and equity typically decreases proportionally, too.
Employees so early on they become co-founders can get anywhere from 49.9% to 5%, much higher than other early employees.

Performance milestones

You have the option of tying equity to performance milestones, but this is typically not recommended as it doubles the risk profile attached to equity compensation.

Lastly, don’t forget that there are other parts to total compensation beyond salary and equity. Read more in our article on creating an attractive compensation model and package for your startup here .

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