Equity Compensation in Startup - Guide
12 April, 2021
Just like no pilot flies alone since every plane needs a crew, that is how no founder can succeed in taking a company off the ground alone. The founder also needs a team to take their idea off the ground. But it is common to find early-stage companies in a place where they do not have the budget to hire their dream team. This is one of the reasons why you can easily see startups giving out equity instead of handsome salaries to their first employees.
In fact, offering equity is actually a great incentive, especially when you know that the company would grow to be highly successful. Moreover, employees would be directly invested in the future of the company. They would put in more effort since it is now their company as well. But to give out equity, you need to consider a lot of things. That is what we would look into and talk about in this post beginning with the kinds of equity compensation you can offer.
Kinds of Equity Compensation
If you are about to offer equity compensation to your employees, then it is important that you know all the different kinds of equity compensation you can offer:
Stock Options: Offering the employees stock options means giving them the rights to purchase shares of the company at a fixed price, called exercise price. The employees gain this right after they have worked with the company for a specific period of time. And when the options vest (which means gets mature and are offered to the employee after the employee stays for a specific time in the company), they gain the rights to sell or transfer the options. This process helps in employee retention. There are two types of stock options:
- Non-qualified stock options (NSOs): In this kind of equity compensation, the employees do not have to report to the IRS when they get this option or when it is exercised. These are not a great option for employees as compared to the ISOs.
- Incentive stock options (ISOs): This option offers special tax advantages that are available only for the employees and not for the non-employees, directors, or consultants.
- Performance shares: These are awarded to the employees only when specific metrics are fulfilled. The metrics here include the total return of the company's stock in relation to an index, return on equity or earnings per share.
- Restricted shares: This is basically a promise that the company makes to pay in shares based on a vesting schedule. In this, the employee would not get any ownership rights to the shares until the shares are earned and issued.
Most of the share types and plans are co-related and you can create your own rules when giving out shares in your startup. These rules would be mentioned in the equity class plan and would be adhered to when giving out the shares.
Benefits of Equity Compensation
Giving the opportunity to own shares in a company has a lot of advantages, including:
In addition to the last point - being on a tight budget, it can be difficult to get the best talents in the industry who are looking for good salaries. By offering them equity, you can easily obtain the best talents as well.
- When you compensate your employees with shares of the company instead of cash, you would be able to save cash for other things that would help your company grow. This is a great thing for startups who have a tight budget.
- The equity compensation programs help in aligning the employee's financial interests with those of the business. This would make the employees more invested in the company. And they would work harder, helping the company grow and increasing the value of the company's stock. They would also see themselves as the owner of the company as they too would be getting the returns of the profits earned by the company.
- With a proper plan and the right kind of vesting schedule, you can easily minimize employee turnover. Most vesting schedules last for 4 years at least, with a one-year cliff (where if an employee leaves before a year, they get nothing). This just makes employees stick with the company and work better.
Finally, if you are in the tech industry, then it is quite important for you to offer equity as compensation since most companies offer this to their employees. So, if you do not offer this, you will find it difficult or might not be able to hire the best talents. It is better to give them the best especially if you aim at growing the company. These employees would be the ones who would help you grow faster and properly.
How Many Shares To Offer Early Employees?
This is a question that many people struggle to get the answer to especially when the company just has about 5 to 10 employees including the founders. So, how much do you really give a key employee or the top talents when you hire them in your startup? While there is no right answer to this question, there are some things that you should keep in mind and some criteria that need to be considered. The main criteria you should consider are:
- Other Compensation
- The risk profile of the venture
Let us talk about these two and understand how they can help you in determining how much to give your employees.
Other compensation means the other than equity, the other benefits that employees get when they join a company. Equity compensation is just one of the things that an employee gets out of the total compensation to join a company. Other things include benefits, salary, incentives, etc. In fact, for each kind of position and geographic market, there is a standard compensation that the employee gets. Increasing and the compensation slightly from what others are offering around you is what helps you get the best talent.
For instance, if you check online, an Advertising Manager who is working in Charlotte, NC would be earning between USD 58,727 and USD 113,908 based on their expertise and experience. So, let us say that you have a company in Charlotte and you want to hire an Advertising Manager for your business. In this case, you will have to offer at least USD 75,000 to USD 90,000 salary to this person without any equity. If you cannot afford this much salary, you would then need to give equity as well with the low salary you are giving. Let us say you can offer them only USD 40,000 as salary. You will have to compensate and give USD 40,000 worth of equity as well as compensation then.
So, equity compensation helps you conserve cash for other things in the business. And with that, it also helps in motivating the employees to perform better. This is because, with equity compensation, employees consider the company as their own and would participate directly in the success of the company. Due to this, it is actually a good idea for employers to always opt to offer equity compensation to their employees. It would only help your startup grow faster and a lot more than you hoped for initially.
Risk Profile of the Venture
The second thing that you need to consider when determining the amount of equity you need to give to an employee is the risk profile of the venture. Let us take an example: in a high-risk situation, where the startup does not have much funding and there can be cases where new employees lose their jobs if the funding doesn't materialize, equity compensation should be higher than otherwise. On the other hand, a company that has enough funds, or a company that has reached its milestone and is less risky, should offer its employees much less equity.
Although these two criteria affect the amount of equity you need to give your employees, you also need to look into the position of the employee while offering them the equity. Here is a guideline that you can follow for offering the employees equity based on their position:
- CEO: 5% to 10% (% here is the ownership of the total shares in the company at this stage when you are offering them with equity)
- Vice Presidents: 1.5% to 3%
- Seniors: 0.3% to 0.7%
- Product Managers: 0.2% to 0.3%
- Mid-level engineer: 0.2% to 0.3%
Finally, it is vital to understand that equity can help you in growing your startup in its initial stages. Just ensure that you prepare the perfect program and add a proper vesting schedule to it as well.
If you are thinking of starting a company and are worried about paying the employees a lot, then this is what you need to do - pay them with equity. In fact, you can begin implementing your idea now. IncParadise can help you in registering your company in the USA and you can then move ahead to start your business. But once you start, remember to keep track of all the shares in your company. For that, you will need a proper cap table application like Eqvista. Just ensure that you keep an eye on how much you are giving out since you do not want to lose all your control.
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