Managing Startup equity compensation for founders and early employees
Startup compensation is often an opaque and awkward topic for first-time founders. How much equity do I receive? My CEO? The PI(s)? Other co-founders? How will the decisions affect future compensation? The truth is, equity allotment is not a one-size-fits-all proposition. Your startup is gaining traction, and you’re bringing on an all-star team to help you build your company. In exchange for their talents and services, you want to offer them equity — but distributing it isn’t an intuitive process.
What is equity in a startup?
In a Silicon Valley Bank (SVB) article says “startup equity describes ownership of a company, typically expressed as a percentage of shares of stock.” Having equity in a business essentially means that you own a small portion of that company. On day one, the founders own 100%. If you have more than one founder, you can choose how you want to share ownership: 50/50, 60/40, 40/40/20,etc. It will depend on how many founders you have and their contribution to the success of your company. However, to build your business, you will likely need to exchange equity for funding and to lure new employees.
Slicing the founder’s pie
How much stock ownership should go to whom? Frank Demmler suggests:
- Share the wealth with those who help to create the value and thus the wealth
- Which co-founders are bringing what kind of value to the table, what kind of value, and how much?
- Realize a harvest of at least 5 to 10 times the original investment
- Make sure the company prospers and grows thus creating a huge, shared pie
Early on, founders need to give up a significant percentage of their equity to match the risk investors are taking by funding their startup. But as you grow and demonstrate greater success, your startup equity increases in value, and investors are typically willing to pay more — or inversely accept less equity in exchange for their funding.
Your startup’s first employees have the opportunity to make the biggest impact. But how much startup equity should you give them? For many founders, determining how much equity each early hire gets isn’t always so clear-cut.
Equity compensation is a popular method of incentivizing employees, especially in the startup world. Essentially, it involves granting employees the right to receive shares in the company, either immediately or over time. This can take the form of stock options, restricted stock units (RSUs), or other equity-based incentives. Equity compensation can be a powerful tool for motivating and retaining employees, as it aligns their interests with those of the company’s shareholders. However, it can also be complex and can create a number of legal and tax issues that startup founders should be aware of.
Consider an option pool from the beginning
An article published in Carta suggests setting up an option pool that sets aside a chunk of equity for employees that helps evenly spread out the stock dilution of each shareholder’s ownership as the company grows. Employers typically reserve 13% to 20% of equity for their employee option pool. Every company has different cash and talent requirements, which explains the large percentage range.
Think about salary and equity together
Equity is only one part of an employee’s compensation package. You’ll also have to decide how much to pay your early employees. Working for an early-stage startup could mean agreeing to a pay cut or a below-market salary. The bigger the gap between the salary you can afford and the market rate, the more equity you may want to offer to make a compelling offer.
Job role levels and fields matter, too
Understanding the level of each of your first hires will help you plan your overall compensation package. If you’re bringing in a C-level executive or top engineer as one of your first hires, those roles will command a premium.
The field each hire works in matters, too. For example, candidates with considerable engineering and product experience are often in high demand and tend to expect the largest equity grants. In other roles, such as sales, the expectation is likely to be more cash and less equity.
Demonstrate the value of your equity
Ultimately, all these considerations about equity percentages have to be grounded in the value of that equity. “The sooner you can find some kind of valuation for your company, the easier this exercise becomes,” Wentz says.
Of course, at the early stages, a startup’s valuation merely reflects investors’ opinion of its worth. Typically, its equity is not liquid. While employees and founders all hope it will be worth much more later on, they understand that the value of their equity could be underwater. A valuation can serve as a concrete starting point for both sides to evaluate equity grants.
There are a number of legal and regulatory issues to consider when implementing an equity compensation plan. One of the most important is compliance with federal and state securities laws. If the equity compensation plan involves the sale of securities (which is typically the case), it must comply with the requirements of the Securities Act of 1933 and other securities laws. This can include registration with the Securities and Exchange Commission (SEC), which can be a time-consuming and expensive process. However, there are a number of exemptions from registration that may be available to startups, such as Rule 701 under the Securities Act.
Another legal issue to consider is the treatment of equity compensation under tax law. Generally, equity compensation is taxed as ordinary income when it is received by the employee. However, if the employee receives stock options, they may have the option to defer taxation until the shares are sold. This can be advantageous for the employee, as it allows them to defer tax liability until they have realized a gain on the shares. However, it can also create a number of tax planning and compliance issues.
Finally, it’s important to consider the terms and conditions of the equity compensation plan itself. This can include the vesting schedule (i.e., the period over which the employee earns the right to receive the shares), the exercise price (i.e., the price at which the employee can purchase the shares), and any other restrictions or limitations on the shares. These terms can have a significant impact on the value of the equity compensation, and can also create legal issues if they are not properly documented and communicated to employees.
Equity compensation can be a powerful tool for motivating and retaining employees, but it is also complex and can create a number of legal and tax issues. Here are a few key takeaways to keep in mind:
Seek legal and tax advice early. It’s important to work with experienced legal and tax advisors to ensure that your equity compensation plan complies with applicable laws and regulations and that you have properly documented the terms and conditions of the plan.
Consider the impact on your cap table. Equity compensation can dilute the ownership stake of existing shareholders, so it’s important to consider the impact on your cap table and the potential for future fundraising rounds.
Communicate clearly with employees. Equity compensation can be complex and difficult to understand, so it’s important to communicate the terms and conditions of the plan clearly and effectively to employees. This can help avoid misunderstandings and legal issues down the road.
Be mindful of tax implications. Equity compensation can create tax planning and compliance issues, so it’s important to work with a tax advisor to ensure that you and your employees are aware of the potential tax consequences of the plan. Whether you are still planning your start-up or have already begun equity allocation discussions, make sure you utilize your resources and even tap expert opinions when possible. Ultimately, how much equity you award and to whom will depend on what’s best for the growth and success of your company.