If you’ve spent any time in the world of tech startups, you understand that equity typically plays a major role in total compensation. Offering equity as part of a compensation package can incentivize potential candidates to consider below-market cash compensation, allowing new businesses that are short on cash to acquire the talent they may not otherwise have the means to hire. Equity is also often offered to potential co-founders, investors, and advisors to mitigate some of the risks those individuals face when choosing to work with or invest in an early-stage organization.
New founders often have questions about utilizing equity, and understandably so. Navigating valuations, equity pools, distributions, and more can be challenging. While it’s important to consult a financial expert in any decision-making, understanding the basics of how equity works can help you get started.
Equity typically equates to a percentage of stock in the company. The price of the stocks is determined through a 409A process. During this process, your company’s financials and other relevant data will be evaluated by an outside entity using IRS regulations. A 409A valuation is typically done annually, and it can cost your organization several thousand dollars, depending on the company stage.
Equity is most commonly awarded via stock options or restricted stocks. Stock options are grants awarded to an employee that gives them the option of purchasing shares at a specified price, called the strike price. The strike price is typically the fair market value of the stock on the day the grant is approved by the board. Granting stock options allows employees to choose when they want to exercise their options, and taxes are only paid on options once they’ve been exercised.
Restricted stock grants give stocks to employees outright when a certain restriction—like time employed or a bonus earned—is lifted. Unlike stock options, taxes are due when the stocks vest, meaning that employees of pre-IPO organizations may end up paying taxes on stocks they are unable to sell. It’s more common for startups to award stock options due to their flexibility and the broader tax implications of utilizing restricted stocks.
It’s important to set aside a number of shares of your organization, known as an equity pool, as early as possible. Many startups set aside between 10-20% of their shares in order to have the means to incentivize employees. This amount is on top of the shares they are already awarding to co-founders, investors, and advisors. Consider this equity pool like a budget that can help you get the expertise you need to be successful while your organization is low on cash. The way that you distribute shares will vary depending on the individual being awarded.
When setting aside equity for employees, sit down and think about how many people you’re planning to hire in the next few years. Consider their level of experience—senior hires often require more equity than junior hires. Allocate additional amounts for further rewarding employees through bonuses or promotions. Often, early employees get more equity because they are taking a bigger risk, while also working hard in a more hectic, less established environment. You’ll also want to consider the amount of cash you have on hand. If you’re unable to pay market wages, you may have to make up for that in equity. Many equity grants range from 0.5% to 3% for first hires.
Often, employee stock grants are awarded on a vesting schedule. This is typically where a percentage of the stocks are awarded regularly over a set period of time. Many companies have a vesting schedule with a cliff, meaning that stocks don’t invest until a certain amount of time.
Startups have a variety of stakeholders, including advisors and investors. How much equity an investor receives depends on the size of the investment and the valuation of the company at the time of their investment. These amounts are negotiated during the investment process. Advisors are individuals with relevant experience who give advice and lend their expertise to the startup. They are often unpaid except in equity, with typical awards being between 0.2% to 1% for advisors.
The default for many co-founders is a 50/50 equity split, but that’s not always the best option. Equity splits among co-founders can be even, but they can also have senior controlling partnerships, where there’s a 60-4 split or something similar. Having frank discussions about the level of risk for co-founders, their level of commitment, and their long-term impact is important. While the work may be split evenly in the beginning, consider the long-term job descriptions of the founders. Often, the CEO of an organization will have a more impactful long-term role and may deserve additional equity due to that responsibility.
Ensure that the co-founder equity allocations also have vesting schedules with a cliff. This means that one founder can’t leave after one year and reap the same rewards as someone who saw the business through for several years and beyond.
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