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How much equity to offer employees

Matt Massucci, Managing Partner and Co-Founder

Attracting and retaining top talent is almost always the difference maker between success and failure, sluggish or rapid growth and ultimately good and great companies. Like most start-ups, you will likely need to provide equity as part of the compensation package since cash can be scarce during the early days. But how much is enough? Although there is not a cookie-cutter answer, the practices described below can help you define your strategy.

(*Before getting into the nuts and bolts, if you need a refresher on how valuation and equity work throughout a company’s life cycle, take a look at the link at the bottome of this article.)

Early Stage Equity

If your company is still more of a vision that has yet to garner marketable value, the standard is to offer straight points of equity to your core team (i.e., 1%, 2%, 5%, 10%). According Y Combinator’s Sam Altman, the most commercially successful seed-stage accelerator, “As an extremely rough stab at actual numbers, I think a company ought to be giving at least 10% in total to the first 10 employees, 5% to the next 20, and 5% to the next 50. In practice, the optimal numbers may be much higher.”

This gets expensive, especially if you need more than a few core members to launch your vision into a working, breathing company, so move away from points of equity as soon as possible.

Talk Dollars and Cents

If the question of equity is overwhelming and confusing, convert it to a dollar figure. When you talk about equity as dollars instead of number of shares or a percentage, you may easily compare it to market conditions, other employees and future value. For instance, if you said, “all engineers will get two percent,” that percentage will have different values as your company grows and moves through rounds of financing. Talking about equity as dollars also rallies employees around the goal to increase company worth.

Deriving the Dollar Value of Equity for Each Employee

We recommend two fairly simple approaches commonly used by compensation consulting firms to determine the dollar value of equity:

  1. Use the current share price
  2. Multiply the employee’s base salary by a fixed, predetermined multiplier

Current Share Price Method

Although your company’s formula may be different, the key is to use a consistent methodology that factors in fully diluted shares and the current company value. (This approach does not apply to the equity given to founders and investors, which should be set by the board.)

Company value = Determine a fair value of your company. You may use a recent offer, formal valuation or market analysis. For our example, let’s say your company is worth $10 million.

Fully diluted shares = This is the entire option pool both issued and outstanding, including common stock issued to founders, issued options and remaining options. For our example, we will assume you have 5,000,000 total shares.

Share price = Company value/fully diluted shares. Your share price would be $2.

Now that you have a share price, it’s easy to back into a dollar value. Let’s say you hire a senior engineer at $100,000 and want to offer $30,000 in equity value. It is presumed that $30,000 will increase over time, which may be factored in to the salary assumption.

Now that you have a fair dollar amount, you can back into the number of shares:

Number of equity shares to offer = equity value/share price, or $30,000/$2.00 = 15,000 shares. This translates to .3 percent of the issued and outstanding shares (15,000 /5,000,000).

Once you agree on a basic formula, you can assign percentages to different levels in your company hierarchy.

The Multiplier Method

Approach number two requires you to first group the organizational chart into buckets. There are four buckets in this example, but in reality, you may need more:

  • Senior Management (i.e., chiefs, VPs, etc.)
  • Director Level (i.e., directors, key engineers, designers, etc.)
  • Major Functions: (i.e., engineers, marketers, etc.)
  • Supporting Functions: (i.e., accounting, reception, etc.)

(As with Founders and Investors, the Board should make the decision regarding the CEO and COO.)

Assign each group a multiplier and then multiply the employee's base salary by the correlating multiplier to get to a dollar value of equity. Again, these multipliers are adjustable:

  • Senior Management: 0.5x
  • Director Level: 0.25x
  • Major Functions: 0.1x
  • Supporting Functions: 0.05x

For this example we will evaluate the Chief Marketing Officer (CMO) who will make a salary of $220k. The dollar value of her equity is $110k ($220k * 0.5multiplier).

Finally, divide the dollar value of equity by the "equity value" of your business and multiply the result by the number of fully diluted shares outstanding to get the grant amount. In our example, the business is worth $10 million and there are 5 million shares outstanding, therefore the CMO gets an equity grant of (($110k/$10M) * 5M shares) which is 55k shares (equivalent to 1.1% of total shares).

Vesting Schedule

The goal of equity is to attract employees who take a sense of ownership in the company. To protect shareholders and other employees, most companies use a vesting schedule with a one-year cliff. A cliff allows companies to terminate a bad hire without diluting the equity pool, since first year’s shares are not allocated until the employee’s one-year anniversary. After the cliff period, the shares may be distributed each month for the duration of the vesting schedule.

In our example, if we had a four-year vestment period with a one-year cliff, our engineer would receive 7,500 shares (25 percent of 30,000) on her first work anniversary. The remaining 22,500 shares would be distributed every month over the next three years (625 shares a month).

Convey the Company’s Growth Trajectory / Make the Equity Stretch

Many will agree a bird in hand is worth more than two in the bush, however would that sentiment change if there were three, four, or five in the bush? In the example above, the company’s share price TODAY is calculated at $1, which is valued at $30,000 as it pertains to our potential engineer. But as the company grows, becomes more profitable and/or pays down debt, the equity value could increase to $2, $3, $4, etc. - thus making the same amount of the engineer’s shares worth $60k, $90k or $120k, respectively.

The onus to paint that picture rests on the founder/CEO’s shoulders, and if conveyed well, can sweeten the perceived value of the equity.

If you're looking for some advice on how to extend a job offer, we have some advice for that too. 

Resources

http://fundersandfounders.com/how-funding-works-splitting-equity/

http://blog.samaltman.com/employee-equity

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