When launching a startup, it’s essential you have a simplified method for calculating early employee equity. Remove the guesswork by building a strong foundation for equity distribution in those early days, and it’ll help the senior management team to budget and track option allocations so your company doesn’t ‘run out of equity’.
Many startups, after weighing up share options versus shares, will opt for share options as they’re relatively straightforward to issue to employees. Share options are a powerful tool to attract, retain and motivate talent as well as compensate for the reduced salaries on offer to early-stage employees. It’s just one of the ways smaller businesses are able to compete with large, established organisations.
So how do you go about creating a solid framework for calculating and distributing equity? To get the ball rolling, here are our top tips to address those equity package conundrums.
Deciding who qualifies as an ‘early employee’ in your startup will help with outlining a compensation and benefits plan. To figure out which employees fall into which category, startup founders commonly divide their workforce into three categories:
However, the definition of an ‘early employee’ will vary from business to business. A startup that grows rapidly onboarding a lot of employees in a short period of time may have a different version of ‘early’ versus a startup that grows at a slower rate.
From the moment you decide to give equity to employees, you need to think seriously about the option pool. As a startup grows and new investors and employees come on board, there’s a risk of the option pool drying up.
Capdesk’s own research found that option pools for awarding employee share options are typically sized at 15-20%, with the average at 17.3%.
However, before committing to a specific figure, think about how the employee equity pool will dilute founder and investor ownership. Likewise, it’s important to look to the future and consider how your startup will expand, how many employees you’ll need at each growth stage and what equity they’ll receive, as you’ll need to reserve some of the pool for future hires.
One way of thinking about it is to budget an option pool in the same way a CFO meticulously plans out the cash runway. You wouldn’t let your business run out of money, so don’t let your option pool empty out.
Founders often have to find the balance between using a general equity framework with their individual judgement – particularly in the case of early, foundational hires.
There are many reasons why early-stage employees deserve equity, but to ensure the allocation of equity is fair, look at the contribution the employee is expected to make and factor in the risk they’re taking by joining an early-stage organisation. Only 10% of startups succeed; surely employees who join the team deserve to be compensated for this risk?
Grouping employees into a tiered system is one way to go about distributing equity: to get the ball rolling separate foundational and non-foundational hires or senior and non-senior roles. Alternatively, a role-based framework is effective. All senior employees receive the same amount of options, mid-level employees slightly less and junior employees the smallest quantity.
Once there’s a system in place, it’s much easier to award further equity, such as at times of promotion or bonus. With a firm point of reference, there’s no need to guess how much that bonus is worth. And there’s no risk of over-allocating the option pool.
One of the most popular methods for calculating early employee equity grants for individuals is by topping up their salary with equity until you hit market rate for their role and level of experience. So, if a startup pays an employee a salary that’s around 80% of the market standard, the equity reward would be calculated at the value of the remaining 20%.
Alternatively, you could choose to follow Fred Wilson’s method instead. This formula calculates the number of options an employee receives based on their salary. The main benefits of this methodology are that it's transparent and easily explained to staff.
How you decide to calculate employee equity is only one half of the equation. The other half is getting organised early enough to put an effective system in place. Not only is this vital as the business grows but it guarantees fairness across the board and allows better management of the option pool from the beginning.
There may be anomalies for bonuses or larger awards to convince exceptional talent to join the organisation, but it pays to have a structure in place.
Before making any final decisions on employee equity packages, seek the advice of a financial professional.
While some startups are content to record their equity distribution on spreadsheets, this quickly becomes messy and complex. Having a dedicated cap table solution not only benefits employers for managing and awarding equity also benefits but also employees who can track and engage with share options as they vest.