Startup Equity Grants: A Founder's Guide

The Rising Significance of Equity Compensation

The competition for skilled professionals is intensifying, making equity compensation increasingly crucial. However, explaining this concept can be challenging, particularly within companies that are privately funded.

The use of stock options or Restricted Stock Units (RSUs) for attracting, motivating, and retaining employees is well-established, spanning decades in both public and private sectors. Currently, equity compensation is playing a more significant role in recruitment, retention, and aligning employee incentives at all levels, extending beyond just executive positions.

Factors Driving the Trend

Several key factors are contributing to this shift in compensation strategies.

• Tech Talent Scarcity: A worldwide deficit of qualified technology professionals means candidates with sought-after skills often receive multiple job offers. These candidates frequently demand equity as part of their overall compensation package.
• Increasing Wages: Labor shortages and prevailing market conditions are driving substantial wage increases. Organizations are seeking methods to enhance total compensation without depleting cash reserves, and equity provides a viable solution.
• Private Valuation Growth: The number of companies attaining unicorn status—a valuation of $1 billion or more—is rapidly expanding. CB Insights reports over 900 global unicorns, with over 450 new unicorns emerging in 2021 alone.
• Compensation Transparency: Access to compensation information is becoming more widespread. Platforms like Glassdoor have long offered salary data for established companies, while AngelList now provides both salary and equity benchmarks specifically for startups.
• Employee Expectations: A substantial majority—over half (53%)—of millennials cite equity compensation as a primary factor in their job acceptance decisions.

It is now essential for company leadership to develop a strong understanding of equity and be able to clearly explain its value and determination process. Let's begin with the foundational principles.

Cultivating an ownership mentality benefits both the organization's performance and employee morale. Consequently, many founders opt to distribute some degree of equity, even if modest, to employees beyond the leadership team. While leaders formulate the vision, a dedicated team is necessary to implement and realize those ideas.

Designing Your Equity Program

After determining that stock options will be included within your overall compensation strategy, the next step involves defining your guiding principles and structuring your equity program.

Determining the Equity Pool Size

Initially, you must establish the size of your employee option pool. It’s prudent to carefully consider your plans before engaging in discussions with investors, as they might advocate for a larger pool than necessary if your proposed size isn’t aligned with your recruitment strategy.

This pool should encompass both currently allocated options and unallocated options intended for key personnel you anticipate hiring over the subsequent 18 to 24 months. Typically, for a venture-backed startup in the seed or Series A stages, the combined management and employee equity pool represents 10%-20% of the total outstanding shares.

Allocating the Equity Pool

It’s important to acknowledge that a single, universally correct method for allocating your equity pool does not exist. Numerous perspectives exist on this subject; however, a framework proposed by Fred Wilson, co-founder and partner at Union Square Ventures, is particularly insightful. A summary is provided below, though reading his complete blog post is recommended. While the specific multipliers may be outdated, the underlying structure offers simplicity and effectively communicates the value of shares to employees.

First, establish the current “best value” of your organization. This represents the valuation at which you would currently sell or secure financing for your business. This valuation can be based on existing offers or standard valuation methodologies, such as comparisons to publicly traded companies or similar transactions.

Organize your company structure into defined brackets. These brackets should encompass all roles and levels eligible for participation in your company’s option plan.

BRACKETS	ROLES	EXAMPLE MULTIPLIER*
	Founder(s) (grant determination handled by the board)
Bracket 1: Non-founder executive team	COO, CFO, GC, CRO, CMO, CTO, GM, chief people officer, and other executive leaders	0.5x
Bracket 2: VP/director level	Managers at the VP and director levels	0.25x
Bracket 3: Key functions	Employees in roles crucial to company success (e.g., delivery, sales, marketing, engineering)	0.1x
Bracket 4: All others	All remaining employees	0.05x

To determine an initial equity grant for new hires, multiply the employee’s annual base salary by the corresponding multiplier to arrive at a dollar value representing their equity. For instance, if an account executive earns $150,000 annually, their equity value would be 0.1 x $150,000, equaling $15,000.

(The multipliers provided are illustrative only; seek guidance from an employee equity consultant before finalizing the multipliers you will implement.)

Individuals who commit to a venture earlier naturally assume greater risk. This raises the question of potential dilution for early employees as the company expands and more equity is distributed. Wilson’s “dollar value of equity” approach effectively mitigates this concern.

Consider the following hypothetical example illustrating how this approach functions for both early-stage and later-stage employees.

Jenny, joining in year one

• Account executive with a $150,000 annual salary
• Assigned to Bracket 3 (0.1x)
• Company’s “best value” is $25 million, with 10 million fully diluted shares outstanding
• Jenny’s equity value is calculated as 0.1 x $150,000, equaling $15,000
• This equates to 6,000 shares, representing 0.06% of the fully diluted shares outstanding

Jerry, joining in year three

• Account executive with a $150,000 annual salary
• Assigned to Bracket 3 (0.1x)
• The dollar value of equity offered to Jerry is 0.1 x $150,000, equaling $15,000
• However, the company’s “best value” has increased to $50 million, with 10 million fully diluted shares outstanding. This translates to 3,000 shares, or 0.03% of the fully diluted shares outstanding.
• Therefore, the value of Jenny’s equity is now double that of Jerry’s, reflecting the company’s increased worth.

The Vesting Schedule

A standard vesting schedule for employees at early-stage companies includes a one-year cliff, meaning shares vest on the first anniversary of the employee’s start date. Following the cliff, vesting typically occurs monthly over a four-year period.

To enhance talent acquisition, some companies are exploring the elimination or significant reduction of the initial one-year cliff. A recent survey of tech compensation practices revealed that over 20% of managers and employees reported that their stock vests immediately or after three months of employment.

Potential hires may request a shortened cliff and overall vesting period; however, the standard vesting schedule remains prevalent for a valid reason: it aids in retaining crucial talent.

Employee Communication Regarding Equity

Having established your core principles, developed the equity program, and confirmed its structure with a specialist, the next significant challenge arises. This involves conveying the details to your employees in a clear and uniform manner.

The goal is to ensure they grasp the benefit this component provides within their total compensation, and how its value is linked to the company’s success.

Anticipate a range of inquiries from your team. Preparation is key to addressing these effectively.

Frequently Asked Questions

Here’s a list of questions you should proactively prepare responses for:

• What is the company’s present valuation, and what methodology is used to calculate it?
• What is the current market value of my equity holdings?
• What is the projected potential value of my equity in the future?
• What is the total size of the equity option pool?
• How will future equity financing rounds affect my share ownership through dilution?
• What is the timeline for when I am eligible to exercise my options?
• What is the vesting schedule for these options? What occurs with my vested options if I depart the company before exercising them?
• What happens to my unvested equity if the company is acquired?
• What are the tax consequences associated with these options?
• Is there a possibility of a salary adjustment as an alternative to equity options?

Collaborate with your leadership team, board members, and HR department to formulate written responses to these anticipated questions.

Developing a comprehensive FAQ document can efficiently address common concerns.

Ensure your recruitment team and hiring managers are well-versed in the intricacies of these discussions.

Conduct a practice session to refine your communication strategy and ensure consistency.

Effective communication fosters understanding and appreciation for the equity program, ultimately contributing to employee engagement and retention.

Key Considerations for Equity Allocation

Strategic foresight and clear communication are paramount when determining equity distribution. Ensure the equity offered is appropriate, justified by sound strategic reasoning, and aligned with desired outcomes.

Avoid viewing equity allocation as a mere procedural task. Its consequences extend significantly beyond typical employee perks like recreational amenities.

Seeking expert guidance is highly recommended. Engaging an equity compensation consultant or legal professional can facilitate informed decision-making from the outset.

Furthermore, a communications or HR specialist can effectively convey the rationale behind equity allocation to your workforce.

The Holistic Value of Equity

Ultimately, the approach to equity and its perceived value are specific to each organization. The total worth of equity is a direct result of all the choices, both major and minor, made throughout the process.

Equity compensation requires careful planning and execution to maximize its benefits.

• Prioritize strategic alignment.
• Invest in clear communication.
• Don't underestimate the long-term impact.

The value derived from equity allocation is not simply a financial figure; it’s a reflection of the company’s values and commitment to its employees.