What’s “fair” in employee equity?
Clients regularly ask us about the “fair” amount of employee equity compensation to grant (in the case of a startup client) or to demand (in the case of an individual client).
This is one of the many questions we are asked that, sorry to say, has no single “right” answer. (You knew I was going to say that.)
Equity for employees – at least for the early hires – is an inexact science, or actually, more like an art. The always sensible VC Fred Wilson of Union Square Ventures (USV) points out that for early hires, there is no formula; broadly speaking, they are likely get equity in whole-number increments: 1%, 2%, 5%, and so on. (Wilson makes the important point that here, we are talking about early employee equity, not co-founder equity – that’s a different conversation.)
Where along the spectrum should a particular employee fall? Ultimately, like any other contract issue, it is negotiable and fundamentally depends on the bargaining power of the parties – who needs whom more. We can, though, suggest some considerations that should factor into a “fair” determination for early hires:
- How much cash compensation is the employee foregoing? As our friend Troy Henikoff of MATH Venture Partners puts it: “Compensation is a combination of salary and equity. You cannot talk about one without the other. If you were a marketer at a large company making $X and went to work at a startup for the same $X of cash compensation, it would be hard to argue that you should receive a lot of equity. If you took a 25% pay cut, then I would expect the balance to be in some equity upside.” [UPDATE: Troy recently posted a helpful video explaining his views on this, here.]
- When valuing the equity component of the compensation, the risk/reward equation has to be considered. Joining an early startup is very risky, and the potential value of the equity to the recipient might be discounted considerably; by contrast, equity in a more mature startup (say, one that has already cleared the proof-of-concept stage and has taken on institutional financing) carries less risk. Further, a startup founded by an experienced entrepreneur with a couple of successful exits under her belt is generally less risky than one founded by a first-time entrepreneur.
- On the reward side of the equation, at any given level of risk, some businesses have higher potential upside than others. For example, all else being equal, a SaaS platform business probably has better potential margins and growth prospects than a labor-intensive services business, though both may be successful businesses in their sectors.
- Finally, the seniority of the employee and the perceived uniqueness of his or her skills always factors heavily into compensation negotiations.
Once the key hires are on board and the company has advanced along the growth curve, it is possible (and in Wilson’s opinion, necessary) to move to a more objective and consistent system for granting equity. Wilson proposes a methodology based on grounded assumptions about the value of the company’s equity. You can read Wilson’s description for yourself, but that post is from 2010 and the numbers likely do not reflect market terms today. However, one of Wilson’s portfolio company executives has taken the data from across the USV portfolio and provided an update of sorts to Wilson’s original methodology. That is here, and is worth reading. There are, of course, many possible ways to do this, and each company needs to come up with the system that is right for it.
Lastly, I would suggest to the company founders out there that while it’s good to strive for accuracy in the total compensation for each employee, remember to consider incentive effects. In other words, will the precisely calibrated grant of equity also motivate your employee to go the extra mile for the company’s success? In the end, this is what all entrepreneurs want their employees to do.
If you are a company founder considering granting equity to your employees, bear in mind that there are some key legal issues to address, from determining the right incentive equity instrument(s) (stock, options, profits interests, appreciation rights, etc.) to considering securities regulations, exemptions, and filings. Likewise, for employees: the form of equity incentive that you accept can have important financial implications, especially on the amount of taxes that will be due and when. It’s important to understand these issues from the outset.
Seek out the advice of capable counsel with experience in this area. May we suggest goodcounsel?
P.S. I came across this nice-looking platform (offering a free service level) called hiringplan.io that purports to help companies institute systems to pay people fairly, relative to a dataset drawn from tech companies. If anyone tries it, let me know how it goes.
Categorised as: Equity Compensation