How should you design your compensation policy? As we’ve seen in the first part dedicated to incentives in startups, equity should be the main driver for both founders and early employees, since it rewards risks and performance. The question is to determine what level of equity should be offered to a given candidate.
While equity is the main driver for both founders and early employees, it doesn’t allow you to buy food or pay your rent. So wages can’t be omitted in the compensation package. The goal of wages in these situations is to allow people to live without stress, while being under market practice.
The general principles of equity are the following:
1. Cover the downside: schematically, equity should cover at least the opportunity cost taken by founders and employees when they accept a discount on the salary and take a bigger risk.
2. Ensure a huge reward (and thus, incentive) for the upside. Founders and early employees never get rich with salary. They (sometimes) get rich through capital.
So in that sense equity rewards risks & performance for founders and employees.
It is a very great means to offer a proportion of the value people actually create, aligning their rewards with the value they help create. When you have a stock option granted, your payoff is the difference between the price of the option (the value of the company when you joined it, where you didn’t contribute) and the price of the selling (the value created in-between, once you’ve started to participate).
Also, equity has another objective: ensure loyalty. Stocks aren’t offered as wages. When you are offered a stock option pool, they are attached to a specific mechanism.
In general, equity is associated with vesting and cliff. The typical formula is “four-year vesting with one year cliff.”
Vesting is a way to give ownership of a specific asset over time. For instance a four-year vesting means that the employees gets 25% of their rights every year. If they leave at the first day of their third year, they will have 50% of the stocks offered. To be precise, the rate at which stocks are vested varies. It is generally on a quarterly basis (around 6%). But sometimes, the frequency is monthly (around 2%), biannually (around 12%) or annually (around 25%).
Cliff represents the period that must elapse before starting the vesting. It is associated with a catch-up so you don’t just postpone the vesting schedule, but hinder people from leaving during the cliff period (where they would lose everything). For instance, in the later example, if the vesting is granted on a monthly basis with a one year cliff, the employee leaving the day before the first year, he wouldn’t have any stocks (and not the first eleven months of vesting he would get without cliff), but the day after the first year he would indeed get the 25%.
How much equity should you give?
The equity package is depending on several variables, but it is mostly linked to the attractiveness of your company, how strategic a position is, how hard a candidate is to attract and retain.Basically, if you are very early stage, looking for a CTO, not being able to pay market price and having a call from an exceptionally talented technical person, in a market where there is a shortage of tech talents, you’d better be ready to give a significant stock plan.
Also, there is a component that needs to be considered: how much is your culture performance-driven vs. egalitarian. If you want to build a company where the individual performance takes a significant role and make very high differences of compensation between the least and the most performing, you can have a very asymmetrical stock offering (offering lots of stocks to few stars and very little if not nothing to the others). If you want to have a more egalitarian company to balance individual performance and team spirit, you might want to offer stock in a more balanced way.
It is important to distinguish between hiring and on-going pool. You shouldn’t offer a very different package for a comparable position, because you cannot know how well someone will perform in the long run (don’t offer more than you need to attract someone). You can offer additional equity to retain your best employees later on if you feel there is too much of a gap between what he has in your company and what he could get outside.
Bottom line: equity offering needs to be adapted to your market, the profiles and company culture.
Now let’s go into the details: how much should you offer precisely?
A very good framework was given by Joel Spolsky, co-founder of StackExchange:
“For simplicity sake, I’m going to start by assuming that you are not going to raise venture capital and you are not going to have outside investors. Later, I’ll explain how to deal with venture capital, but for now assume no investors.
Also for simplicity sake, let’s temporarily assume that the founders all quit their jobs and start working on the new company full time at the same time. Later, I’ll explain how to deal with founders who do not start at the same time.
Here’s the principle. As your company grows, you tend to add people in “layers”.
For many companies, each “layer” will be approximately one year long. By the time your company is big enough to sell to Google or go public or whatever, you probably have about 6 layers: the founders and roughly five layers of employees. Each successive layer is larger. There might be two founders, five early employees in layer 2, 25 employees in layer 3, and 200 employees in layer 4. The later layers took less risk.
The founders should end up with about 50% of the company, total. Each of the next five layers should end up with about 10% of the company, split equally among everyone in the layer.
Two founders start the company. They each take 2500 shares. There are 5000 shares outstanding, so each founder owns half. [50%-50%]
They hire four employees in year one. These four employees each take 250 shares. There are 6000 shares outstanding. [So each employee have 2.5% (and the founders diluted)]
They hire another 20 employees in year two. Each one takes 50 shares. They get fewer shares because they took less risk, and they get 50 shares because we’re giving each layer 1000 shares to divide up. [So each of these 20 employees have 0.5% (and the founders and first four employees are diluted).]
By the time the company has six layers, you have given out 10,000 shares. Each founder ends up owning 25%. Each employee layer owns 10% collectively. The earliest employees who took the most risk own the most shares.”
Of course, you don’t have to divide the 10 points of each layer by the number of people, you can offer more equity for more senior people.
Rule of thumb:
Equity in a dynamic perspective
Marie Ekeland, co-founder of daphni, says that on average a public company has offered circa 5% of employee stock plan every year in the US.
You can find the data from a benchmark of the Tech 120 below (look at the new shares as %):
In private companies, the founders can offer stocks as they wish before their fundraising. When they raise funds, business angels and VCs usually add pool of equity for the founders and employees so they can attract great talents. Since fundraising usually occurs every 18 months, you can design your layers with this timeframe (or with a shorter timeframe, like every 6 months, dividing the stock pool by the number of period before the next fundraising).
Special thanks to Mathieu Daix, Marie Ekeland, Pierre-Yves Meerschman & Anna Kowalska for their insights!
Do you have any other practices or recommendation regarding comp? Let us know in comments!