Starting from scratch – the entrepreneur's preferred method
Founders have to deal with a myriad of different issues when starting their companies, and understanding equity is one of them. This guide is designed to make that process easier for founders who are building their knowledge of equity from scratch. It will cover the basics, including topics such as:
- Why you should give stock away at all
- The difference between ‘cash equity’ and ‘sweat’ equity
- The different ways in which you can give away equity
- How much equity you should give away to your employees
Why should I give away equity at all?
Equity can be a key way for early-stage startups to both attract and retain the best talent. Often, it can be difficult for founders to compete with salaries of more established companies, but if they can inspire the best talent to share their vision, then offering them a financial stake in its success can seal the deal. But equity shouldn’t just be a tool to attract talent at the early stages. Equity is a key part of startup culture: it creates ownership among employees, who feel they are an integral part of the project, and have a financial incentive in seeing it succeed. They invest in the company, and in this way they become part of its journey. You don’t have to share the successes of your company among your team – but if they’re the people who made it into a success, then why wouldn’t you want to?
Common and preferred stock – what’s the difference?
Let’s start with the basics. A security is a financial instrument that holds some monetary value. Equity is a type of security that represents ownership held by shareholders in an entity – a company, partnership, or trust – represented in the form of shares in capital stock. So, in a nutshell, equity is a representation of ownership, that also holds financial value in its own right.
There are two key types of equity, common stock and preferred stock. Common stock is the most common form (unsurprisingly), and usually held by founders and employees. Preferred stock is usually held by investors; and thus these two types of equity can also be seen as “sweat equity” (common) and “cash equity” (preferred). In its most basic form, preferred stock gives its owner the option to either keep their shares, or take back their investment. This is most relevant in the case of a sale. For example, imagine a Venture Capitalist (VC) decides to invest €5m in your company in exchange for 10% equity. The next day, you decide to sell your company for €15m. This means the VC’s 10% ownership gets them €1.5m in return for their investment; a loss of €3.5m. You, on the other hand, have made a €13.5m profit. Preferred stocks are designed to stop these types of situations happening.
The other key thing to note about preferred stock is that it is higher than common stock in the priority ladder of ownership. In other words, if your company goes into liquidation, common stockholders do not receive money until creditors and preferred shareholders have been paid. On the upside, common stock usually outperforms preferred stock in the long run, so it’s not all bad being a common stockholder.
How do I give my employees equity?
It’s worth delving down into common stock a little more deeply to understand what your options are when giving away equity. To keep things simple, let’s explore four key types of common stock: founder stock, restricted stock awards (RSAs), restricted stock units (RSUs), and stock options.
Founder stock is fairly self-explanatory – the stock that you, as a founder, issue yourself when you form a company. It usually contains vesting provisions to prevent one founder leaving early on with all of their stock (more on vesting later). Founders normally start with 100% of their company, which becomes diluted over time as investors take stock in return for investment, and employees are granted equity: it’s not uncommon for founders to have less than 40% equity remaining after a couple of funding rounds.
RSAs are a type of common stock typically issued to senior figures hired early on. RSAs are a form of stock grants, which means that the employee owns these shares from the start. This is significant, because it means that they are seen as taxable income (more on this later). However, like other forms of stock, they are normally distributed over a vesting period. RSAs usually contain restrictions on how the stock can be sold. One example is the right of first refusal upon the event of sale: companies usually retain the right to be offered the opportunity to buy the stock back, for the same price that its owner has been offered for it, before the stock can be sold to a third party.
RSUs are a type of equity that has become a lot more common over the last five years. Essentially, an RSU is a promise to grant stock once a vesting period has been satisfied. The stock will be granted, and it will be granted outright – but you may have to wait a while to get it. Founders are often moving towards this model of stock granting due to its tax implications.
Stock options are the most common form of employee equity. Unlike a stock grant, a stock option is the right to purchase stock at a set price (known as the ‘grant price’, ‘strike price’, or ‘exercise price’) during a fixed time period. The strike price is set at a ‘fair market value’ for the shares at the time that the option is issued. From an employee’s perspective, the key advantage of this is that, if the stock value goes up, he or she is still able to purchase the stock for the strike price – sometimes significantly lower than the market value. The stock can then be sold for profit. On the downside, unlike stock grants, your employee will still have to invest at least some money in order to take ownership of the stock.
So what’s vesting?
All of these types of common stock have something in common: they’re usually distributed over a vesting period. Vesting is simply the granting of stock, or stock options, over a fixed time period (usually four years). So, if you grant your employee a 10,000 share option, with a four-year vesting period, then he or she would take ownership of the stock options at a rate of 2,500 shares per year. Many founders also choose to ‘cliff vest’ for the employee’s first year at the company: this means that the employee only receives their first year share options on their anniversary. After this, shares and share options typically vest monthly or quarterly. Vesting can also be performance-related, or backloaded towards the end of the four-year period in order to retain top talent for longer. Whatever the vesting structure, the strike price for stock options remains constant throughout the vesting period – the ‘fair market value’ of when the options were first granted.
What kind of equity should I give to my employees?
Unfortunately, there’s no easy answer to this question. All types of employee equity have their pros and cons. If you grant shares, then your employees will be subject to tax implications. Because stock has value, it is seen as taxable income in most countries. So if you grant an employee 10,000 units of stock valued at €1 a share, then you are granting them €10,000 of taxable income – despite being illiquid assets (i.e. not possible to sell). This option is usually better during the very early stages, when the stock is worth little, or for senior employees who can deal with the tax implications. For employees who don’t meet these criteria, then share options may make more sense. However, share options can create their own difficulties, as when an employee comes to ‘exercise’ their stock options (i.e. actually buy the stock), this can require a significant financial outlay.
How much equity should I give my employees?
At the very early stages, the answer to this question is, ‘whatever it takes’. If they’re the right person to help you make your dream a reality, then you should offer as much equity as you need to get them on board. Luckily, after these first key hires, you can transform the art of employee equity into more of a science.
A good formula for roughly calculating employee equity after these very early stages has been borrowed from Fred Wilson’s excellent blog and is as follows.
- Work out the value of your company. This should be the ‘best value’ – the value that you would actually sell your company for.
- Divide your employees into brackets based on seniority: bracket 1 should be for C-level executives; bracket 2 is for director-level managers and key people (superstar employees); bracket 3 is for employees who are performing key functions (teams such as engineering, product, marketing); and bracket 4 is for employees who are not in key functions – receptionists, clerical employees, and so on.
- Put a multiplier next to these brackets. For example: bracket 1 – 0.5x; bracket 2 – 0.25x; bracket 3 – 0.1x; bracket 4 – 0.05x.
- Multiply the employee’s base salary by this multiplier to get the euro value of the equity you should be offering. So if your VP Product is on €120.000 a year, then multiply their salary by 0.5 to get €60.000. This is the value of equity you should be offering them.
Equity is a complicated subject, and essential to navigate successfully. This is to ensure that you attract and retain the right talent, but also so that you don’t face legal difficulties further down the line. Hopefully, you should now be better equipped to tackle the basics, but it is always worth consulting a lawyer if you’re planning on putting this knowledge into practice. There’s many different firms out there, but it makes good sense to find one that know the tech world inside out – for example Cooley LLP.
Written by Edmund MacKeith