Employee Equity can be a vital tenet of your startup’s early strategy
Founders have to deal with a variety of different early-stage issues. Above all, employee motivation and talent acquisition should be at the heart of your business strategy. To achieve both of these at once, employee equity can be a secret weapon in hiring the best talent with the highest financial motivation.
As an early-stage startup, it’s often hard to find the adequate funds to offer a deserving salary to the first talent your company hires.
This is where employee equity comes in.
By promising your potential hires a slice of the future profits, you can present them with a lucrative investment that depends on their work. It can often be a win-win scenario in budding startups; creating a collective mentality, enticing a shared vision while also creating loyalty in early-stage startup teams.
In this guide, we’ll make it easy to understand how to provide equity to your employees. It will cover the basics, including:
- 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
We will also discuss higher-level topics, such as vesting, the legal implications of providing equity, and, most importantly, how to hire the best talent that deserves a share in your company.
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. Early-stage startups can rarely compete with established VC-backed companies on salaries and benefits. However, if you can inspire the best talent to share your vision, offering employee equity can help seal the deal.
It’s important to remember that 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; giving them the motivation to really become invested in the company. If their income depends on the company’s outcome, they are much more likely not just to work harder, but to create a more energetic atmosphere within the business.
It’s often easy to forget that a company is a collective of people working towards a common goal; this is what equity helps to highlight. After all, if they’ve been there since the beginning and they've worked hard to see the company succeed, why not reward them for their motivation?
Sharing equity lets your employees share in the journey towards success.
Sweat Equity vs. Cash Equity — What’s the Difference?
Let’s start with the basics:
- Equity is a type of security that represents ownership held by shareholders in an entity
- Overall, equity is a representation of ownership that also holds financial value
- Equity is usually represented as common stock or preferred stock
- Founders and employees hold common stock
- Investors hold preferred stock
- Common stock is earned through work (i.e. Sweat Equity)
- Preferred stock is earned through investment (i.e. Cash Equity)
Therefore, in almost all circumstances, you should provide your employees with Sweat Equity, or Common Stock. This way, your employees invest themselves in the company the same way you do, creating a collective investment of time and effort.
How do I Give my Employees Equity?
There are five key types of common stock:
- Founder stock
- Restricted stock awards (RSAs)
- Restricted stock units (RSUs)
- Stock options
- Virtual stock options
It’s worth delving into the concept of common stock a little more to better understand what your options are. Each one has its own benefits, and it's important to know which one is right for your company.
Founder stock is fairly self-explanatory. It's the stock that you, as a founder, issue yourself when you form a company. It usually contains vesting provisions to prevent one founder from leaving early on with all of their stock (more on vesting later). Founders normally start with 100% of their company. This 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.
Restricted Stock Awards (RSAs)
RSAs are a type of common stock typically issued to senior figures hired early on. RSAs are a form of stock grant, which means that the employee owns these shares from the start. This is significant because it means that they are seen as taxable income. This is why it’s best to only provide this to high-level employees as they often already have the means to manage the tax implications.
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. This stops the stock from immediately being sold to a third party. This way, they can keep the stock within the company, avoiding ownership and takeover issues.
Restricted Stock Units (RSUs)
RSUs are a type of equity that has become a lot more common over the last few 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 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’). 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, they are 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 their stock.
Virtual Stock Options
Virtual Stock Options can be a great workaround for companies that would prefer to not deal with the tax and administration complications that come with providing equity. In this situation, the company doesn’t provide actual stock options to the employee, just a virtual equivalent that they can cash in at a later date. This is an excellent way to reward key hires with equity while maintaining a high-degree of control of your startup.
As the stock does not technically exist, it also helps employees avoid the tax difficulties that can come from conventional stock ownership. When the vesting period allows, the virtual stock is then given to the employee in cash, similar to quarterly or annual bonuses.
Vesting Periods and Employee Retention
All of these types of stock have something in common: they’re distributed over a vesting period.
Vesting is the granting of stock, or stock options, over a fixed time period.
For example, if you grant your employee a 10,000 share option, with a four-year vesting period, they would take ownership of the stock options at a rate of 2,500 shares per year.
Many founders choose to ‘cliff vest’ for the employee’s first year at the company. This means that the employee only receives their first year of share options on their one-year 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?
There’s no straightforward answer to this question.
Every type of employee equity has its own 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.
For example, 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 it being impossible 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 investment.
How Much Equity Should I Give my Employees?
At the very early stages, the answer to this question is whatever they're worth. 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.
In total, however, it's good to set an employee equity limit: ensuring that you don't give away too much of your company. The majority of startups keep their employee equity pool to between 10-20% of the total.
However, this depends on what stage of growth your company is in, how much you want to grow in the next 18 months, and a myriad of other factors. In general, it’s best to keep it below 20% to ensure stability.
Below is a standard formula for allocating employee equity.
How to Provide Employee Equity
1. Work out the value of your company. This should be the ‘best value’ – the value that you would actually sell your company for.
2. 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
- Bracket 3 is for employees who are performing key functions
- Bracket 4 is for everyone else in the company.
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
3. Multiply the employee’s base salary by this multiplier to get the euro value of the equity you should be offering.
For example, if your VP of 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.
How do I Implement Employee Equity into my Hiring Strategy?
Equity is a complicated subject and you need to master it in the early days of your startup to create a solid hiring strategy. But, how do you find the employees that deserve all that equity?
ACELR8 is an embedded recruitment service that can source exceptional, approved employees for all levels. From C-level superstars to entry-level hopefuls, the ACELR8 team can work within your company to ensure that every new hire fits into your culture and future goals. Our consultants and recruiting coaches can work with you to advise and create an equity offer structure for all your new team members.