If you are running a startup, you must simultaneously balance team building, product development, cash flow management, and much more. But the initial days of a startup are not easy. Lack of money and mentorship hinders experimentation and acquisition of top talents. It is difficult to onboard mentors and competent employees without hard cash.
So, offering equity is the next best option to attract and retain crucial ones. We call it equity compensation or ESOPs (employee stock ownership plan). You do not need to give them a big percentage or make them co-founders. Instead, a small percentage of equity acts as a long-term incentive.
What is Equity Compensation?
Equity compensation means offering ownership in the business (what we know as equity) as a part of the compensation. This type of compensation is commonly practiced in startups and tech companies. Normally, equity compensation invites a 409a valuation to compute the share value and overall ESOPs. Post this valuation, founders set aside a percentage of equity (10-15%) to cover the compensation. It helps bring the salary package to the level of other private and corporate companies.
Different options offer equity to employees and other members, such as advisories, COO, and CTO. They have varying tax implications, exercise rules, and pros and cons. Let us quickly take a look at them.
Types of Equity Compensation
Offering equity to an employee means sharing control and ownership rights. Choosing the right kind of equity offering will impact employee incentivization. Depending upon the role and seniority, you can choose the type of equity compensation. Here are 5 types of stock options to provide equity to your employees:
1. Stock Options
Stock options mean offering the purchase of company stocks at a set price (exercise price) on a future date (exercise date). The period between the allotment and exercise date is called the vesting period.
You allow the employees to buy stocks in the future but at current prices. So, when the stock value appreciates in the future, the employee profits from the difference between current and future prices. The vesting period generally varies between 4-6 years, including one year of cliff period. The Cliff period is the minimum time an employee works in the company.
Stock options are a great way to offer equity as you do not lose ownership and do not have to pay in cash immediately. Employees are also motivated to stay in the organization until the vesting period and serve religiously. Also, if the employee serves the entire vesting period, the stocks are taxable as per the capital gains rate.
2. Restricted Stock
Restricted stocks mean a promise to offer stocks to employees after the vesting period. Unlike stock options, employees receive the stock and do not need to purchase it on the exercise date. Since these are acquired on a future date, employees can not trade them off during the vesting period.
It is conditioned to be forfeited in case some prerequisites are not fulfilled. It is usually offered to the executives instead of the regular employees. It helps in retaining the top executives in the company.
3. Stock Appreciation Rights
Like stock options, stock appreciation rights allow the employees to receive either cash or stocks equal to the excess of future prices and the exercise price. The only difference between stock options and stock appreciation is that the company does not need to lose ownership/ control of the business if settled in cash.
Again, there is a vesting period and exercise date. Employees can choose whether they want cash or want to trade stocks directly.
4. Performance Shares
Performance shares provide stock options to executives or directors when they fulfill certain performance criteria. Unlike restricted stock, equity is offered when the employee meets a certain performance indicator only and not after the vesting period. These criteria could be the return on equity or earning per share targets. Alternatively, the performance of the company is compared to its peers.
The primary goal is to enhance performance and not retention. These act as a great motivation factor for employees who drive results to the company.
5. Sweat Equity Share
Sweat equity shares are shares given at a discounted rate or for some consideration other than cash. Companies offer it to employees or directors in exchange for bringing technical competence, know-how, value addition, and intellectual property rights for the business. It generally clocks a lock-in period for a minimum of 3 years for publicly-traded companies.
Again, unlike stock options, sweat equity shares are directly issued to the employees. The primary goal is again to attract and retain the top employees and executives in the business.
Depending on your business capacity, employees’ financial goals, and companies’ cash flows, you can choose an apt alternative to offer equity compensation. You must clearly state the type of equity chosen on the employee contract. Once you decide on the type of equity compensation, let us see how much equity you should give away.
How is Equity Compensation Calculated?
We discussed that equity compensation is offering a small percentage of the equity to employees as a part of the salary package. But how do we decide that percentage? Equity is valuable for your startup. You can not give it away easily for each person that joins the company. Nor can you afford to offer any percent (large percent) to employees. The entire process of equity compensation can be summarised in five steps:
- Setting aside a percentage of equity (ideally 10-15%) for ESOP, i.e., creating an option pool.
- Select the type of equity compensation to offer.
- Decide the vesting period for the stock options.
- Ascertaining the equity size for each role.
- Create a cap table to document the equity share effectively.
1. Create Option Pool
The first step to equity compensation is creating an option pool. It simply means setting aside a percentage of the equity for employee compensation. It ranges from 10 to 25%, depending upon the business structure. This can further be increased in the future as and when the need arises, which might reduce the stock value.
Ideally, a startup should set aside 15% for the option pool, which cautiously needs to be distributed.
2. Select Type of Equity Compensation
The second step involves selecting the type of equity compensation (discussed before) depending upon the ownership you wish to retain and share. The most common equity compensation is the stock option. Companies frequently opt for this because it saves cash outflow and incentivizes employees. However, certain restrictions should be implied on selling company stock to avoid transfer to a third party.
3. Vesting Period Determination
A vesting period is a minimum period an employee must work with your startup/ company to earn the equity offered. It ranges from 4-6 years or even more, depending upon the type of equity compensation. Certain types demand more vesting periods.
For instance, if a company has a four-year vesting period with a one-year cliff period. In such a situation, the employee earns 25% of yearly equity.
However, if employees leave, they can exercise their equity on stocks vested within a limited period, generally 90-days. If the employee does not act upon it, they lose the equity option, and stocks are transferred back to the option pool.
4. Equity Size for Each Role
The equity size offered to each person can vary depending upon the seniority or size of the company. Generally, higher equity is offered for executive-level or director-level roles. Smaller businesses offer greater equity when we consider the size of the business.
For instance, a startup with just a founder and co-founder will offer equity equivalent to their holding to any new member that joins. Additionally, initial employees are crucial for the business as they act as founding members.
2) In the Silicon Valley, if you’re hiring your 1st employee, & you’ve raised NO $$ & are paying very little (e.g $0-$10k / yr or thereabouts), your first employee is basically a co-founder.
And the equity tranche for employee 1 should be closer to a co-founder level.
— Elizabeth Yin is on a tweet break. (@dunkhippo33) February 11, 2021
Hence, they are offered more equity in comparison to the ones that are recruited later. You need to consider the industry standards and offer accordingly to incentivize employees.
|Seniority Level||% of total company’s equity|
|C-level||1% to 2.5%|
|VP||0.25% to 1.75%|
|Directors||0.5% to 1%|
|Managers||0.2% to 0.75%|
|Other Employees||0 to 0.25%|
If you have over 50 employees, you can offer 90-50% of ESOPs to senior-level employees, 25-40% to middle-level employees, and 10-25% to junior-level employees.
For advisors, the equity can vary between 1-3%, depending on their expertise.
5. ESOP Management
Finally, once you decide and put together all the elements of ESOPs to allot equity, it is crucial to focus on ESOP management. It involves maintaining a capitalization table, a document showing all the company’s shareholders.
Technically, it gives a brief of how many stocks are employees, directors, executives, and other members holding. Even though some startups rely on excel sheets and other basic tools for ESOP management, having an automation tech stack makes it less cumbersome.
It comes with a freemium model and helps tackle issues like reconciliation and data security. It assists you with ESOP liquidity and ESOP management and reduces multiple costs related to storage and handling.
Finally, let us understand how equity compensation will empower your startup to work efficiently. It does much more than employee retention and saving cash flows.
Benefits of Equity Compensation
Tech companies and startups love equity compensation for a reason. It does not restrict onboarding and retaining the talent and employees in the company. It offers greater utility as a compensation tool.
1. Minimize cash outflow
Equity compensation becomes part of the salary package. Hence, the cash compensation lowers, reducing cash outflow in the normal course of business. Since cash flow is the biggest challenge in a startup, equity compensation is beneficial for startups and companies with low MRR.
2. Attract experts and skilled personnel
For a startup, getting experts and advisors with technical competence and the right skills is difficult due to the unavailability of funds. Equity is an effective medium to attract these people, crucial for business growth.
3. Retain top employees
Often the best employees leave the organization if not compensated well or below industry standards. Equity is a long-term incentive that motivates these top employees to stay with the business. Retention is extremely crucial for businesses to not only save top employees but to avoid costs of replacement.
4. Reduce employee turnover
Equity compensation helps reduce employee turnover as it is an incentive to stay with the business for longer (until the vesting period). It saves the cost of hiring new people, training, and other mishandling costs during training.
5. Improve employee involvement
Equity gives the employees ownership and, at times, voting/ management rights. As a result, employees align their goals with business goals and are more invested in the business. With time as the equity value increases, employee loyalty and commitment boosts.
All these benefits make equity compensation a common practice in many startups. Even though some implications, legal compliance, and management are required, it is a great way to run your startup. We will quickly demonstrate the equity compensation in action below.
Equity Compensation Examples
Let us demonstrate how equity compensation is practiced in various situations and business models.
1. Equity Compensation for Startup
For early-stage startups that are not capable of paying, you dilute equity. People that join in become the part of founding members.
Your startup is at an early stage with zero (negative) company valuation. You offer equity in a way that the person joining becomes a founding member. The employee receives 5% equity which later pays off when the company valuation increases. In this situation, you might not dilute management rights.
2. Equity Compensation for Private Companies
The biggest concern is losing ownership and management rights as a private company. However, with the right protective measures, you can offer equity compensation to compete with the salary packages of public companies.
Your company is at a pre-seed stage, with a valuation of $70K. You offer performance shares to your employee. You set aside 15% of equity for the option pool. You set the performance indicator to achieve an ROE of 5.6%. So, when the business’s ROE reaches the criterion, the employee gets the valuation and salary in cash.
3. Equity Compensation for Series A
Your company valuation is $22 million. You offer ISO* (incentive stock option) to your employees. You set aside 15% of equity for the option pool. You offer stocks to the public at $2 but $0.75 to your employees. So, an employee who is offered 0.001% of equity purchases stock for $16500 and sells it for $44000.
*PS: ISO and NSO are restricted to US equity compensation plans, not applicable to Indian companies.
3 Tips to Leverage Equity Compensation Effectively
Finally, let us quickly go through some tips to ensure that you use equity wisely and get maximum benefit.
1. Understand hiring needs–
Before you hire employees and plan to compensate with lucrative salaries, understand your hiring needs. Do you need a specific skill or someone to fill the basic admin role? Getting clarity of hiring needs helps you assess how much equity to offer.
2. Vet the employees–
Handing over equity to employees demands a background check and vetting of employees. You do not want to hire anyone who later misuses business stocks.
3. Focusing on the individual goals–
Tie up the equity to the individual’s financial goal and later associate that with a business goal. Business indicators like return on equity act as a great criterion. These ensure that business grows with each hiring round.
Finally, do not opt for equity for each employee that you hire. Surely the early team-building requires equity distribution but does not give it away for anything. Opt for it only when hiring a technically competent manager/ executive or hiring to scale the business.
Equity compensation is a viable option to attract and retain top talents in the competitive market. It only needs careful consideration to deploy and manage them. ESOP management is equally important but can be cumbersome, involving constant back-and-forth on excel sheets. Solution? An automation tool that assists you with cap table and ESOP management.
trica is one product that manages your cap table and ESOPs by eliminating security and reconciliation issues. It is an end-to-end solution to create, digitize, manage ESOPs and sync effortlessly with your HRMS.