Startup founders don’t want to give away equity, even to investors if they can avoid it. But parting with some equity at an early-stage for co-founders and your first employees could be one of the brightest things a young business can do.
This way of doing things is well established in the United States (US), with some CEOs there often happy to part with as much as 95 per cent of the business to employees and investors if it helps them IPO and get rich from their remaining 10 per cent. But it is less common elsewhere in the world, especially in Africa.
Why give your employees equity?
Offering employee equity is one of the strongest hiring tools you could have. If you want your startup to really scale, you want the best people. You’re highly unlikely to be able to compete with large corporations in terms of salary, so offering equity is the best trick you have up your sleeve. Take a big pay cheque from Microsoft, they’re rich; take equity in your startup, they have a shot at becoming very rich indeed.
The people that are willing to take a risk by passing up a high salary and taking equity instead are also the people you want in your startup. They are willing to take a risk and put their own financial prospects in the same basket as those of your startup. Rewarding these people in the long-term could pay dividends.
Employees rewarded with equity rather than a base salary will also be far more invested in making the business work, putting in long hours. If an employee owns part of the business, they know they a vital part of the startup team, and will benefit from what the company makes out of success, whether an IPO or exit. This empowerment can prove a major benefit to your company, with well-motivated employees crucial to startup success.
In expenditure terms, offering early-stage and valued employees equity options instead of cash is also positive. Not only are the individuals concerned likely to be far more invested in and concerned about your startup’s successes, it also minimising the cash outlay of the startup and allows it to spend sparse funds on other things, such as marketing or technology needs.
Sometimes employees may not want equity. This means that either they have a preference for cash upfront, or the benefits of equity have not been made clear to them. But there are ways of putting equity packages together than suit individual employees. You can offer lots of equity plus a little cash, or the other way around. Each member of staff you consider for equity has the right to pick the package that is best for them. But if employees do not want equity, you should be concerned. They evidently haven’t bought in to the company and its long-term success.
How to calculate how much equity to offer
Usually, early-stage employees are offered a “one-year cliff”, after which stock options vest monthly or annually. In terms of how much to offer, it depends on the startup in question, but in the US executives or early hires are often given as much as three per cent of the total shares of the company, though this often becomes diluted over time as the startup takes on further investment.
The amount you choose to vest in an early-stage employee will also differ from that vested in the founder or any co-founders. Founders probably haven’t been and won’t be paid for a long time, and as such require for equity in return for their risk.They also came up with the concept. Employees come along later, have more cash as compensation, and likely didn’t have that much impact on the concept of the startup.
Deciding how much equity to give employees is not a particularly scientific process, especially at the early stage. The best we have has probably been drafted by Paul Graham with his Equity Equation. Without getting too technical, you need to work out how much a certain individual increases the average outcome of your business. If you want to make a “profit” on the individual’s contribution to your business, you can factor down the equity offered, but Graham’s equation should give a fair idea of how much equity would be due.
Startup founders need to view equity compensation in much the same way as they see investment. The loss of salary for the employee should be viewed as roughly similar to the equity that would be given for that amount if it were put into the company by an investor. Founders should also be just as discriminative when it comes to giving equity to employers as they would be giving it to investors. But founders have a little more leeway when it comes to employees, who should be creating more value than investment money.
The same pitfalls apply as when negotiating an angel investment term sheet, so be wary. But get the sweat equity concept right, and incentivised employees could add significant value to your startup, while also doing well themselves.