Most people who join a startup are the type of people who will put in 80 hours a week to avoid a 40-hour work week. They’re in for a penny, in for a pound -- they're physiologically and emotionally committed to a venture.
Before the companies in Silicon Valley (the HP’s, eBay’s and Cisco’s) began the practice of granting stock options to regular employees as a way to reward people for their loyalty and efforts, it wasn’t something most companies practiced.
Today, the equity culture among growing companies -- particularly those in the technology space -- is now universal. When it’s done right, it can do a few things, like:
- Cover any downside of the opportunity costs taken by employees
- Align the risk and reward of employees betting on an unproven company
- Reward long-term value creation and thinking by employees
Even though the practice is so widespread, many startups still fail to put in place an equity compensation plan that adequately rewards its employees over time.
Some even put it off until it’s too late, and for David Willbrand, this move is concerning. As a seasoned VC and emerging company attorney, David has seen this mistake rear its head time and time again. Based on his observations, this hesitation to face an uncomfortable issue early on tends to cause problems down the line as startups grow.
Here’s a quick start guide to the number one mistake most founders make, and some best practices to keep in mind when it comes to building compensation benefits.
Waiting to begin is the #1 mistake many founders make.
We all know time is a precious commodity in early-stage companies.
In the day-to-day at a startup, waiting – on any account – can come back to bite founders in the behind. When it comes to compensation packages, it can be very irritating to people (employees) to not get the full economic value of what they bargained for.
Unfortunately, this happens routinely.
A founder hires someone and they wait days, weeks and months before addressing compensation plans.
“There are lots of legal issues to kind of ‘punt-on’. Internally, there are lots of [legal] things that can be fixed . . . there are lots of things aren’t so urgent they have to be dealt with right away. You [as a founder] have to make the hard choices because there are only 24 hours in a day," said Willbrand.
“But, when it comes to equity, you have got to do it immediately. Whether they’re getting restricted stock or stock options, it is calibrated against the fair market value of the company today,” says Willbrand. “If you wait -- and companies do this all the time -- it's costly. I’m not going to say you can’t fix it, but it’s going to cost you 10 times as much and it’s going to be a hack, not a good fix.”
Fair market value and figuring it out
Generally speaking, stock options are treated as non-qualified deferred compensation if the stock options have an exercise price that is less than the fair market value on the date of the grant.
With that come several rules, including but not limited to :
- The exercise price must be at least equal to or above the fair market value (FMV) of the underlying shares as of the grant date;
- The number of shares subject to the option must be fixed on the grant date of the option; and
- The option may not include any additional feature such as an exchange for other deferred compensation or material modifications for the deferral of compensation.
The danger in waiting on putting this to paper, is "you have to price the options at that new value," says Willbrand.
Where you see things truly become horrific is in the context of an IPO.
"In that process, you hire people more quickly and the value of a company races up real fast. Companies going through this are required to complete a 409a evaluation every month. And the value goes way up," stated Willbrand.
“It’s really bad and it’s very hard to unwind that and get back to where it was. You’ll have to spend some serious money on compensation lawyers in the process. It can become a financial and legal nightmare—one involving very expensive lawyers to fix.”
The best advice for any founder is “the minute you have a handshake on a new hire, call your lawyer and get the option papers papered ASAP," he says.
Best practices when calculating early-stage benefits
“If your early hires don’t have to take a paycheck for a while, they’re not going to take one for a while. They will make all the sacrifices you make as a founder and that’s what the equity is about,” he says.
David always suggests starting any conversation by asking yourself or your founders “Are you hiring someone who will be a co-founder, an executive or a key contributor?”
“Founder” has no legal meaning, it’s an existential concept -- it’s not a role. “When someone says they’re a founder you don’t know what they do but if someone is a CTO, CFO, the answer is usually more clear,” David says. “If the answer is “I’m hiring a co-founder” then the conversation to have with them is that this person is going get at least 20 percent of the company and what comes with that are realistic and measurable expectations."
Most companies put considerable effort into the size of their equity grants for new hires, and there are several tools out there to help calculate this, but when you build out the equity distribution for your hires these are the common things to consider:
- How attractive your company is
- What role you’re hiring for
- How difficult it will be to hire and retain someone
- Domain expertise in your new hire
- Their connections
- Experience with related ventures
- Ability to make significant contributions
- Replaceable - are there lots of other people out there who can do the same thing.
- Part-time vs. Full-time - doing something on the side is less valuable
Pre-Series A: David's Notes
If you tell your employees to think like a founder, then you need to consistently align equity with their contribution to the success of the company.
"I see gamesmanship come into play in this stage," Willbrand says. "A CEO will usually come in at 3 percent instead of 1.5 percent. The notion here is that the person isn’t a co-founder, but it's pre-series A, so it’s still a very fragile enterprise. As a consequence, they take a lot of risk getting into it and they should probably should get a little more equity."
Series A+: David's Notes
"I see the percentages stay pretty steady after Series A, B, C, etc. and you'd usually offer a CEO 6 percent here," says Willbrand. "Those stages band somewhat close together and you won't see a CEO come in at Series B at 15 percent and then 2 percent at a Series D. That’s not the way it’s going to swing."
- Manage the equity pool like you would a budget. As your company grows, you can figure out who you need to add to the team one or two years down the road. Having an idea of who you need to hire means you can start planning and setting aside a percentage of equity for your first few hires. Ultimately the founding team should retain 50 percent ownership of the company. As you bring people on, you can look to offer options as a percentage of base salary and depending on the job function (marketing, engineering, customer service) and seniority (C-level, director, mid-level, entry-level).
- Research competitive salaries and industry compensation. With your list of key positions in hand, check out some salaries and what normal equity offerings are for those roles. Check out salary websites with free and low-cost subscription services.
- Work with a good venture attorney. This isn’t the time to work with your family’s friend’s third cousin who is an IP-law attorney but could possibly figure out how to help you think through your options approach. You want to work with someone who specializes in venture law. When you make any decision involving equity, always run it through a trusted and experienced advisor.
Other Benefits to Consider
Benefits can become an extension of a startup’s culture and are used in all recruiting efforts—for current and potential employees. While equity should be part of the package, no matter the size of your business, you can also focus on less-pricey and still valuable perks that make your company more attractive.
This doesn't necessarily mean you have to offer elaborate company outings (Airbnb offers a $2,000 travel stipend to all employees, for example). This could include things like allowing pets at the office, gym memberships or catered lunches. This also includes benefits that don’t cost anything to you or your business like a 401K, flexible remote-working options, wellness exchanges, and health insurance (HSA). You can even bring in financial advisors to come to talk to your employees about managing funds for free.
In the End
Early-stage companies don’t usually have compensation packages as lucrative as big companies but can offer flexibility and opportunities that make the difference acceptable.
The one thing to keep in mind is that equity is a privilege. “Most people in my experience, in the midwest and east coast, they are paying some version close to market value. The stock you get is there is compensation -- but it’s also an expression that stakeholders want you to stay committed. This isn’t a 401k match. This isn’t a bonus. Those are meaningful but there’s a legacy all for one and one for all. You should treat it seriously. You’re being invited to this club.” said David.