Equity Compensation for Employees — Is it a good idea for Startups?
In case you are thinking of giving out equity to your vendor or employee, you should know everything about this before you do it. It is because this topic is multi-faceted. If you are giving a huge percentage of your company to someone, you are getting into a contract that is just like marriage. It is a long-term relationship between you and your partner or employee.
However, if you are offering an employee in your company with an ISO, then it is not the same as this. But giving them a share of your company is also a huge thing. You need to know all about it before you can just pick up a chunk of the company and give it out for some time. This article would talk all about equity compensation and help you understand everything better.
What Is Equity Compensation?
Let us begin with understanding equity compensation. To put it in simple words, equity compensation is non-cash pay that is given to the employees in the company as an incentive to work with the company. Equity compensation usually consists of options, stock grants and stock warrants. Each of these investment vehicles represents the ownership of the employees in the company.
These are incentives that provide the employees with a share in the profits of the company through appreciation. It helps in retention (mostly when there is a vesting schedule added to it) and encourages productivity. At times, for startups usually, equity compensation might accompany a below-market salary.
Equity Options: Stock Grants, Stock Options & Stock Warrants
There are three main kinds of equity options that can be offered as equity compensation to employees. These include stock warrants, stock options and stock grants. Each has its own benefits and demerits. So, do take the help from your lawyer before you give them out in your company.
Each has been explained to help you understand them a bit:
1. Stock Grants
Talking about the basics, one stock is a slice of the company. Each shareholder in the company has different amounts of stocks, that in turn, represent their ownership in the company. And when we talk about stocks as a form of equity given to employees, we refer to the stock grants. So, a stock grant is an amount of stock that is granted to the employee as a form of compensation. The stock grants are great, especially for the startup employee for three reasons:
- The early-stage startups can only share a small number of stocks. Due to this, a single shareholder would hold a huge chunk of shares.
- Being a shareholder, the employee would have some formal rights in the company.
- The employee can get the shares instantly, at the market price.
Nonetheless, this plan is bad news for the company since they do not just give shares of the company, but also the decision-making power. So, you will have to be sure of who you have on your team and who you are offering the stock grants to.
2. Stock Options
Stock options are something you might have already heard about as they are the most common kind of equity compensation offered to the employees in a company, especially the startups. It is basically an option given to the employees where they can buy or sell the company shares at a stated fixed or discounted rate. The employee getting the stock options means that they get a promise of purchasing the company stocks from you at a certain price. This is usually a better price than one could find in the market.
To give out stock options, you will need to create a plan where the price of the stock is specified (called the grant price) and the time during which the employee can exercise their options. This time is usually defined as the vesting schedule (explained further) and expiration date. An employee is not allowed to exercise their options before the vesting date or after the expiration date. There are two benefits of this plan — one is that you only give permission to purchase stocks and gain profits from selling them later on. You are not giving any power. Second, the employees can get their options after a given time, making them stick with the company for long.
There are two kinds of stock options: Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs). ISOs are available only for the employees and offer special tax advantages. NSOs can be given to the directors and consultants as well and they do not have to report to the IRS when they get this option or when it becomes exercisable.
3. Stock Warrants
Stock warrants are like stock options but have one main difference. The stock warrants give rights to purchase the stocks from the company, while the options give them the possibility to purchase the stocks from you personally. Although this seems like a trivial difference, the difference is a lot when you actually are using them. Employees need to pay for the rights that come with the warrants. So, if you use this option, you might not gain a committed team but would get capital for your startup.
What Is Vesting?
As shared above, there is something called vesting schedules that comes with the stock warrants and stock options that are given to the employees. The vesting date is basically the first date on which the employee can get their stocks. And the vesting period is the time before the employee can exercise their options or warrants. During this time, the employee would get parts of their total stock quarterly or monthly. And all the stocks then would be fully vesting after the vesting date.
The vesting schedule can be of 3 to 5 years and can have many rules added on to it for the employees to fulfill. Some plans have a “Cliff” period as well, where for a specific period of time initially, the employees would not get any stocks. For example, in a 4 year vesting plan, the first year would be the cliff period, and the employee would begin getting portions of their total shares after the one year. The portions would keep coming in quarterly or monthly as per the plan.
Why Offer Equity to Your Employees?
Well, there are many great reasons why you should offer equity compensation to your employees especially if you are a startup and do not have much funds to give great salaries. These include:
- Reduces burn rate & keeps up team quality: Being a startup, you obviously wouldn’t have so much to pay high salaries to the best talent. This leads companies to hire junior employees, which then leads to poor performance. This option would help you hire the senior employees at the cost of junior ones and offer them stock options as well.
- Offers a sense of ownership to the team: Giving employees equity compensation makes them feel like they own a piece of the company. This changes things where they begin to take decisions for the betterment of the company. And this obviously increases productivity and even brings in a lot of more growth for the company.
- Injects loyalty and filters unfit talent: When you add the cliff and vesting period in the plan, you will have the employees working on the projects for a year at below-market salary. This can help you see if they are fit for the job (as they would leave on their own). Plus, you lose nothing! And the ones that stay would become your long-term partners.
How Much Equity Should You Give Out?
Well, you do not want to give out a lot of equity to the employees in your company, obviously. So, it is important to keep a formula in mind that would help you see who to give and how much to give. To help you, here is a formula that can help you in obtaining the final amount of equity to give.
Role % / Risk Factor + Seniority = Number of Shares You Should Give
To break this and make it easier:
Now explaining each factor.
First, you need to decide which positions are crucial for your business and assign a percentage value from 0 to 1. For instance, if your product is a software, the product manager is the one who is the most important followed by the rest. This person can have 0.7%.
When you join a company of three or four, the risk of failure is high. The risk factor can be calculated based on the size of your company using multiples — 6 people have a value of 2; 15 people have a value of 3 and so on. So, if the product manager joins the company where there are 22 people, the risk factor would be 4.
Think a bit and evaluate what the seniority levels in your startup are. And even if you want to believe in flat hierarchies in a startup, there still are differences in seniority level to take into account. Additionally, you can add a value member to each seniority level such as 0.1 for senior, 0.2 for lead, 0.3 for director and so on.
At the end, just ensure that you are not giving too much or too less of the equity compensation to your employees.
Equity can be the very thing in helping your startup reach the top, but only if it is used in the right way. The formula shared above would help you a lot. Just choose the right plans and get your calculations right. Rest all would then fall in place properly.
And don’t forget, if you are about to give out equity to your employees or even to investors, it is crucial for you to keep a track of all of the equity. The best way to do it is through a cap table application. Eqvista is a great application that you can use. It runs on advanced technology and would help you manage and track all the shares in your company.