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It is important to start a startup equity conversation. A dream of success and disruption often drives employees working at a startup at its very early stages, but that is not enough to ensure financial stability, especially in a recession. The following article is a startup early employee equity bible. Learn everything you need to know about startup equity compensation and equity for early employees and benefit from the expert opinion we share.
Imagine you work for a hot, up-and-coming tech startup in Silicon Valley, and on call over the weekend. There is a looming uncertainty about the company’s success. So much for being your own boss. If you lust a high-risk, high-reward lifestyle, you must know your worth as an employee and shareholder. Enter startup employee equity compensation.
Aside from the rush of building something off the ground, early employees are incentivized through equity for early employees compensation programs: a springy mattress to fall on in case all else fails. This means that all staff members become immediate shareholders in their company. In the circumstance that the startup is taken over by a private equity firm or sold to another corporation, the employees don’t leave empty-handed. But what is typical equity for startup employees? And what is equity?
According to Investopedia, equity is “the amount of money that would be returned to a company’s shareholders if all the assets were liquidated and if all the company’s debt was paid off”
Equity ownership in a business grants you a stake in the company, in the form of typical stock options. While initially, it may not hold significant value, the potential for substantial payouts arises if the company prospers. At scaleups like Adyen, a Dutch payment company, employees witnessed their equity soar into the millions as the company’s valuation skyrocketed. Starting in 2006, adyen is now worth €49.15 billion. Employees at such organizations are paper millionaires; a name for those who cannot readily cash out their stock options as their businesses remain privately owned. The value of the employees’ equity becomes tangible in the event of an acquisition, merger, or initial public offering, known as liquidity events. These milestones reward startup employees for their dedication and risk-taking, offering the possibility of eyebrow-raising seven-figure payouts, even with a small ownership percentage acquired during the company's early stages.
When startup founders embark on dividing ownership within their company, they must carefully consider three main categories: founders, employees, and investors. One crucial aspect is providing equity to startup employees to assign ownership. This involves allocating a portion of the startup's value to employees as non-cash compensation, granting them a specific percentage of ownership. Regardless of whether the company is a budding startup or an established business, this approach holds compelling reasons for startups, in particular, to adopt such a scheme. Depending on the volume of employees and cash flow, companies may opt for the following schemes:
Shares represent an immediate ownership stake in a company. When shares are issued and allocated, the employee becomes a shareholder with voting rights, entitled to dividends, and a share in the company's assets in case of liquidation or sale. For example, if Jip is issued 1,000 ordinary shares out of a total of 100,000 shares, he owns 1% of the company and has 1% voting rights and dividend entitlements. Shares provide shareholders with a tangible stake in the company, allowing them to participate in decision-making processes, receive a portion of profits, and benefit from its growth. In the early stages of a company, granting equity in the form of shares is common.
Stock options are a right to purchase company shares from the founder at a predetermined price in the future. This price is commonly referred to as the 'exercise' or 'strike' price. The whole idea behind options is that employees can wait for the shares to increase in value, and once they do, they can choose to buy them at a lower fixed price. Later on, they can sell the shares at the current market value, thereby making a profit from the price difference. It's like a win-win situation for the employees, allowing them to take advantage of the share's appreciation and turn it into financial gain.
Stock warrants are a type of financial instrument that grants the holder the right to purchase or sell a specific number of company shares at a predetermined price. Unlike stock options, warrants have a longer expiration period, allowing the holder more time to exercise their rights. However, it's important to note that warrants can only be exercised within a specific timeframe, typically between the vesting and expiration dates. This means that holders have the opportunity to buy or sell the shares at the agreed-upon price within that specific window.
The EMI share options scheme is created by HMRC (Her Majesty's Revenue and Customs) in the UK. It allows small businesses to give their employees the opportunity to own company shares with significant tax advantages. The scheme aims to support small businesses by making it easier to offer equity. If you choose the EMI scheme, HMRC will officially approve the value of your shares. This approval helps you set a fixed price for employees to buy the shares when they exercise their options. While the EMI scheme involves additional administrative work, the tax benefits for the business and employees make it worthwhile. Your business can deduct Corporation Tax based on the difference between the market value of the shares and the price paid by employees.
In the world of post-capitalism, everyone wants to be a private owner. In a rampant ecosystem, startups proliferate, startups become scaleups, and scaleups become conglomerates. For early-stage startups, larger corporate salaries pose a challenge, and many companies turn to equity as a means to attract top talent and bridge the salary gap. Offering employees a share in the company's ownership, in addition to competitive salaries, entices skilled individuals and instills a sense of investment in the company's success.
The prospect of potentially cashing in valuable shares for a substantial sum down the line is a powerful motivator for talented employees. While it has become increasingly common for startups to grant equity, this practice is not limited to a particular company size or stage. Any organization can choose to award equity as a way to align employees with company goals, foster long-term commitment, enhance team cohesion, promote a positive company culture, and attract high-calibre talent.
Distributing equity among employees juxtaposes financial rewards directly with the company's success, ensuring that personal interests are closely tied to the company's. This, in turn, promotes long-term commitment and encourages employees to go above and beyond their regular duties. Moreover, offering equity as a part of the compensation package can be a compelling factor for attracting top talent, as it demonstrates the company's commitment to rewarding and retaining valuable employees.
Before series A funding, startups have more leeway to be generous with equity grants. Typical equity for early employees in these early stages hovers around 1%, with the potential for even higher percentages for key hires or co-founders. However, there is no one-size-fits-all approach, and equity allocation depends on factors such as an individual's value and expertise. In certain cases, startups may be willing to negotiate a larger equity share to secure a pivotal employee who can drive transformative change.
Equity awards vary based on seniority and role within the company. At the director level, equity stakes typically range from 0.4% to 1.25%, while lead managers or engineers may receive 0.5% to 1%. Senior managers or engineers may expect 0.33% to 0.66%, and managers or junior employees could receive 0.2% to 0.33%. These grants reflect each individual's expected value to the business, with senior-level positions often commanding a more significant equity stake, such as up to 5% for a CEO.
As startups progress and secure series B and C funding, equity awards may become more standardized and focused on performance and seniority. The initial individualized grants may give way to a more generalized scheme accessible to all employees, with transparency in the equity levels assigned to different roles and departments. These decisions are influenced by factors such as revenue growth, increasing salaries, and the need for more structured equity allocation as the business expands.
Employees should be aware of a crucial stock option term that can limit their ability to convert equity into cash. For instance, in a conversation with an employee from a prominent European scaleup, it was revealed that the company only allows a three-month exercise window for stock options after leaving the organization. This means the employee is faced with the need to pay around €100k to purchase the options. Ideally, startups should offer an exercise window of at least five years to give employees a better chance of realizing value from their stock options. Additionally, employees of early-stage startups should be cautious of "buyback rights”, which grant companies the authority to repurchase equity from employees without their consent.
Want to know what the experts think? Then read on.
An important factor to consider when determining fair and equitable equity compensation in a startup is the level of risk associated with each team member's role.
For instance, if one employee's role is more hands-on with customer development, which can be considered atypically risky, then they may require a proportionately higher equity compensation than a back-end engineer working on code. The reason being their role entails more financial or reputational risks that, if not managed correctly, can drastically affect the startup's future success.
By taking this into account, companies can ensure greater motivation and retention from employees on uncertain terms while still rewarding them fairly for their efforts.
Tasia Duske, CEO, Museum Hack
Research and analyze market standards and industry benchmarks for equity compensation. This involves examining compensation practices in similar startups, considering the stage of your company, industry norms, and the roles of employees. Understanding the market context helps ensure that your equity compensation aligns with industry standards and offers a fair and competitive package to attract and retain top talent.
By considering market standards and industry benchmarks, startups can establish equity compensation structures that promote fairness, attract skilled professionals, and align with industry practices.
Samuel Fletcher, Co-founder, SupplyGem
A vesting schedule is a plan that determines when an employee can fully own the equity they've been granted. If you're not paying attention to the vesting schedule, there's a risk that employees could walk away with a larger piece of the pie than they've earned.
It usually spans over several years (like four) and has a cliff period at the beginning (like one year). This means that an employee wouldn't earn any equity until they've completed their first year of service. After that point, their shares would "vest" incrementally over the next few years until they're fully vested.
Johannes Larsson, Founder and CEO, JohannesLarsson.com
When evaluating fair and equitable equity compensation in a startup, it’s crucial to assess the company’s growth potential. Factors such as market opportunity, competitive advantage, and scalability play a significant role in determining the value of equity.
A startup with promising growth prospects is more likely to generate higher returns for its shareholders. By considering the startup’s growth potential, you can gauge the potential upside of your equity compensation and make a more informed decision.
If you’re in doubt, you can talk to a due diligence consultant to learn more about potential risks.
Tobias Liebsch, Co-founder, Fintalent.io
When determining fair and equitable equity compensation in a startup, it is crucial to consider the stage of the company.
In the early stages, when the startup is in its ideation or seed phase, the equity compensation should be higher for employees and early team members as they take on more risk and commit their time and expertise to build the company from the ground up.
On the other hand, in the later stages, when the startup has already established a market presence and a revenue stream, the equity compensation should be lower as the risk is lower and the business has already built value. By considering the startup stage, the equity compensation can be structured fairly and equitably for both the company and its team members.
Jefferson McCall, Co-founder and HR Head, TechBullish
A quick math lesson: equity is calculated by subtracting liabilities from the value of assets owned. As a company profits through inventory, cash, and accounts receivable, their assets also increase.
There is no better way to entangle the personal and the corporate than by giving an employee a feeling of ownership. The different ways a company may offer equity compensation include stock grants, stock warrants, options, and an EMI option. This aids recruitment, attracts talent, and creates an involved staff. This is not to say that employees can immediately cash in their stake; only in liquidity events, such as if a private equity firm takes over, staff may realize their ownership. There is quite a lot to know about private equity and venture capital. It is essential for both startups and employees to carefully consider the size of the option pool and distribute equity accordingly.
By understanding the dynamics of equity compensation, startups can effectively utilize stock options to attract, motivate, and retain talent. The success of equity schemes relies on clear communication and fair practices, but above all, the employees must be aware of their worth to a company and of their corresponding ownership rights.
