Whether you’re a brand new startup trying to put together your initial team with limited cash on hand or a seasoned enterprise looking to reward key personnel for their contributions, handing out equity in your company can be an extremely effective method. Determining how much to give is a whole other question with many possible answers.
To simplify things a bit, consider that equity can be represented in basically two formats, a percentage of the company or a quantity of company stock. At the initial stages of a startup, it’s more common for the first 5-10 employees to receive their equity in terms of percentage points (i.e. 1%,2%, 5% or whatever you choose to hand out). This is extremely expensive for the company, and this practice of handing out equity on the basis of percentage points should only be used sparingly. Because you don’t yet have a strong understanding of your company’s potential valuation, these percentages can translate into substantial, and unintended, dollar amount down the road.
As the startup grows and establishes itself, you can start to take a much more measured approach towards employee equity allocation.
The Startup Equity Equation
Paul Graham, and his popular equity equation, proposes that you should first estimate how much the output of your company will increase by hiring that employee and use that as the basis for calculating the amount of stock he/she should receive.
i = 1 / (1 – n)
n = (i – 1) / i
In this equation, ‘i’ is the value of the company after the hire. So for example if you a feel that an employee will help raise the output by 20%, then i becomes 1.2. Solving for ‘n’ will reveal the amount of equity that employee’s contribution represents.
1.2 = 1/(1 – n)
n = (1.2 – 1) / 1.2 = 16.7%
Hence, the most you should allocate to him is 16.7% in company equity. In other words, if you traded 16.7% of your company’s equity to acquire the employee, you would break even. At this point, you’ll need to decide how much you’ll want the company to ‘make’ on the deal. For example, if you want the company to double its money on each dollar it spends on labor, you would set aside half of the 16.7%, leaving you with 8.35% to compensate the employee.
Base salary, payroll taxes, insurance and general overhead should be deducted from this 8.35%. A good rule of thumb is to use 30-50% above the salary for the employee to represent their total overhead expense to the company. Divide this amount by the total company value and subtract that from the equity you allocated to compensate the employee.
For example, if the employee in our scenario had a base salary of $100,000 and the company was valued at $2 million, the estimated total cost would be about $130,000 – $150,000, which translates to 6.5% – 7.5%. Taking the median of 7% and deducting this from our 8.35% allocation, the new employee can be offered up to 1.35% in additional company equity.
Put a Dollar Value to Equity Holdings
Another well respected method that is followed by consulting firms advising companies about to go public is to put a dollar value on the amount of equity being offered to their employees. This helps them get a tangible idea of the value they are receiving.
The way to go about this is to divide your employees into brackets of seniority/importance. Each bracket or tier is allocated a factor, like 0.5x for the top most tier, .25x for the second, 0.1x for the third and so on. There are no limits on how many tiers to use or how to determine the factors.
Each employee in the bracket has their base salary multiplied by the factor for that tier. For example, a person in the top tier earning say $175k is eligible for equity of $87.5k. This value is then divided by the current value of your company and then multiplied by the total number of outstanding shares.
If the value of the company is $25 million and 10 million shares have to be given out then, a person in the top tier gets, $87.5k/ $25mm x 10 million = 35k shares.
This method gives employees with a fixed quantity they can refer to and, in conjunction with the value of each share, assess the amount they stand to earn with the IPO.
Should You Value Risk?
There is also the question of a valuation of the amount of risk that your key employees have taken by joining your startup and the opportunities that they have forgone by declining jobs at established companies.
There is inherent risk in taking equity as a part of your compensation instead of cash. Simply translating that cash amount into an equity share doesn’t fully represent the situation since the employee is also exposed to the risk of getting less or nothing at all if the venture fails to achieve the expected results. As a bootstrapped startup, it is in your interest to keep cash outflows as low as possible while you ramp up, so offering a ‘risk premium’ to early employees can make a lot of sense.
One of the biggest advantages in allocating value to risk is that those initial employees are more invested in your company’s idea and have a stronger motivation to see it grow and succeed.
How much is this risk worth?
A myriad of factors goes into determining the proper value for risk. Your market position, the buzz your startup has generated, the viability of the concept, interest from venture capitalists, and so on. The average premium for substituting equity for cash is typically 20%. However, the more you displace cash, the higher this premium tends to increase.
The amount of equity key startup employees should get remains, as Fred Wilson states in his article Employee Equity: How Much?, more of an art than a science. In the end, founders of fledgling startups must sell their dream and vision to their team and inspire them to take the plunge with them all the way to the finish line.