Deciding how much equity to offer your startup’s team members is confusing and easy to get wrong. Because each startup is different, and each person joins in a different situation, there are no one-size-fits-all rules. To make good decisions, you’ll need to understand the considerations.
There are several ways to grant someone an equity interest in a company, including outright grants of Common Stock, grants of Common Stock with restrictions that allow the company to repurchase some or all of the stock subject to a vesting schedule (RSUs), stock options that give someone the right to purchase stock in the future, and warrants (which are also a future right but which are not typically used for compensation and thus won’t be discussed here). Common Stock and Restricted Stock both represent actual, immediate ownership in the company, whereas options and warrants—while conveying certain economic rights—do not represent actual ownership in the company until they are exercised.
Stock grants for founders
When you first incorporate your venture, you establish the structure of the company, but no one actually owns any of it until the board of directors (a) authorizes a fixed number of shares of stock, and then (b) issues (or “grants”) some of those shares to specific people. The most important of those numbers is not the authorized amount, which will typically be 10 million shares for a high-growth startup, but rather the number of shares actually issued. If, for example, you grant yourself only 1,000 shares, but that’s the only grant, then you will own 100% of the company.
There are two crucial things to keep in mind when granting equity to yourself and your co-founders. The first is that everyone must be subject to reverse vesting. This means that although each founder is getting stock at the beginning, their right to keep that stock depends on their staying with the company. (The last thing you want to do is to incorporate a company with a co-founder, issue them stock, and then have them leave the next day.) Reverse vesting means that the company has a declining right to repurchase some of the founder’s stock for the same price that was paid for it (i.e., pennies), if the founder leaves for any reason.
The second thing to understand is that the relative number of shares that each founder is granted should be based on looking forward, not backward. That is, shares should not be allocated in direct proportion to ‘hours of work’ or ‘foregone salary’, but rather ‘how vital will this person be to adding value to the company as we move forward?’
Once your core founding team has determined its appropriate equity allocation, you are all set, until the time comes to hire the company’s first non-founder employee. Even though this person (or people) will be paid a salary, all of the same benefits of equity compensation—including both rewards and incentives—apply to them as well. But rather than granting them Common Stock (often called Founders’ Stock), industry best practice is to grant their equity in the form of stock options.
Option grants for employees
Stock options represent the right to purchase a specified number of shares of Common Stock at a specific price representing the market value of the company’s stock at the time of grant, regardless of whatever the market value of the stock will be in the future when the options are exercised. Options are typically used to grant equity to people who are not founders or investors, and come in two forms that relate to their tax treatment: Incentive (Qualified) Stock Options, or ISOs, and Non-qualified Stock Options, NSOs or NQSOs. Startup equity incentive plans typically allow for grants of both flavors, with the specific situation determining which one is used.
Because the company needs to be able to sell the appropriate shares to the employee once the options are exercised, those shares (1) need to exist, but (2) be reserved so that they are not sold to anyone else. This is done by allocating a specified number of shares of Common Stock to an Option Pool, where they are held by the company (and recorded on its capitalization table) until the options are exercised. Because the shares ‘exist’ (even though no one yet actually owns them), they have an effect on what percentage of the company other shareholders (such as founders and investors) own.
One good reason to keep the option pool relatively small is to prevent unnecessary dilution during funding, as Babak Nivi noted in his 2007 post “The Option Pool Shuffle.” To do so, you’ll need to consider a few things: who do you need to hire before your next round? How much equity will you need to offer to hire the right candidate? And, by multiplying those numbers together, how many options will you need available?
Let’s say that you have a co-founder and want to hire a non-co-founder developer. How much equity do you give them? Leo Polovets of Susa Ventures suggests offering between 1% and 2% for a lead developer, based on data from Silicon Valley early-stage startups. Fred Wilson of Union Square ventures has posted an entire free, online class where he goes into great detail about structuring employee equity, which is definitely worth watching.
What about advisors? Gil Silberman, a startup lawyer, suggests advisors (who are not board members) should get anywhere from .1%-.25% based on his experiences with many startups. Remember, though, that these numbers are just a guide. You may choose to increase the percentage to as much as 1%, depending on how much you are engaging your advisor, which may be quite a bit, especially in the beginning.
The primary takeaway is that you’re basing these percentages (which only represent the person’s share at a specific point in time) on value and fundraising criteria rather than when someone joined your company. Once you start hiring non-founding team members, you want to ensure that you’re not doling out unnecessarily large percentages of equity simply because that person came on board early.
Here’s how the option pool works in the context of fundraising. Typically, the unissued shares in your pool would account for somewhere between 10% and 15% of the post-money value (what your company is worth after investment closes). Let’s say that the shares you issue to your founding team represent 90% of the value of the company, and you then create an option pool to which you assign 10% of the value. (Note that neither of these has anything to do with “authorized shares’. It just means that however many shares are allocated to the option pool, nine times as many in total have been granted to the founders).
Now it comes time to hire your first few employees, so in addition to their salaries, you grant them (in total) half of the pool that you have reserved for options. You now have 90% of your fully diluted ownership in the hands of the founders, 5% (in the form of options) in the hands of your first employees, and 5% of your fully diluted ownership remaining in the pool in the form of unissued options.
That’s fine, until it comes time to raise money from outside investors. In conjunction with a fundraising event, your investors will typically require a +/- 10% pool of unissued options be available after the funding. So let’s say that your investors are purchasing shares equal to 20% of the company’s valuation. This means that you actually have to reserve more than 10% for the option pool from the ownership of the company before the investors put in their money (that’s why this is called the pre-money valuation). In this case, the amount will need to be 12.5%, in order to ensure that it is 10% after the investors’ shares come into play and dilute everyone who had shares before that time.
It’s important to understand that you won’t be creating a “new” option pool each time you fundraise. Instead, you will have to refresh your current pool by authorizing new shares so that it is equivalent to 10% (or whatever percentage you had to reserve after the investment) of the new post-money value. The graph below shows the relative percentage of equity holdings before, during, and after the investment.
Option grants for contractors
If you hire contractors in the early stages of your startup, you might be tempted to offer them equity in exchange for their services. While this sounds good because it can save you cash, it can actually be problematic. That’s because neither of the two main goals of startup equity apply here: equity-for-work is not a reward for making the company more valuable over the long term, nor is it subject to a vesting schedule as an incentive for someone to stay with the company for the long haul. That said, sometimes it may be unavoidable, and in this situation, it’s important to note that your startup can’t issue ISOs to contractors. There are also several things you should consider: how long will they be contracted for? What level of expertise are they providing? What is the market demand for their type of expertise? How much work are they going to be doing?
Determining equity stakes for contractors can be harder than employees because, unlike employees, contractors are usually hired for a specific project or designated period of time. Their commitment level is going to be different, and your control over their work significantly less. For each contractor, try to set your baseline as the minimum amount you need to offer that contractor in order to incentivize them. With that in mind, you’ll also need to take into account the fact that equity has more of a risk factor than cash incentives. What percentage you ultimately land upon will depend on how valuable the contractor’s work is to your startup and the market demand for their skillset.
However you decide to handle contractor equity, ensure that you properly distinguish contractors from employees. Otherwise you might run into a host of tax problems later on. Further, you should treat your contractors as individuals with different rates and requirements, rather than trying to apply a specific percentage of equity to all contractors that you bring on board.
Figuring out how to distribute equity is complex, no matter how you slice it. Here are a few key points to keep in mind:
- When granting equity at any level, work from a value mentality and not just a “who came first” mentality.
- Make clear distinctions between positions in your company, and understand individual roles and contributions. But also understand how certain decisions, like the size of your option pool, can affect all players.
- Have as much foresight as possible. Take into account all possible events such as fundraising, dilution, and changes in hiring needs.
The most important thing to remember is that dividing equity is not an exact science, and what works for one startup may not work for another. So make sure you do your research, talk to an expert, and plan ahead for the next 12-18 months as best you can.
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This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.