How much equity should you give your startup’s first employees?

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Chris Wentz has been through several hiring cycles at his universal smartkey technology startup. When he founded EveryKey in 2015, he consulted with advisors and early investors before landing on an employee equity plan. He decided to offer 1% of equity for each non-founding hire in the first batch—a fairly standard going rate. He then offered half that amount to each new batch of hires. The second group would get .5% each, the third would get .25%, and so forth.  

 While Wentz landed on a simple formula, for many founders, determining how much equity each early hire should get isn’t always so clear-cut. David Steinberg is the founder of Zeta International, a strategic marketing company. “This is much more of an art than a science,” he says. “You want your people to be partners with you and be really motivated.”

 Here are seven key factors to keep in mind when thinking about how much equity to give your first 10 employees.

Always have an option pool

 This is your first step when you’re thinking about equity compensation, and founders should do it as early as possible. An option pool sets aside a chunk of equity for employees right up front. It also helps evenly spread out the dilution of each shareholder’s ownership as the company grows. Understanding how option pools work and why they’ve been growing is critical, as they will affect dilution.  

Employee option pools can range from 5% to 30% of a startup’s equity, according to Carta data. Steinberg recommends establishing a pool of about 10% for early key hires and 10% for future employees. But relying on rules of thumb alone can be dangerous, as every company has different cash and talent requirements. More important, Steinberg says, is understanding your hiring needs. How many and what type of employees do you plan to hire before you go back to investors for more capital?

Think about salary and equity together

Equity is only one part of an employee’s compensation package. Its other main component is salary. Working for an early-stage startup often means agreeing to a pay cut or a below-market salary. The bigger the gap between the salary you can afford and the market rate, the more equity you’ll need to offer to make a compelling offer.

“What’s the cash consideration an employee is giving up to work with you?” says Steinberg. Say, for example, you want to hire an employee who was making $180,000 a year. If you can only offer them a salary of $120,000, you’ll have to make up that gap by offering more equity. 

Sometimes those tradeoffs are significant. Wentz says that an early employee at EveryKey was willing to forgo a salary entirely for the first two years. He rewarded that employee with an outsized equity grant. “They got a significantly higher percentage of equity than somebody taking home pretty close to their market rate in salary,” he says.

Employee number is essential

A critical criteria for determining how much equity an employee should get is how early they join. Those who join earliest are taking on the greatest amount of risk and usually agreeing to a lower salary than they might get elsewhere. They expect—and deserve—a commensurate reward. “A lot of companies that are successful focus heavily not just on title but on employee number as well,” says Steinberg. “The receptionist who has been with Microsoft since they started probably made more money than the SVP they brought in last week.”

Levels and fields matter, too

The skill set and value a new hire brings to a company is also very important. If you’re bringing in a C-level executive or top engineer as one of your first hires, those roles will command a premium. A junior employee can expect less. Understanding the level of each of your first hires will help you plan your overall compensation package.

The field each hire works in matters, too. Steinberg says it always made sense for him to offer bigger equity packages to strong engineers who could build complex products. Because candidates with considerable engineering and product experience are often in high demand, they tend to expect the largest equity grants. In other roles, such as sales, the expectation is likely to be more cash and less equity.  

Demonstrate the worth of your equity

Ultimately, all these considerations about equity percentages have to be grounded in the value of that equity. “The sooner you can find some kind of valuation for your company, the easier this exercise becomes,” Wentz says.

Of course, at the early stages, a startup’s valuation merely reflects investors’ opinion of its worth. Typically, its equity is not readily tradable. While employees and founders all hope it will be worth much more later on, they understand that the value of their equity could dissipate if the startup doesn’t make it. But a valuation can serve as a concrete starting point for both sides to evaluate equity grants.

If, for instance, you raise angel money on a $5 million valuation and bring on an employee who is taking a $100,000 annual pay cut, you can then do the math to determine what $100,000 in annual salary would translate to in equity. “It’s always important to have a rationale behind the equity you are giving,” says Wentz.

Prioritize transparency

Regardless of how much equity you decide to give, make your rationale clear to employees from the start, says Joe Beninato, who has founded four tech companies and was one of the first employees at four others over his career. “It’s important to be equitable and transparent about what’s happening,” he says. “That means telling them, ‘We have set aside this much in a pool and you are either getting X percent of the pool or Y percent of the company—and we think that’s reasonable or higher than market rate.”

Have a contingency plan in place

One of the biggest mistakes founders make is not planning for the unexpected. Employees and even founders may decide—or be asked—to leave a startup prematurely. Discussions around what happens to their equity can then quickly get messy. Steinberg says a vesting schedule and a buy-sell agreement will clarify the process for everyone.

 Wentz says that a typical vesting schedule is around four years with a one-year cliff, which is when the first portion of an employee’s equity vests. A buy-sell agreement is a legally binding contract that requires the departing employee to sell their equity back to the company at a predetermined price and can help avert messy disputes.

 The reality is that founders have many things to worry about when they’re starting their companies and don’t always think through all the potential scenarios. “First-time founders are just trying to get things going,” says Steinberg. That can come back to bite them, especially if their dreams come true and their startup makes it big. “At the end of the day, people don’t think about what happens if we win,” he adds. 

But if you have a plan in place, you can mitigate potential downsides. “Whenever somebody with an appropriate vesting schedule and cliff decided to leave the company, I’ve never felt regret at the equity they walked away with,” Steinberg says, “because that person put in the work,” he says.   

DISCLOSURE: This communication is on behalf of eShares Inc., d/b/a Carta Inc. (“Carta”).  This communication is for informational purposes only, and contains general information only.  Carta is not, by means of this communication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services.  This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests.  Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor.  This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein. ©2021 eShares Inc., d/b/a Carta Inc. (“Carta”). All rights reserved. Reproduction prohibited.

 

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