The equity granted to your team speaks volumes more than merely being part of the compensation. When building a committed, invested, passionate team, something which should be your paramount priority as a founder, nothing matters more than HOW you accomplish this.
Is your team comprised of investors or employees?
I want you to first ask and answer that question by warping your perspective of the term “investor” for a moment. I’m not asking you if your co-founder and employees are indeed investors, I’m asking you if they are investing their time in your venture. How do you perceive their contribution? In my opening paragraph, I intentionally used the term “invested” when describing what might be your team. Are they invested? I think of it this way and hope that you do too, people that work for startups are investors. Now, that’s a bold and potentially confusing statement as it minces words and might make one wonder if that means people working for you are indeed the investors. But that’s not what I mean. Consider the fact that nothing makes a formal investor any more an investor by definition than the mere fact that they gave you money in exchange for equity. Money, they earned, through employment (unless they have family wealth or won a lottery). What makes your initial team any different? Rather than investing their money directly, they are doing it indirectly, with their time and experience; often in the sense that you are underpaying what they are really worth as professionals for the simple reason that they want to invest in and contribute to the success of this venture. What do they get for that investment?
Is your team comprised of employees or investors? How do you perceive their role? Do you value that investment of their time? Perhaps even if you don’t value it, are you paying them less than market for their work? These are important questions that drive at your personality, your psychology, and the culture and organization that you’re building. Think of it simply this way before we really explore how you determine the equity to grant:
- Employees are paid a market rate for their work. You have no investment in them, as such, and you are both financially free and clear to part ways at any time. You’ve paid them a fair wage, their value. You have no other obligation to them but be clear about the implications of that: they have no other obligation to you.
- Investors give you something of value that you need in exchange for ownership in the business relative to the value of the business, their contribution, and the risk involved. Are people working with you not investing something? You are investing in them by way of their gaining ownership and they in turn are more committed, passionate, and involved in the success of the business because they own a piece of it through blood, sweat, and tears.
The critical importance of this question of equity is evident in those two distinctions: what commitment are you making to your team and how passionate and committed do you want them to be in what you’re doing?
“Wait a minute Paul, we do invest in our employees with on the job training, a great work environment, etc. We are loyal to our employees and they love working for us.”
All of that is well and good but such benefits are fundamentally intangible, without clear value, and short term. When dealing with the question of equity, you have to consider that equity establishes permanence in the form of ownership. The intrinsic and real value of such a thing requires much more consideration than simply asking, what is my company worth and what’s the standard grant for such a person?
Determining the Equity to Give Your Startup Team
Start by appreciating that the equity due someone has less (but not nothing) to do with their job and more to do with your stage, their role, their value, and the potential valuation of the company with which they can consider equity vs. compensation.
If you are seed stage or even earlier, the person gets more than were the case at a later stage. They are taking more risk and have a greater impact at this stage and thus, deserve more.
Disagree? I think you treat your team like employees and that has implications to their passion, commitment, and contribution. Are you paying them well enough? At a seed stage you are VERY likely to fail and the team contributing to your success is making a greater investment in that success than would be the case when you are more established. You are likely to completely fail under which circumstances, you all lose everything. You walk away with nothing. That’s a risky proposition for anyone contributing to your success and that risk warrants more investment in THEM to ensure they benefit in some way should you see any degree of success. If you aren’t paying them a market rate, they deserve more because they are investing their opportunity cost in you.
Are they considered a founder? C-level? Part time? Consulting or freelance? Or (god forbid), are you outsourcing? More to less, relative to my list. It has nothing to do with the job. The developer or marketing person doesn’t get more or less because of what they do, it’s the level of their involvement, their role, that matters.
If you’re outsourcing consider that the right answer is that they get no equity unless you aren’t paying them at all. Individuals who are building a company of their own are making their own investment, in their company. It’s a subtle distinction from consultants and freelancers who are investing in you but will forever remain free from you; individuals can be committed to you (and you to them), they get paid and earn ownership (though to a lesser degree, obviously, than full time employees) – outsourced companies are only committed to their business and you don’t want to mis-perceive ‘partnership,’ or non-compete as suggesting that they indeed care about your success as they are building their own company and will focus on the success of that first.
Their value is as a person with an industry standard compensation. That’s what they are worth. I appreciate that you think they are worth what you think your app is worth or what you are willing to pay to get something done but you can’t think that way when dealing with equity. A job that earns $300k is a person valued at $300k a year.
So, how do you deal with equity if you are only paying them $250k? What if you’re only paying them $100k? Now contrast that against the person who earns, given what they do and their experience, only $150k per year. They are intrinsically worth half as much so under paying them, paying our second hire only $100k when they are worth $150k is proportionally distinct from paying our $300k person only $200k. In both cases, we’re paying 60% of what they are worth but the higher paid individual, the person worth more is sacrificing much more of that value to invest in you.
The POTENTIAL Value of the Company
Having establish who is working with you and their value relative to your stage, the next decision is contingent upon what your company COULD be worth.
That’s a critical path to dealing with equity effectively. It is NOT based on what your company is worth. It’s not based on a perception of future valuation, alone. It is contingent upon being able to liquidate that value and if in the future you can’t exit in some way that they can get cash money for their ownership, their ownership isn’t worth much is it?
Is the company’s equity likely to be worth anything, when, and how much? This requires an exit (or IPO).
If your company won’t likely get acquired, can’t IPO, or you simply never want out, then equity doesn’t really have financial value, it has value in ownership. Be clear, might your company get acquired at any point in the future? Then it has financial value and you can you determine the value of the equity you are granting someone relative to that future value. The distinction is simply that instead of having equity worth something, they are effectively a partner. Begging the questions, do they get a say relative to their ownership?! If the answer is that it’s not likely worth anything and they aren’t considered an owner with an opinion, why would they want equity??
Balance all of those questions first
Notice we haven’t even talked about what you are willing to pay them, what you can afford, nor vesting and the risk of committing to someone. Before you can even start the conversation about how much to actually give them, you have to agree on your stage, their role, their value, and the potential valuation of the company in the future when it can be liquidated.
Now consider how much they should be paid for their job (cash money) and balance/negotiate with the equity. More equity if you’re underpaying, less equity if paying well.
What of a Cliff and Vesting?
One of the most under-appreciated considerations in an equity grant is that of when they get to start earning equity and over what time they get more. Most companies default to a standard 1 year cliff (when they start earning equity) and 4 year vesting (over what time frame and how quickly they get more).
You do NOT need to follow the conventional 1 year / 4 years and could cliff earlier (which might be worth something more to the person) or vest faster (same idea). For example, I’ve heard of companies letting people go after 11 months; getting from that person as much as they can before they get any equity at all. Nasty and unethical, no? But it happens. Why not set a cliff at 3 months and vest over a longer period of time? Value them more quickly so they are held in regard promptly but that doesn’t mean they have to benefit from the entirety of the grant moer quickly; stretch it out.
Consider that a seed startup takes years to be worth anything whereas a later stage company has a shorter cycle to some liquidity: at a later stage, the equity is worth something more quickly so giving it to someone, more quickly, might be worth more to them.
Point being, when the equity is “theirs” is also an important consideration as it conveys more quickly on your part, a commitment and investment in them.
Why Equity Matters
In mature startup ecosystems, I’ve experienced that there are standards, norms, to the equity grant relative to roles. C-levels at the Series A stage get X. It’s conventional. Does that happen where you live/work? If your local economy is still wrestling with these standards, you have an inefficient ecosystem in which everyone constantly needs to discuss, negotiate, and consider the value of equity before making commitments. That’s a burden on both parties and something that slows the pace of innovation.