October 20

Equity Compensation: The Key to Luring and Keeping Top Talent, But How Do You Slice the Pie for Future Payoff?

Early stage start-ups rarely have the budget to hire a dream team. So they lure top talent with equity compensation, a chunk of company ownership, that will offer new hires the potential of a lucrative payoff at a future date.

Sure, equity compensation helps you discourage your new team—the founders, advisors and employees—from bolting for greener pastures and a higher salary elsewhere. But it’s hard to project the long-term implications of the compensation decisions you’re making in the here and now. Factor in all those details about complex securities law, tax, and accounting implications and you’ve got your work cut out for you. What’s more, fall short in your calculation, and you could end up with steep IRS penalties and possibly in court trying to avoid even more negative consequences.

Things happen. The future trajectory you’ve set your sights on for your company could turn out worse or better than you’d expected. What if when stock options become vested your bottom line isn’t as robust as you’d planned. On the other hand, consider a brighter scenario when your company does so well that the 10% stake promised to a senior team member cuts a larger slice out of profits that you’d like to keep in the company coffers.

You need to put in the hard work before you onboard your team. Understand the various options such as deferred compensation mechanisms and the legal and tax implications for both the company and your employees. Having an experienced attorney and tax advisor on hand to help you strategize is also key. You can’t allow your eagerness to get in the way of your compensation calculation. You must understand as precisely as possible how the equity you promise today will impact the value of what you’re giving away tomorrow.

Feelings Don't Count

It takes more than a feeling about how your new venture will fare in the future to figure out how much of the pie you should give away. Talk feelings. You’re emotionalizing how much any individual’s contributions will be worth when the company reaches a milestone. How accurate can those feelings be when there’s so much more to consider like the  internal and external variables to a company’s success journey.

When it comes to the founders, for example, some business experts recommend a technique called “slicing pie.” The method frowns upon the focus on an unknowable future. Instead, it determines your split based on what everybody is willing to invest at the start. It’s a lot like blackjack, if everyone places the same bet, their returns are equal. But those who bet more, get a larger piece of the pie.

Drill down from founders to other sought-after employees. More factors come into play:

  • Timing   The early team you put together should definitely get more stock than employees who onboard later. Is a key hire a third person who joins your two-person team—in  which case he or she may be considered a co-founder—or the head of sales or marketing hired once your start-up has a product or service to sell and promote. The difference in equity may range from a 10% stake for the third founder to 1% or 2% stake to the sales and marketing head. The experience of the person also factors into that percentage differential.

  • Risk – There’s a huge difference between the person among the first three team members of a start-up and a person who’s number 50 to onboard. Risk is the value that takes that timing difference into account. Some experts suggest that you calculate the risk factor based on the size of the company at the time the employee is joining. For example, a six-person firm might have a value of two, 15 a value of three, 30 a value of 4 and so on.

  • Position and Seniority – While every team member is important, there are clear factors that you should take into account and quantify. There is a distinction to be made, for example, between a senior engineer in a tech start-up or an experienced business development employee. While the senior engineer may get as much as a 1% stake, the business development individual may be given only a fractional cut. Similarly, an engineer coming in at the mid-level may be awarded .45% as opposed to .15% for a junior engineer.

  • Titles – Be judicious in awarding titles. Sometimes there’s a tendency to inflate them. That can cause skewed perspectives about degrees of contribution to the success of the firm and open the door to ill-conceived entitlements.

  • Advisors and Directors. You will also want a mix of talent, including experienced people who don’t come to work for you full-time. These are the advisors and directors who might have knowledge of your start-up’s industry sector and whose guidance may contribute to your company’s success. How do you evaluate their slice of the pie?

Vesting: A Timetable for Gaining Rights to Their Stock

Because equity typically comes in the form of stock options (See attached infographic)how these options are granted or exercised also becomes an important part of your calculation. The term vesting refers to the means of gaining right to exercise a stock, or the first date the employee can retain their stock. A vesting schedule provides the timetable in which the employee gains the rights to the options. 

Vesting is important because it keeps the employee engaged and focused on helping the company over time.  Rather than granting stock to a new employee all at once, the employee invests time and energy into the company and, in return, receives stock pursuant to the vesting schedule.  Vesting can occur in many ways, either linearly or nonlinearly over time (months, quarters, years), or at certain pre-defined company milestones (e.g., your subscriber base reaches a certain threshold; sales reach certain revenue thresholds). This incentivizes employees to commit with sweat equity long-term. 

Vesting schedules are also important in seeking future outside financing. Vesting schedules signal to investors, partners, shareholders, and other stakeholders that the founders, too, have a long-term commitment to the company.

No One Size Fits All With Vesting

There’s no one-size-fits-all approach to establishing a vesting schedule. The common vesting schedules seem to fall somewhere between three and five years. Most employees, however, are subject to a cliff period during which they will not receive any stock options. Typically, a cliff period is the first year of employment. In the period during which employees are not receiving stock, they are incented by the promise of receiving stock once their vesting period does start. In other words, the longer they stay, the more their gain, making vesting a hook that keeps employees engaged.

Giving out equity may seem like the best course of action to get your new venture off the ground. But, as always, there are unique circumstances surrounding your company—your industry, timeframes, business model and need for seed money from investors down the road, etc. Those variables require that you seek professional guidance from your attorney and accountant.

At Garza LLC, we’re committed to helping you attract talent now and retain top talent for the future. We can provide the guidance you will need as you evaluate various equity strategies and navigate the maze of securities and tax law.

Call us at 208.557.8705 and let us help you develop a plan to attract top talent today that also makes long-term sense for your company.

You may also like