How to Allocate Equity in a Startup?

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I might be building a new team for the new company. While I’m a little reluctant to do so because it’s always a risk, I do miss having people I can count on and who are pulling for the work we’re doing. Teams can be great (and they can break down, as well–a subject for another post).

So a question I get from entrepreneurs is how to allocate stock. There are a lot of other posts about this, so I’m not going to do into great detail here (just Google “startup equity employees” and “Feld startup equity”). But here are a few thoughts.

Don’t be greedy.
There’s negative dilution and positive dilution. Positive dilution is when you give stock or options and are diluted as a result, but the person creates more value than the cost of the dilution. Negative dilution is when the contributor doesn’t increase the overall value of the company, or worse, hurts it.
Create a formula for “deferred” pay. There’s really no such thing as deferred pay. There’s pay not taken, and if it gets made up in the future, it is through bonuses, salary increase, or equity. If an employee takes less money for the same work, I value that more highly than the cash value and will give that employee more for their deferred salary in equity than the dollar value. Early on, 50% discount on equity makes sense.

Don’t value your own company. You have no idea how much your company is worth. It’s not a million. It’s definitely not $5 million. You don’t know until someone pays money for stock.So if you don’t know, then don’t allocate shares according to number of shares, allocate based on percentage of ownership. For the first 10 employees, don’t allocate less than 1% per employee, and give key employees more. If you have 3 key employees (not including founders), give them 4% each with typical 4-year vesting. That’s 12%. Of what? You have no idea, nor do they, but you’ve given them great incentive to kick ass. Let’s say the other 7 get 1%–so that’s 19%, and we’ll round up to 20% just for ease. That leaves founders with 80%.

Plan on dilution. You’ll get diluted by new employees, but at a slower rate than the first 10. Expect at least 20% dilution in your first round of funding, plus any friends and family money.

Don’t sweat the dilution. What matters are two numbers: your exit number, and your percentage of the exit. You’d rather have 10% of $50 million than 50% of $10 million, assuming it takes the same time and effort to get to both exits. But if you can get to $5 million twice as fast, take that route, because your time on Earth matters.

Don’t hire VPs or CEOs until you have a model that’s really working–meaning you have customers, revenue, and can sustain yourselves. Too many startups get top-heavy too soon, just to satisfy investors need for feeling safe and confident. Screw that–you know more than anyone what you’re doing (and if you don’t, you’ll find out).

Cash is king. So don’t spend a lot on marketing, on lawyers, on deals, on mergers, on anything other than 1) serving customers and 2) serving customers.

Your equity is worthless without customers. Start every day asking how you can reach and serve customers that day, and if it’s too early to charge them, set a goal of getting 10, 20, 50 customers who will use your stuff for free. Their feedback and insight will solve a lot of problems for you and can create significant value down the road.

With that said here are some general guidelines for dealing with risk scenarios for people joining your dream:

Risk Profile of the Venture: The second criteria to consider when determining the amount of equity to give an employee or prospective employee is the risk profile of the venture. For instance, in a high-risk environment, such as a start-up without funding (in which case new employees will lose their jobs if funding doesn’t materialize), equity compensation should be higher than usual.

Conversely, a well funded company, or a company that has already reached key milestones/is less risky, should offer employees less equity.

While these criteria affect the precise amounts of equity that should be offered to employees, Guy Kawasaki, on his blog, has created general guidelines regarding the range of equity that is typically offered to employees based on their position.

Guy’s list is as follows: – Senior engineer: 0.3% to 0.7% – Mid-level engineer: 0.2% to 0.4% – Product manager: 0.2% to 0.3% – Head Architect: 1.0% to 1.5% – Vice presidents: 1.5% to 3.0% – CEO (brought in to replace the founder): 5.0% – 10% (A study by consulting firm the William M. Mercer, Inc. conducted in 1999 found that the median equity stake among non-founding CEO’s following an IPO was 4.0%).

Finally, it is important to note that equity is typically vested over 36 to 48 months. Vesting is critical as it helps employerǃÙs retain employees. Sometimes vesting is done in equal installments (e.g., 4% equity stake vesting at 1% per year for four years), while at other times it is done in escalating installments (e.g., 4% equity stake vesting at 0.5% after the first year, 0.8% after the second, 1.2% after the third and 1.5% after the fourth).

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  • http://www.tripleiconsulting.com/ small business philippines

    Great tips you have here, Steven. If equity gets too tricky, there’s always the option of turning to business consultants.

  • http://www.nextpaydayonline.com/ payday loans

    I’ve started my own small company on a loan. Do I also have to worry about equity or is that exclusive to bigger businesses?

  • Anonymous

    Equity is dependent on what your hiring strategy will be and what your goals are in relation to how much money is needed and how quickly it is needed. Equity is usually like an IOU to get work done now and pay it back later when the business generates profit from all the sweat equity that was spent up front.

  • Jon Wilson

    Another important thing to do for startup businesses, especially those that require equipment, is to buy business insurance.

  • http://www.idealabsconsulting.com/ Info

    Great article.  Outside of the equity distributions, the best advice from this article is:

    “So don’t spend a lot on marketing, on lawyers, on deals, on mergers, on
    anything other than 1) serving customers and 2) serving customers.”

  • Victor

    Great article Steven. Except I know that Charlie Crystle wrote this original article back in 2010 (he’s a good friend of mine). So be sure to attribute when the article is basically 99% someone else’s work.

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