Here’s How Startup Founders Should Offer Employee Equity
As a startup founder, you know that employee equity is no simple matter. The stock options you offer to employees aren’t just a bunch of percentages and numbers; They’re a reflection of your company’s values and philosophies.
Not to mention, how you structure things with employee number one can have serious financial impacts down the road. So it’s important to create a startup compensation package that reflect the company culture and financial outcomes you actually want.
Disclaimer: You should always work with your attorney and tax advisor when building your employee equity strategy. But, to help you get started, we’ve outlined nine steps and key decisions you’ll have to make when structuring an equity plan that’s right for your company.
Step 1. Hire your dream team
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One of the major benefits of offering startup stock options is that they can help you recruit top talent. Who are the crucial hires you need over the next 12 to 24 months?
Sketch out your team, then solidify a hiring plan that takes into account the timing of your next round of funding. “Have a plan for how many people you plan to hire in the next 15 to 24 months and have an estimate for a low and high equity range for each role,” says Lynn Perking, CEO and co-founder of UrbanSitter. “This will prevent you from making one-off decisions case by case as you hire people.”
Things to check out:
- These hiring email templates help make the process a snap.
- Hire your first employee with this in-depth guide.
Step 2. Carve out your startup equity pool
“It’s easy to start giving equity away on a first-come, first-served basis without thinking about the CTO or CMO that’s on your to-hire list,” cautions Kevin Barenblat, co-founder of Fast Forward and Context Optional. “Before you know it you’ve run through the employee option pool. It’s better to plan ahead, reserving equity for key hires and being mindful that you’ll want to hire some senior employees (who require significant chunks of stock options) down the line.”
To help you avoid this very pitfall, set aside a percentage of stock for your initial group of hires. Philosophies vary on just how much to set aside, which is why the average equity for startup employees is all over the place.
With your hiring plan in hand, ask yourself these three questions:
- How many people do you want to hire? As a rule of thumb, the more people you employ, the larger the employee equity pool should be.
- How senior are your hires? More senior or technical hires, which are in higher demand, typically receive more equity, so you’ll want to cut out a larger slice.
- When is your next round of financing? Each time you raise funding, you’ll issue new shares to investors. At the same time, you’ll likely increase the size of the employee equity pool for additional hires post-financing.
You’ll want to increase the size of your option pool as you add more employees. Every year you might want to evaluate the remaining size of your pool and increase it by several percentage points. Just keep in mind that every time you increase the pool, you dilute ownership. Each person in that pool now owns a smaller percentage of the company.
And you can’t just increase your pool willy nilly; Your board and stockholders have to approve the size each time this happens. It’s best practice to manage your pool like you would a budget, saving some stock for bigger hires that come up down the road.
Things to check out:
- A treasure trove of recommendations from seasoned founders on Quora.
- Venture Hacks’ article, “The Option Pool Shuffle,” details how to create an option pool from a hiring plan.
- Venture capitalist Fred Wilson proposes his own formula for sizing option pools for investors and future employees.
- Y Combinator’s Sam Altman wrote a convincing piece on offering more startup equity to employees, which spurred a healthy debate on the matter. It’s worth a read.
Step 3. Research competitive startup salaries and compensation
With your list of key positions in hand, look into salaries and equity norms for those roles. A little scrappiness can go a long way in doing this research. Ask your founder friends or investor pals, and check out salary sites with free and low-cost subscription services.
Here are a few places to get you started:
- Angel.co provides a useful list of benchmark salaries and equity for startups.
- Glassdoor, Payscale, or Salary.com tend to provide salary data for larger companies. It’s helpful to know what your employees are turning down to join your venture.
- Leo Polovets crunched some data on AngelList job postings, publishing a comprehensive analysis of salary benchmarks.
- Paul Graham’s equity equation is worth considering while you estimate the current and future value of a candidate.
Step 4. Set your vesting and cliff schedule
A lot of businesses take a standard approach: A four-year linear vesting schedule with a one-year cliff. There’s are a few reasons why this often makes sense:
- As someone contributes more to the company, they get more equity to match.
- It helps ensure someone is a good fit for your company before they get to own a piece of it.
- It incentivizes people to stick around.
But before you go with a vanilla vesting schedule, make sure it also jives with the values and time horizons of your business. For example, some companies looking further down the road offer five-, six-, or even 10-year vests.
Things to check out:
- Entrepreneur Rob Fitzpatrick provides a beginner’s guide to vesting.
- Andy Rachleff, who founded Wealthfront, outlines the benefits and considerations of vesting stock options.
- Sam Altman’s piece on employee equity covers this topic as well, proposing perspectives on alternative vesting schedules.
Step 5. Stock options or restricted stock?
For early-stage startups, granting stock options is usually the way to go. But if you’re considering issuing stock straight up, it’s good to be aware of the tax implications for your employees.
Granting stock options lets your team choose when to exercise. This choice gives them the privilege of waiting until they think their investment in the company will be worthwhile. However, if employees are granted stock directly, this choice evaporates. They’ll own the stock as soon as it vests, possibly triggering — gulp — thousands of dollars in taxes. If the stock can’t be sold because the company isn’t public yet, paying those taxes can be a tall order.
In a nutshell? If you’re gung-ho about granting alternative forms of startup equity, make sure your employees are, too.
And don’t forget: Your board needs to approve the equity grant for every single employee. An employee’s exercise price is locked in at the fair market value (FMV) upon approval of the board. If they don’t approve the grant, it doesn’t exist!
Things to check out:
- The National Center for Employee Ownership breaks down the tax implications of options vs. restricted stock.
- Finance guru Andy Rachleff (who is currently the CEO of Wealthfront), also wrote a smart article on the topic.
Step 6. Plan for grants and employee promotions
Employee equity isn’t just important for recruitment — it can also help with employee retention and recognition. If you plan to keep your team around for the long haul, you’ll want to build a promotion structure for star performers. Will you grant employees more equity for stellar performance? Or after two years? How about when they’re promoted?
A formalized plan will help motivate your team and enable you to plan for future stock option allocation.
One founder we talked to viewed startup equity in more straightforward terms: “Be sure you’re continuing to reward your team members as they grow with your company. Four years is a long time to fully vest; It can be the entire lifecycle of a startup. As employees take on new roles and own more responsibilities it’s important to compensate them for their contribution. They have domain expertise and tenure, and their equity stake should reflect that.”
Things to check out:
- Wealthfront’s employee equity plan is worth reviewing in detail, both to see a particular philosophy in action and the math behind calculating employee equity. Promotions are a big part of why this plan is plain awesome.
Step 7. Set an expiration timeline
When an employee leaves, when should their stock options expire? The standard expiration is three months after someone terminates their contract, but that trend is slowly changing.
Many people think it isn’t fair to force employees — especially those who don’t have large savings — to exercise their stock options before they’re ready for a potential financial burden. A longer expiration timeline can allow your team to exercise when they have a more substantial income or when stock becomes liquid after the company goes public.
While providing more flexibility is great for employees, there are significant administrative strains if you offer an extended expiration timeline. They’re a bit convoluted, but here’s a quick explanation:
ISO vs. NSO
The US tax code provides two types of stock options: ISOs (incentive stock options) and NSOs (nonqualified stock options).
- ISOs can only be issued to employees. They have special tax benefits because they’re meant to be used as carrots for employees.
- NSOs are for anyone, including employees, independent contractors, and investors.
Why do these types matter? Because ISOs expire three months after an employee leaves a company. That’s why the standard expiration for options is also three months.
So, if you’d like to let your team exercise more than three months after leaving, you can convert their ISOs to NSOs and set a new expiration timeline. While this favors your employees, managing the switch means more work for your legal and accounting teams. You’ll also increase the number of option holders who are not employees, which isn’t ideal.
It’s up to you to weigh the pros and cons and figure out whether offering a more flexible exercising timeline is core to your company’s values.
Things to check out:
- Startup Lawyer has a great post outlining the differences between ISOs and NSOs.
Step 8. Decide if your employees can exercise early
“Exercising early” means you allow your employees to exercise (i.e. purchase stock) before their equity has vested. That means they won’t actually own their stock until it’s vested.
The benefit to exercising right after receiving a stock option grant is that the employee’s exercise price is valued the same as the company’s Common Stock (i.e. the current FMV), which means they are not responsible for any taxes that year (or until they eventually sell the stock).
However, in order to not be responsible for taxes, employees must file an 83(b) election within 30 days of their early exercise date. They’ll also need to file the election with their taxes that year. The 83(b) election is a document notifying the IRS that someone has early exercised and that the difference between their exercise price and the FMV is zero, and therefore they do not owe any taxes on the transaction.
Again, many early-stage startups don’t allow employees to exercise early. Nonetheless, it’s worth knowing that offering the ability to early exercise is a possibility. Consider the pros and cons and decide what’s right for your company:
- Pros: Early exercise can provide a bunch of tax benefits for employees. Exercising early also means your employees become stockholders, which cultivates a strong sense of ownership.
- Cons: Early exercising can create extra accounting and administrative work for your company. If an employee exercises early but leaves before their stock has fully vested, you’ll have to manage a repurchase process, which opens its own delectable can of worms. You may also have to help your employee navigate the 83(b) election process. The 83(b) is a form that has to be filed within 30 days from the date your employee decides to early exercise.
Things to check out:
- Quora discussions on the pros and cons of offering the option to exercise early.
- Startup Lawyer’s post on the difference between ISOs and NSOs is super helpful for understanding this issue, too.
Step 9. Give yourself a hug
Nice job! You now know how to put together the startup equity package your future employees are dreaming of. Check out 25 cute animals hugging — it’s exactly what it sounds like — and give yourself a hug. Difficult milestones are always worthy of celebration, and you’re now that much closer to building a team of owners!
“As a founder, the right thing to do is to treat your employees like true owners of the business,” said Joshua Reeves, co-founder and CEO of Gusto. “The standard equity packages are slowly changing, and we’re excited to be part of this new wave of treating the employee as a true owner of the business.”