Equity refers to the ownership of a company, typically in the form of stock or the right to acquire stock. While you can't pay employees solely with equity, startups commonly use equity to incentivize their employees and attract talent.
Factors Influencing Equity Awards
The process of determining the appropriate amount of equity to grant to employees is not straightforward. There is no single method to calculate how much equity to grant, as the appropriate equity award varies based on several factors. Typically, equity awards depend on the employee's seniority, experience, role in the company, and negotiating position. Given the various factors involved, the best method for calculating an equity award is for companies to benchmark their employees' equity compensation against their peers.
Benchmarking Equity Awards
Benchmarking looks at the "market" for employee equity compensation at similar companies for a similarly situated employee. Several resources, such as Carta Compensation Benchmarking and Pave, provide valuable insights into equity compensation practices within the startup ecosystem. These platforms can help startups understand how their equity offerings compare to the market and assist in making informed decisions about whether to match or exceed competitor offerings. Outside legal counsel, such as Perkins Coie, can offer guidance in navigating these complex decisions.
Recent Benchmarking Data
According to recent data from Carta, the first few hires at tech startups tend to receive slightly higher percentages of equity grants. Specifically, on average, at the 50th percentile, a company may give the first hire 1.49% equity. The fifth hire may receive 0.34%, whereas the tenth hire may only receive 0.18%. Hiring ten employees at the 50th percentile means allocating 4.75% of the company. Conversely, hiring ten employees at the 75th percentile totals 11.61% of the company. If the company decides to be generous with early employee equity, it will need a larger pool quickly, as this number is already higher than the usual 10% option pool for pre-seed startups (not that a startup will likely hire ten people before raising funding).
Using Equity for Consultants and Strategic Partners
Startups also sometimes use equity instead of cash to pay consultants or strategic partners, especially pre-seed startups with limited cash resources. However, it's important to recognize that this compensation method can be costly in the long term. It is crucial for companies to be cautious and avoid creating open-ended commitments to issue stock, which can lead to complications and dilution of ownership. For more details, see our blog post Paying Consultants and Strategic Partners with Equity.
Common Mistakes in Granting Equity Compensation
There are a few common mistakes when granting equity compensation:
- Avoid Dollar-Value Equivalents: When calculating the amount of equity, we generally do not recommend using a dollar-value equivalent of equity awards because this method requires making many (often wildly incorrect) assumptions about the current and future value of the company. Plus, it would give grantees an incorrect representation that the company and their equity awards are valued at a certain amount.
- Fixed Percentage Pitfalls: We do not recommend giving a fixed percentage of the company's ownership, as grantees often fail to clearly understand when the percentage is measured and at what value and that the percentage won't be fixed over time.
- Approval Requirements: Equity grants require board and sometimes shareholder approval. An officer or founder does not have the unilateral power and authority to grant equity, and if the action is unauthorized, the officer, founder, and company could be subject to liability.
- Fair Market Value: Equity grants must be valued at fair market value at the time of grant. Stock cannot be given away or sold for less than fair market value without causing tax and other legal consequences to the stock recipient and the company.
For more common mistakes, see our post Equity Compensation: Avoid the Most Common Mistakes.
Conclusion
Equity is a powerful tool for startups, serving as a means to compensate and incentivize employees. However, the complexity of equity compensation requires careful consideration, strategic planning, and adherence to legal and regulatory standards to ensure that it serves its intended purpose without unintended consequences. Therefore, there are no one-size-fits-all approaches to granting employees the "perfect" amount of equity. Benchmarking is really the only way to go.
*Perkins Coie Summer Associate Claire Chen contributed to writing this blog post.