In 2005, David Choe was invited to paint a number of murals at Facebook’s HQ in Palo Alto. At the time, Facebook wasn’t the goliath it is today and so, Choe was given a couple of options: he could have $60,000 in cash, or stock (equal to the equivalent amount of the cash back then).
Choe may have lost out and made nothing if the company had gone under, but because it was a monumental success, he is now worth approximately $200 million. Of course, not every equity compensation story is a David Choe Story.
If you’re thinking about extending equity to an employee or a vendor (as in the example above), you should know that the topic is multi-faceted.
If you’re giving a large percentage of your company to someone (and yes, two percent is large), you’re entering into a contract that’s really a whole lot like marriage in that it creates a long-term relationship between you and the employee or partner.
If however you are giving a “normal employee” an incentive stock option plan (more on that later), that’s entirely different.
Make sure you understand all of your options before making any decisions.
In this article, I’m going to examine:
- What equity compensation is
- Different types of equity compensation
- Finding great employees first
- Good scenarios for offering equity compensation
- Bad scenarios for offering equity compensation
- Equity compensation alternatives
If you have any questions about equity compensation, please leave a comment below. We’ll be happy to help.
What is equity compensation?
Equity compensation is when you offer your employees equity in your business (a “share” in company ownership).
More often than not, equity compensation is an attraction and retention tool, rather than a replacement to salary. While some companies may use it as a means of paying employees a lower salary upfront, it’s very rarely offered as a complete replacement to receiving a regular compensation package.
Typically, employers that offer employees equity compensation will do so in the form of common stock, preferred stock, or stock options. I’ll go into the difference between these in just a moment.
Types of equity compensation
When business owners decide to go down the route of equity compensation, there are two primary options to choose between. They include:
In terms of equity compensation, this is by far the most common scenario. Stock options (known as “share options” in the U.K.) give an employee the right to purchase stock in the future (or within a fixed period of time), for a set price which is determined at the time the options are given. This is a great deal for employees if shares of stock are high in the future. It will mean they get to buy at the much lower price. There’s also no requirement to purchase the stock should the stock end up going lower in value over time.
Stock options are issued to employees usually through an Employee Stock Option Plan (ESOP) and include what is called a “vesting period.” The vesting period, often three or four years, frees up a percentage of the options for the employee to purchase the longer they stay at the company. However, if the employee leaves the company before the vesting period is over, the employee gives up any stock that has not “vested” yet and any vested stock that they have not purchased, or “exercised.”
Stock options are typically issued to encourage loyalty in the company and to reward employees who stick with the company over time. The longer employees stay, the more of their stock options they “vest.”
This type of stock gives you a portion of ownership in the business immediately. As opposed to stock options where the employee can decide to purchase the stock or not, restricted stock is often “granted” or given to the employee. It’s called restricted stock because it often comes with restrictions, such as vesting. This type of stock is typically given to founders and early employees with the stock value is near zero.
Finding good employees is critical
If equity compensation is on your mind before you start hiring, make sure you’re good at hiring excellent candidates, especially if you’ll be offering restricted stock rather than stock options.
If you’re offering restricted stock in your company, it’s important to remember that if you give (or “grant”) employees stock, once that stock is vested, the employee is a shareholder in the business.
Even someone that is only a minority stockholder has rights that could become an administrative pain, and that could interfere with the goals of the majority leadership team.
According to intellectual property attorney Kurt Anderson, shareholders generally have the right to access certain corporate records and financial information.
They also have the right to vote or withhold their vote or consent to certain corporate actions.
Kurt says, “In some states, even non-voting stockholders may have the right to vote on certain heroic corporate events. For any corporate action that requires unanimous stockholder consent, even a minority stockholder holds a veto right. Even where unanimity is not required, taking corporate action by unanimous consent (rather than a formal vote) is frequently more convenient for routine corporate tasks, such as the annual election of directors. For example, no privately held company needs the expense and disruption of having to hold a formal stockholders meeting to annually elect directors when it could be done by signing a simple unanimous consent.”
Before you consider giving away any true equity incentives, consider what the recipient could do to disrupt your company if he or she leaves, but holds onto the stock. Think carefully before you hire someone new and offer them stock from the outset.
Another thing to consider is that giving away stock, whether stock options or restricted stock grants, is giving away a slice of ownership pie. There’s not an unlimited amount of stock to give out, so handing out a percentage of the company to the wrong person might mean that you don’t have enough equity to give to another future hire.
Here are a few rules for hiring good employees:
- Look for people that take initiative, who are self-starters, and who want to work for a company like yours.
- Hire people that are passionate about the product or service you offer.
- Hire to fill gaps you can’t fill. Know your weaknesses and hire for those.
- Recruit through referrals if possible.
- Potential can offer more value than experience. Pick someone that’s a fit for you and your company, rather than someone with 15 years of experience.
- Hire slowly, fire fast.
- And, perhaps most importantly, look for people that are in it for the long-term. You may want to offer a probation period before offering anything so that you have some time to get to know them.
If you’re just getting started, and are hiring for the first time, make sure to read carefully through the advice below on when to offer and when not to offer equity compensation. Also, if you do ultimately decided to offer it, make sure to use a lawyer.
When should you offer equity compensation?
Typically, you offer equity compensation when you are getting started and don’t have enough cash to pay the salaries you would like to pay, or when you’d like to attract and retain high quality employees.
1. When it’s the “norm” for your industry
Noah Parsons, COO at Palo Alto Software says, “If you’re in Silicon Valley and/or building any kind of tech startup, it’s considered the norm to offer equity as part of a compensation package.”
But, why is this the norm for so many technology companies?
There are a couple of reasons:
First, companies know that offering an equity package is often the only way to distinguish the offers they make to candidates who know they can take their skills and earn the same salary almost anywhere else. And given the number of technology startup companies, it doesn’t come as a huge surprise that these companies may offer equity in order to attract the best talent.
More importantly, Silicon Valley startups are typically high-growth companies with an exit plan: either they’ll go public or they will be acquired. Because working for a startup with such a plan requires an enormous amount of work and dedication, giving employees ownership in the company helps balance the huge effort required. And, if the exit does happen, everyone gets rewarded for all of their hard work.
2. If you have grand plans for your startup
Offer equity if you plan for your company to grow quickly, or if you’re seeking investment from VCs or angel investors. Noah Parsons says, “VCs and most savvy angel investors will require that you offer equity compensation to key employees to make sure that you can attract and retain a strong team.”
Generally this is because investors want to recoup their investment as fast as possible and for as much as possible, and a strong team is required to build a valuable company quickly.
By attracting a strong team, that is in it through thick and thin, investors increase the chances of getting a return on their investment.
Furthermore, giving ownership to employees helps ensure everyone buys into the long hours and hard work. And, if things work out when the exit happens, everyone gets rewarded.
3. When an employee has demonstrated superior skill over a long period of time
The right time to extend equity is sometimes when someone has demonstrated superior skill over a long period of time. It’s both a reward and an opportunity for that person to excel even further.
That said, do not offer equity unless you want the employee to stay for the long term.
Offering equity at a later date means you’ve also had the chance to vet the employee’s suitability for the role. Offer equity too soon and you could be in a big pickle when you find out that the employee isn’t a great fit for your company (see point four on when not to offer equity compensation).
4. If you are sure the employee has a genuine ability to influence outcomes leading to the company’s success
According to Michael Roberts, President of an HR Consulting Firm in Vancouver BC, “Equity is more common in very senior roles, since those roles by definition have more responsibility for a larger share of the company’s success. Conversely, very junior employees have relatively little influence over the company, so their equity grants should be correspondingly much smaller, if at all.”
5. When cash flow is poor
If cash flow (enough cash coming into the business to keep the business running) is a problem for a new startup, equity compensation may be a good way to circumnavigate the issue of having to pay employees a substantial amount of money each month.
When should you not offer equity compensation?
1. When you’re looking to hire short-term talent or solve short-term cash flow problems
According to Tim Berry, this is one of the more common and expensive mistakes people make.
“I’ve seen this so many times. People give percentages away to their lawyers, their graphic artists, their friends, and their relatives, but for no good reason. Then what happens is if the business makes it a year or two into actual business, suddenly those once-naive founders realize they are doing business with partners, who own part of their company, who don’t work, don’t care, criticize, and drag the decision-making processes. Pay the fees [for your vendors]. Don’t save starting costs by giving the business away.”
2. When you’re happy with a “lifestyle business”
If you don’t have big dreams for your company and are happy running it day to day (you’re not thinking about your IPO or acquisition in five years), then offering equity in the business is not fair to employees. If you offer equity to employees in a “lifestyle business,” you could be leading them on—because that equity will never turn into real money until the business is sold or the company goes public.
3. If you’re starting a new business and are already bogged down by the details
Equity compensation is complex. Understanding its tax, accounting, and legal implications is going to require help from professionals. If you’ve already got a lot on your plate, we don’t advise going down this route.
4. If you haven’t vetted the candidate
Equity should not be doled out as casually as spare change, especially when you consider that it gives employees a say in your company.
Rasheen Carbin is currently Director of Marketing at nspHire. He experienced this problem first-hand at the last startup company he worked for.
“At my previous startup we offered a consultant we used two percent equity and the chance to become our CFO. It turned out that employment at a startup wasn’t his thing. We made a mistake by not getting to know him better before making the offer.”
Simply put, you shouldn’t extend equity to an employee when you haven’t vetted them closely.
5. If you don’t need to
According to serial entrepreneur and founder of Slumber Sage Kenny Kline, “If your startup can afford to pay near market salaries and has a good culture, then you will be able to attract top talent without offering equity compensation.”
This way, if your company does well, you will get more value out of it, and so too will your investors.
Before you try equity compensation, try this:
Dyanne Ross Hanson is the president of Exit Planning Strategies, and she believes there are alternative routes to offering equity that will be just as likely to entice great candidates to join your company.
“I suggest an owner use cash-based incentive plans instead. Then, if they think the key employee is potential ownership succession material, develop an equity incentive plan. However, never before a two year probationary period and not until the owner has determined the employee is a fit with the company, culture, and vendors. And is willing to share company finances, future, etc.”
Don’t forget: Money only motivates to a certain point.
Kurt Anderson, an intellectual property attorney at Giordano Halleran & Ciesla in New Jersey, suggests trying non-equity incentives, including:
- Sale participation rights: Sale participation rights gives the recipient the right to participate (i.e., receive money) when the company is sold based on a formula that frequently mimics a notional percentage interest in the company.
- Phantom stock: Phantom stock arrangements do much the same thing, but provide the recipient with phantom stock which may provide any or all of the financial benefits of actual stock, without the right to vote or otherwise participate in management.
- Stock appreciation rights: Stock appreciation rights generally give the recipient the right to receive money based on increase in the value of the company’s stock.
Because equity compensation is a complex topic, you will need to get good legal, accounting, and tax advice.
Consider your other options, and tread carefully in the early stages of business!
Many thanks to all of the others who contributed to and helped me understand this topic better:
Eric Chen, associate professor of Business Administration at the University of Saint Joseph; Rick Coplin, vice president of Community Partner Ventures with Rev1 Ventures; and Jenny Barton, as well as the Quality Solicitors SSB team.