Equity is an important part of compensation for early employees in startups. It gives them ownership and aligns them with company goals, which motivates them to work harder and stay longer. In addition, it allows early employees to share in the company’s success.
Once the founders have received their equity, it’s time to hire the crucial first employees. Startups may have difficulty attracting top talent, particularly in competitive industries, without equity. Offering equity not only demonstrates that the founders believe in the company’s potential, but also motivates early employees who want to contribute meaningfully and have a stake in the company’s success. Therefore, equity compensation is essential for attracting and retaining top talent, and it creates a win-win situation for everyone involved.
Why should a startup establish an employee pool when they incorporate?
A common mistake is issuing all authorized shares to the founders, only to realize later that shares need to be issued to employees, requiring an amendment to the certificate of incorporation. To ensure that founders have enough equity to attract and retain top talent without overly diluting their ownership stake, they must set aside a certain percentage of equity for future employees.
In addition, an employee pool is required to comply with Section 701 of the Securities Act of 1933. This provision allows companies to offer and issue securities as part of an employee compensation plan without registering them with the Securities and Exchange Commission (SEC). Companies can offer securities to their employees, directors, general partners, trustees, officers, and certain consultants and advisors under this provision without having to comply with the registration and disclosure requirements that would typically apply to a public offering of securities. However, compliance requires an established equity plan and pool.
Therefore, it is important to set up the employee pool and equity plan right after launch. The typical startup employee pool is between 10%–20% of authorized shares.
Early Startup Employee Equity Allocation
Determining how much equity to offer early startup employees can be a complex decision that depends on several factors, such as the stage of the startup, the employee’s role and responsibilities, current market conditions, talent market conditions, and available funding.
Typically, it’s common to offer a larger equity stake to early startup employees compared to those who join later, as the risk and uncertainty are higher in the initial stages of the startup. However, the exact amount of equity to offer depends on several factors, such as the employee’s role and contribution, market standards, and available funding.
Below are two rules of thumb that can help founders:
Rule of Thumb #1: The first 10 employees should receive roughly 10% of the company.
- Hires 1–5 should receive between 0.25%–3%.
- Hires 6–10 should receive between 0.10%–1%.
Rule of Thumb # 2: More equity means less cash.
In most cases, if an individual is receiving a salary considerably lower than what is considered “market” for their role, they will anticipate receiving more equity as compensation. Typically, the first 10 employees are paid well below what their job is worth and, therefore, receive a much larger share of equity compared to someone hired after later rounds of funding. On the other hand, if an early employee is demanding a high salary, their equity should be decreased.
These two rules of thumb are just that—guidelines. Don’t place too much weight on them. Ultimately, determining how much equity to give early startup employees requires a case-by-case analysis of the startup’s needs, goals and available resources. Market standards play a role in determining equity allocation. It’s essential to research what similar startups in the industry are offering their employees to stay competitive and attract top talent. It’s crucial to balance the needs of the business with the needs of the employees to ensure everyone is motivated to work toward the same goal.
Vesting Schedules: Ensuring Early Employee Retention
Equity compensation is a great way to attract and retain top talent. However, in order to make sure that employees are committed to the company for the long haul, it’s important to implement vesting schedules. These schedules are clauses in employees’ equity award agreements that outline how their equity will be distributed over a specific period of time.
By using vesting schedules, startups can ensure that early employees stay with the company for a certain period of time before receiving their full equity stake. Vesting schedules provide both a carrot and a stick. The carrot is that employees who remain committed to the company long-term contribute more value and (hopefully) increase the value of their stock. The stick is that if an employee leaves early, they won’t receive their full equity award.
A typical startup vesting schedule is four years, with a one-year cliff. For example, if an employee is granted 10,000 shares of stock but only receives 25% of those shares after their first year of employment, they would receive an additional 25% after each subsequent year, until they have received all 10,000 shares after four years.
Lastly, vesting schedules allow both parties to evaluate whether an employee is a good fit for the company. If an employee isn’t a good fit, they can be terminated before the one-year cliff and won’t walk away with any ownership in the company.
Handling Early Employee Departures and Unvested Equity
While vesting schedules can help ensure that early employees remain committed to the company for a certain period of time, there are situations where an employee may leave before their equity fully vests or is realized. In such cases, it’s important for founders to have a plan in place to handle these departures.
The most common approach is for the company to repurchase the unvested equity from the departing employee at the original issuance price.
It’s important for founders to consult with legal and financial advisors when considering how best to handle early employee departures and unvested equity. If you’re looking for legal counsel, feel free to reach out to us here.