If you want your employees to think like owners, you have to make sure their contribution to the success of the company is reflected in their ownership stake.
Employee equity is what makes Silicon Valley’s startup culture special. Fairchild Semiconductor and Hewlett Packard were among the first companies anywhere to offer meaningful startup equity to people outside the ranks of top management. In offering employee stock option programs, these companies recognized engineers as key to the success of tech firms. They also created a more egalitarian way of doing business, by giving employees a sense of ownership.
The benefits are real. Employees who bet on untried companies should get to share the risk and reward. But option compensation is even harder to get right than cash. If you give an employee stock outright, its value is taxed as cash, even if the employee can’t sell it yet. And an employee that owns stock outright can walk away with it, even if they haven’t contributed to the company yet.
Enter stock options, also called warrants. Stock options give the employee the right to purchase stock in future, at today’s fair market value. Option grants have a gradual vesting schedule - say, 25% per year over four years - so that the employee has an incentive to stay. Taxes are paid when the options are exercised, so that the employee has the money to pay them. An employee usually has to stick around for 12 months before options begin to vest. This 12 month waiting period is called a “cliff”. Options vest incrementally after that.
A useful rule of thumb for a founder is to set aside 10-20% of equity in an option pool for employees. Common practice is grant more to senior executives and high performers, and less (or sometimes none) to juniors and support staff. Risk tolerance varies from employee to employee, so the company might offer a choice of high cash/lower equity and low cash/higher equity packages to new hires.
Obviously, adding employee stock dilutes the founder’s equity. Even so, most founders would rather own 65% of a hugely successful company than 100% of a less successful one. (Note that if the company takes in outside capital, everyone shares pro-rata in the dilution.)
Three reasons to make follow-on option grants
So far so good, but what happens at the end of four years, when the initial option grant is fully vested? Companies that don’t offer additional startup equity struggle to retain talent. A great employee stock option program doesn’t just reward new hires. It also:
rewards employees who have been promoted, by bringing their grants up to the level you would hire them at today.
rewards outstanding performance, whether the employee has been promoted or not.
starting at two to three years from the employee’s hiring date, grants additional options each year. In this way, the employee’s incentive to stay continues over time, rather than ending abruptly on their fourth anniversary.
These follow-on grants are crucial to retention. Young companies ignore them at their peril.
Six ways to be great at startup equity
1. Think how you feel about the value of your company’s equity over time.
Decide how you feel about it, because at some point you will need to take action on those values. Give yourself some time to watch and learn. Start thinking early about how to retain, not just how to hire.
2. Become awesome at understanding your company’s option plan and explaining it to new hires.
Put in writing:
The number of shares you are granting to the employee
The company's current share price
How many shares the company has issued (so the employee knows their percentage)
Vesting schedules and cliffs
Whether they can buy shares after they leave
Being good about explaining startup equity is a differentiator for small companies. It helps establish trust and reasonable expectations from the beginning. Your attempt to land this fish should not get in the way of setting up a good relationship and making it work over time.
3. Run a calculation FOR your employee.
If they can reproduce your calculation that will increase confidence. For example:
“Your shares are 10,000 in number at a strike price of $1.50. So if, when they're all vested, you decide to buy those shares, you’d pay $15,000. But you might decide to do that only if the company’s share price is higher - say $6/share. Then, for buying these options at $15,000, you might have a value of $60,000, before tax.”
4. Manage expectations of equity in new hires.
Don’t let recruiters blow the upside out of proportion in order to meet their numbers. Your company needs to go public or get acquired for the equity to be worth anything at all. Educate your employees about this, and be transparent.
5. Slot people into grades from the very beginning.
Yes, there will be lots of empty grades in your list of grades. It will help support your salary decisions from the very beginning and you will much easier detect mistakes. But only if you keep track.
Example: Two founders hire their first engineer. Eyeballing the grades, they decide that this new hire is an E2. A couple months later, the founders hire another engineer and decide she’s an E3. By writing these decisions down, the founders can quickly realize, six months later, that the supposed E2 is kicking ass and doing better than the E3. Now there is information to tell the person that they get a raise, to decide who to try to retain; or to simply say “You're kicking ass and exceeding our initial expectations. Here's a title boost (if you do titles). As soon as we have more money we're looking at a raise for you.”
6. Understand you’re going to make mistakes right now.
Decide right now that future you will forgive past you for not being omniscient. The purpose of thinking about these things now is not to be perfect, but get early practice before it becomes critical.