April 10, 2015
Once you raise a seed round or generate enough money to start building your team, you’ll need to start thinking about employee equity.
It’s common practice for tech startup to use stock options and equity with the promise of a financial reward down the line in order to attract amazing talent.
The problem with employee equity is it’s one of the most controversial topics in the startup community as there are so many conflicting points of view.
We went out to research the best resources from those who know best, which will give you a great insight into all aspects of how employee equity works.
Employee Equity, by Sam Altman
Sam Altman, acting president at Y Combinator, argues that founders are granting early employees too little equity:
“Founders certainly deserve a huge premium for starting the earliest, but probably not 100 or 200x what employee number 5 gets. Additionally, companies can now get more done with less people.”
He also states that the default 4-year vesting with a 1-year cliff is not the best choice and proposes a 6-year vesting schedule with above market grants, arguing that it will help filter for employees that really believe in the company’s mission.
The Equity Equation, by Paul Graham
In 2007, Paul Graham wrote an essay about general startup equity. When talking about employee equity, he proposes that how much equity to give a specific employee should be determined by the following formula:
“You should give up n% of your company if what you trade it for improves your average outcome enough that the (100 – n)% you have left is worth more than the whole company was before”
Suppose that employee will work for you in return for 3% of your company. In this case, n is .03 and 1/(1 – n) is 1,031. If you believe that employee can improve your outcome for more than 3.1%, you should pull the trigger.
Employee Equity: Too Little?, by Fred Wilson
Sam Altman’s piece on employee equity (see above) triggered a response on Fred Wilson, the legendary venture capitalist. That ‘response’ was a great post on the subject.
Fred Wilson states that he agrees with Sam Altman on almost everything he wrote, except point #1: ‘employees don’t get enough equity’.
First, he sustains that many of his portfolio companies ended up regretting huge equity grants down the line because the founder’s stake got extremely diluted.
Finally, he explains that competition in the market is driving equity percentages for engineers up, instead of down as described. Now, the default is a 20-25% option pool, instead of the 10-20% carved in the past.
The Option Pool Shuffle, by Venture Hacks
In 2007, Venture Hacks wrote a great article summarizing why you should keep your eyes glued to your option pool while raising money, because they might slip it into the pre-money valuation and cut your effective valuation by 20%-30%.
To quote the VH team: “Don’t let your investors determine the size of the option pool for you. Use a hiring plan to justify a small option pool, increase your share price, and increase your effective valuation.”
Are Founders Really 1000x, More Valuable Than Employees?, by Venture Hacks
There has been a heated discussion in the valley about founders vs. employees value. This discussions revolves one question: are founders 100-1000x more valuable than early employees? Should they keep almost 100% of the company while employee #1 only owns a few percent?
Their answer is yes, because at first, founders aren’t fundable. Their business value is approximately $0, while employees start with stock options worth at least $100,000.
Changing Equity Structures for Early Sartup Employees, by Ben Yoskovitz
Ben argues that employees should get enough equity to feel an emotional ownership of the product and company they are building. The problem is the equity ownership the market proposes (see this table) isn’t enough for employees to become emotionally invested.
Early employees aren’t founders, but they are so critical to the success of your startup that they should feel like them in terms of ownership, emotional attachment, and responsibility.
Sizing Option Pools in Connection With Financings, by Fred Wilson
Fred Wilson explains the formula he uses when deciding how big an option pool to carve when investing in his portfolio companies.
1. Take the cumulative salaries of all the hires you need to make between this round and the next one. 5 employees at $75k each will work.
2. Divide the result by your post-money valuation, let’s say $5M. That gives you 7.5%.
3. That’s the size of the option pool you’ll need.
This is because at the start of your company, you’ll need to be more generous with early employees. That is what needs to keep them happy and excited to be working in your startup.
Analyzing AngelList: Salary and Equity Benchmarks, by Leo Polovets
Reading about the subject is great, as it will give you further understanding of the topic. What is more valuable is the actual equity grants startups are offering to their employees.
Leo Polovets, a VC at Susa Ventures, analyzed every AngelList job posting via their API, and got the average employee equity offering, determined by how early they joined:
- Hire #1: 2% – 3% of equity
- Hires #2 through #5: 1% – 2%
- Hires #6 and #7: 0.5% – 1%
- Hires #8 through #14: 0.4% – 0.8%
- Hires #15 through #19: 0.3% – 0.7%
- Hires #21 through #27: 0.25% – 0.6%
- Hires #28 through #34: 0.25% – 0.5%
The One Number You Should Know About Your Equity Grant, by Chris Dixon
This advice is for potential startup employees, but it will help founders avoid a common mistake.
Chris Dixon argues that number and price of shares, percent of the outstanding option pool, strike price, and your equity related to other employees doesn’t matter. The only number that matters is the percent of the company you are being granted.
A Newbie’s Guide to Startup Compensation, by Tony Wright
When deciding how to expand his team at Rescue Time, Tony Wright discovered 3 harsh realities about startup options:
1. Employees with decent salaries and options will almost never get rich in a liquidity event.
2. Options vest over 4 years. If there is no acceleration at acquisition on those shares, you’ll need to spend the remaining time of the 4 years over at acquirer.
3. How the options are set up very much affect how attractive the co’ is to a buyer. 100% acceleration is amazing for employees, but it doesn’t work for the buyer.
Startup Equity for Employees, by Andy Payne
This is a complete guide on equity for employees. It covers stock classes, stock vs. options, dilution, vesting, founder’s/restricted stock, salary vs. equity and negotiation. Again, this answer is geared towards employees but it’s a must read for both sides of the table.
Quora Discussion on ‘How Much Equity Should Be Given To Early Employees When The Company Is Bootstrapped?’
Leonard Kim’s answer is extremely detailed and valuable, but other people share great valid viewpoints too.
HackerNews Discussion: Equity For A First Employee
Tons of extremely valuable responses from the HackerNews community. A must-read if you are hiring your first employee.