Splitting Equity The Right Way
As the war for talent intensifies, founders are increasingly turning to part-ownership as a means of attracting and retaining personnel from larger tech firms that may offer higher pay. And the data backs this up. Companies offering equity schemes are 26% more likely to have better quality hires.
While equity benefits are well-known in the startup ecosystem, many entrepreneurs are unfamiliar with how to create equity benefit programmes. To make matters more difficult, there is no magic formula for determining equity split; a startup’s allocation can be influenced by a variety of circumstances, and for early-stage firms, the split is based only on estimates rather than concrete metrics.
In a bid to bridge this gap, we look into how founders should set up an equity scheme to distribute employees’ slice of the pie evenly and fairly. This article is the sequel part of our Equity series that dives into what an equity package is and whether offering a generous salary or equity is the better deal.
The 5 Step Equity Process:
The following process should be considered as a guideline only.
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Create An Employee Stock Option Pool (ESOP)
Also called an option pool or equity pool, an ESOP is a block of company shares a startup creates, added to the existing number of shares, and set aside for future employees. As a general rule of thumb, we advise setting aside 10%-15% equity for the ESOP. For example, if you own 10,000 shares (100% of the company) and create an option pool of 1,500 shares, there are now 11,500 shares of company stock on a fully diluted basis.
An option pool can attract talent, especially if you can’t afford to pay market rate salaries, and investors, as a guarantee the startup has components in place to continue scaling.
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Choose Your Equity Type
The three main types of equity to grant to employees are:
- Stock options – the most common type of equity offered by startups, this equity type gives employees the right to acquire or sell a defined amount of shares from the company’s founders at a predetermined price. Between the vesting date (when the employee has earned his or her stock options) and the expiration date, the employee can exercise his or her right.
- Stock warrants – are the right to buy or sell a specific amount of shares from the company at a predetermined price. Like stock options, warrants can also be exercised between the vesting and expiration dates, however, their expiration durations are frequently longer.
- Stock grants – stock grants give you ownership of a specific amount of stock. They do not have a vesting or expiration date, thus the employee can sell the shares whenever they choose.
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Determine Your Vesting Period
Commonly used as an incentive to keep employees dedicated to growing your startup, a vesting period is defined as the time during which an employee must earn (or vest) their allotted shares by working for the company. A four-year vesting schedule and a one-year cliff (the minimum time the employee must stay with the company before the vesting schedule begins) are the most common vesting provisions.
For example, a four-year vesting schedule indicates that each stockholder’s equity will vest equally in 48 phases, once a month for four years. If an employee leaves the startup before the first year is finished, they renounce all equity they have vested. On the other hand, if an employee decides to leave the company and some of their shares have vested, they generally have ninety days after leaving the company to buy or exercise their stock options.
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Decide How Much Equity To Assign
Some startups provide employees different amounts of equity depending on their role’s seniority, while others give everyone the same amount of equity regardless of their position. Others base it on the startup’s investment round or its age.
It’s no secret that a high percentage of startups fail at an early stage, and therefore early startup employees take on a significant risk when they join the company. To reflect this fact, most businesses offer more equity to the earliest employees. For example, you might offer 1% equity for the first ten employees and 0.5% for the fiftieth employee.
A standard distribution of equity amongst an organization is listed below. Keep in mind that these are guidelines and excellent starting points for discussion.
- Founders: 50 to 70 percent
- Investors: 20 to 30 percent
- Option pool: 10 to 20 percent
As a founder, determining your own stake can be fairly straightforward. However, if you have a co-founder/s, deciding how it should be split is an important conversation. If you want your startup to succeed in the long run, having open, honest conversations with your co-founders early and often are important When deciding how to distribute stock with your co-founders, think about the amount of risk you’re willing to take, your degree of commitment, and who owns the business idea.
The amount of equity an investor receives depends on the company’s valuation at the time they invest and the magnitude of their investment. When pitching and negotiating your next round of capital from outside investors, conversations about equity should take place.
Many professionals are incentivized by partial ownership in the company they are working in and establishing, knowing that the company’s success can result in financial gain on a personal level. When determining how to offer equity to your employees, consider percentage of ownership, vesting schedule and types of shares awarded.
Tip: Educate Your Employees On The Value Of Equity
It’s pointless to give employees stock options if they don’t grasp how the plan works or see the long-term benefits. Get in touch with equity management platforms as an accessible application for employees to learn about the value of their stock, track their shares, and see how they’re performing.
Conduct a series of activities, such as ‘lunch and learns’ to go over the terms and conditions of the established scheme, speeches from entrepreneurs who have experienced large exits, or quarterly meetings to ensure that everyone is aware of the future business goals.
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Document Employee Equity In A Cap Table
A capitalization table (or cap table) is a record of all the shareholders of your company, including any employees, advisers or investors who have equity (this might include friends and family, angels or VCs who’ve invested in your business along the way).
Included in your cap table should be the total number of stock options that have already been exercised and the total number of shares remaining in the option pool. Make sure to update this option on a regular basis to ensure it accurately reflects the company’s current ownership. As well as being a key financial document to share with potential investors, an up-to-date cap table will assist with key business decisions about the fundraising process.
The Takeaway:
Detailing an equity program is no mean feat. Having open and honest discussions early on will ensure everyone who is receiving a slice of the equity pie will feel valued and happy, benefitting the startup’s runway to success. For any advice on setting up your equity program, feel free to get in touch today!
