Posts from management

Reblog: Employee Equity: How Much

This may be the most popular AVC post of all time based on the amount of traffic it gets month after month after month. I think I may rewrite it at some point because while I still believe the basic ideas here are correct, some of the math has changed due to market pressures and it deserves a rewrite. With that caveat, here it is.

——————————————–

The most common comment in the long and complicated MBA Mondays series on Employee Equity is the question of how much equity should you grant when you make a hire. I am going to try to address that question in this post.

First, a caveat. For your first key hires, three, five, maybe as much as ten, you will probably not be able to use any kind of formula. Getting someone to join your dream before it is much of anything is an art not a science. And the amount of equity you need to grant to accomplish these hires is also an art and most certainly not a science. However, a rule of thumb for those first few hires is that you will be granting them in terms of points of equity (ie 1%, 2%, 5%, 10%). To be clear, these are hires we are talking about, not co-founders. Co-founders are an entirely different discussion and I am not talking about them in this post.

Once you have assembled a core team that is operating the business, you need to move from art to science in terms of granting employee equity. And most importantly you need to move away from points of equity to the dollar value of equity. Giving out equity in terms of points is very expensive and you need to move away from it as soon as it is reasonable to do so.

We have developed a formula that we like to use for this purpose. I got this formula from a big compensation consulting firm. We hired them to advise a company I was on the board of that was going public a long time ago. I’ve modified it in a few places to simplify it. But it is based on a common practive in compensation consulting. And it is based on the dollar value of equity.

The first thing you do is you figure out how valuable your company is (we call this “best value”). This is NOT your 409a valuation (we call that “fair value”). This “best value” can be the valuation on the last round of financing. Or it can be a recent offer to buy your company that you turned down. Or it can be the discounted value of future cash flows. Or it can be a public market comp analysis. Whatever approach you use, it should be the value of your company that you would sell or finance your business at right now. Let’s say the number is $25mm. This is an important data point for this effort. The other important data point is the number of fully diluted shares. Let’s say that is 10mm shares outstanding.

The second thing you do is break up your org chart into brackets. There is no bracket  for the CEO and COO. Grants for CEOs and COOs should and will be made by the Board. The first bracket is the senior management team; the CFO, Chief Revenue Officer/VP Sales, Chief Marketing Officer/VP Marketing, Chief Product Officer/VP Product, CTO, VP Eng, Chief People Officer/VP HR, General Counsel, and anyone else on the senior team. The second bracket is Director level managers and key people (engineering and design superstars for sure). The third bracket are employees who are in the key functions like engineering, product, marketing, etc. And the fourth bracket are employees who are not in key functions. This could include reception, clerical employees, etc.

When you have the brackets set up, you put a multiplier next to them. There are no hard and fast rules on multipliers. You can also have many more brackets than four. I am sticking with four brackets to make this post simple. Here are our default brackets:

Senior Team: 0.5x

Director Level: 0.25x

Key Functions: 0.1x

All Others: 0.05x

Then you multiply the employee’s base salary by the multiplier to get to a dollar value of equity. Let’s say your VP Product is making $175k per year. Then the dollar value of equity you offer them is 0.5 x $175k, which is equal to $87.5k. Let’s say a director level product person is making $125k. Then the dollar value of equity you offer them is 0.25 x $125k which is equal to $31.25k.

Then you divide the dollar value of equity by the “best value” of your business and multiply the result by the number of fully diluted shares outstanding to get the grant amount. We said that the business was worth $25mm and there are 10mm shares outstanding. So the VP Product gets an equity grant of ((87.5k/25mm)  * 10mm) which is 35k shares. And the the director level product person gets an equity grant of ((31.25k/25mm) *10mm) which is 12.5k shares.

Another, possibly simpler, way to do this is to use the current share price. You get that by dividing the best value of your company ($25mm) by the fully diluted shares outstanding (10mm). In this case, it would be $2.50 per share. Then you simply divide the dollar value of equity by the current share price. You’ll get the same numbers and it is easier to explain and understand.

The key thing is to communicate the equity grant in dollar values, not in percentage of the company. Startups should be able to dramatically increase the value of their equity over the four years a stock grant vests. We expect our companies to be able to increase in value three to five times over a four year period. So a grant with a value of $125k could be worth $400k to $600k over the time period it vests. And of course, there is always the possiblilty of a breakout that increases 10x over that time. Talking about grants in dollar values emphasizes that equity aligns interests around increasing the value of the company and makes it tangible to the employees.

When you are doing retention grants, I like to use the same formula but divide the dollar value of the retention grant by two to reflect that they are being made every two years. That means the the unvested equity at the time of the retention grant should be roughly equal to the dollar value of unvested equity at the time of the initial grant.

We have a very sophisticated spreadsheet that Andrew Parker built that lays all of this out for current employees and future hires. We share it with our portfolio companies but I do not want to post it here because it is very complicated and requires someone to hand hold the users. And this blog doesn’t come with end user support.

I hope this methodology makes sense to all of you and helps answer the question of “how much?”. Issuing equity to employees does not have to be an art form, particularly once the company has grown into a real business and is scaling up. Using a methodology, whether it is this one or some other one, is a good practice to promote fairness and rigor in a very important part of the compensation scheme.

Options and Offer Letters

A CEO of one of our portfolio companies sent me a question about process in making offers and equity grants. I sent him a reply. And I thought, “this reply is a blog post”. So here is the reply with the specifics redacted. I hope folks will find this useful.

————————-
It is a Board’s responsibility to approve all option grants. Most boards do this at the start of the Board Meeting. It is usually just a formality, but it is good governance to do that.

The management team obviously can’t wait for the Board Meetings to make offers. So most companies make offers that are contingent on board approval, but that approval is assumed that it is going to be there. Otherwise the management will be in a tough spot having made a promise they can’t keep.

What I generally suggest is that management have a standard options grant. It could be as simple as “everyone gets at least 1000 shares when they join, important role players get 5000 shares, directors get 10,000 shares, software engineers get 10,000 shares, senior software engineers get 20,000 shares, VPs get 50,000 shares. C level gets 100,000 shares”

I just made that up. You should make one that makes sense to you.

Then you get the Board to sign off on the standard grants. Then you can make offers with standard grants in them knowing that they will be approved.

If you want to go wildly off the standard grant for a special situation (relo, super star, etc), just shoot the board an email and get buy-in before making the offer. You will still want to get formal approval at the next Board Meeting.

I also suggest building an options budget. To do this you take your standard grant schedule, and then map it to your hiring and retention plan (I suggest granting options to current employees every two years as part of a retention plan) and then you will have an options budget for the next few years. That is a great thing to have.

For many of you, this is all obvious stuff. But you would be surprised how confusing all of this is to many entrepreneurs. So I figured I would put it out there.

A Founder’s Notebook

One of my favorite things to do on the Internet is curate. I do that on my tumblr and also at usv.com. I find good stuff around the Internet and I grab it and share it with others.

So when I see others doing a great job with curating, I like to acknowledge it and point others to it. And that’s the subject of today’s post. David Jackson is the founder of Seeking Alpha, a community of stock market investors. He’s been curating management advice from around the Internet on a blog called A Founder’s Notebook for a while now. It’s really good.

My only complaint is that its not on Tumblr, where it would be an instant and easy follow. It takes more work to follow a blog when its on the open Internet (when you don’t use RSS. i don’t). However, there is a subscribe via email option on the right sidebar which is how I get his updates.

Anyway, if you are a  founder and like reading advice from around the web on management, product, and strategy, I recommend A Founder’s Notebook. It’s really well done.

CEO Bootcamp

My friend and former business partner Jerry Colonna has created CEO Bootcamp. It’s a four day retreat in the Colorado mountains with 19 other CEOs and a few facilitators, led by Jerry. The first CEO Bootcamp was last fall and you can see what attendees thought about it here. And here’s a blog post by Sooinn Lee about her experience last fall at CEO Bootcamp.

There are two aspects to this experience. There are the four days where attendees learn skills to help them manage the leadership role they are in, and there is the ongoing support that the group of CEOs provide each other after the retreat is over.

The CEO Bootcamp has some requirements. They are:

  • You’re the CEO of a tech start­up that has employees.
  • This is the first time you have been a CEO within a company of this scale.
  • You’ve logged immeasurable hours and have made tremendous sacrifices.
  • You’ve had success with your company. You realize there is more to this game than “success.”
  • You may be tired, but you must be vulnerable, curious and courageous.

If you fit these requirements and want to spend four days in early April in the Colorado mountains with a bunch of peer CEOs figuring out what it takes to be a successful leader, you can apply here.

Employee Equity

Longtime readers will know this is a topic near and dear to my heart. I did a whole MBA Mondays series on this topic and I followed that up with a Skillshare class on the topic.

So I was excited to see that First Round Capital featured a blog post by Andy Rachleff on this topic yesterday. Andy was a founding partner at Benchmark and knows his way around a startup cap table. Andy included this slide deck in his post and I will reblog it here.

You will notice that Andy's plan differs a bit from my plan. But not by much. The important similarities are that Andy and I both encourage companies to not only grant equity at the start date but also on an ongoing basis so that employees' equity ownership grows as their tenure and contributions grow. This is critical.

Where Andy and I differ a bit is how to calculate how much equity should be granted. Andy suggests using market comps. I don't like doing that because 0.1% of one company can be worth a lot more or less than 0.1% of another company. I prefer to issue equity based on a multiple of current cash comp divided by the current valuation of the business. I lay that all out in my Skillshare class.

While I don't call out promotion and performance bonuses specifically in my Skillshare class, I am a big fan of both.

It is so great that folks like Andy are taking the time to lay out an approach and model to this issue. It is something literally every startup we work with struggles with. Getting it right is hard, but worth it.

The Fall Of The Alphas

Fall of alphasI read a book this weekend. It is called The Fall of The Alphas. It was written by my friend and former colleague Dana Ardi. Dana is a corporate anthropologist. She studies what makes management teams work. She has also been a writer, a recruiter, a coach, a VC, and a private equity investor.

There is a change afoot in the global economy that is impacting every institution, every market, and every business. Hierarchies are giving way to networks. At USV we have turned this observation into an investment thesis.

Dana has seen the same change impacting management teams, managers, and the companies themselves. Her book is about this change and in it she explores how the iconic Alpha CEO is giving way to a new kind of leader/manager that she, naturally, calls the Beta CEO.

Unlike many business books, this one is not boring or hard to read. Dana tells stories to make her points. Her language is light and airy but the lessons are clear and actionable.

If you lead a company or a team inside a company, you ought to read this book. It will change how you think about leadership and leadership styles.

Starting and Finishing

AVC regular Donna White posted this to her Tumblr yesterday:

I'm a crotchety old guy. I worry about all these new companies. I’m glad that they’re easier to start, but the problem is, they’re just as hard to finish as they have always been.

The quote is from Mike Olson in this post.

The thing in Mike's quote that really speaks to me is the difference between starting and finishing. Starting requires an idea/inspiration, a team, some technical skills, the ability to iterate on the MVP and find product market fit. That's hard for sure, but what happens after you find product market fit is even harder. That's called building the company and building the business. And that is where I have seen all founders struggle. The ones that have done it before a few times seem to manage through this struggle better. The ones who are doing it for the first time really need a lot of help from mentors, coaches, and their team to get to the finish line. And many don't. Mike handed his company over to more seasoned managers and many other founders end up doing that too. Sometimes the VCs/investors have a role in making that happen. Sometimes the founder makes that call on their own.

The skills that get you from idea, through initial product, past product market fit, and into a market leading company are very different from what it takes to manage a 200-500-1000 person global business that needs to exectute well across a range of dimensions and keep everyone aligned, motivated, and working well together.

The quick pivots, the exhausting product/engineering sprints, the rapid fire innovation, the missionary zeal, etc work so well in the early days but they get old quickly and they don't scale. At some point calm, rational, supportive, and highly communicative management skills are required. And learning those on the job is hard. As Mike points out in his post, it is a bit easier to learn those skills from watching someone else who is really good at doing that. And that is why Mike argues that founders should pay their dues working in someone else's company before starting their own.

I agree with Mike that learning from someone else is a better model for becoming a great CEO. But often a first time founder has the right idea at the right time and assembles the right team and ships the right product. And getting behind that kind of founder has produced the best returns over time for USV and for many VC firms. So the art is helping the first time founder learn how to turn themselves into a great leader manager or helping them decide that they should step aside and let someone else take over.

I have seen both done both many times. There isn't a right way or a wrong way. But there is a right way or a wrong way in a specific situation with a specific founder and company. It all depends on whether the founder wants to make that shift, is making that shift over a reasonable period of time, and that the company is making that shift with them.

It's postseason baseball time. So I will use a baseball analogy here. The starter rarely pitches a complete game. Most times the winning team will leverage both a great start and a great close from two different pitchers. And there are plenty of both in the hall of fame.

Update: As my friend John points out, there are only 5 closers in the hall of fame. Not sure what that means for this post, other than my analogy was a bad one and I should have done some homework before using it.