Employee Equity: How Much?
The most common comment in this 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:
NOTE: The numbers below are as of 2010. They have moved a lot since then. The Senior Team numbers have moved the most. I would not recommend using these numbers or you will be below market with your employee equity grants.
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.
This blog post describes a methodology to size employee equity grants. I believe that this methodology is best practice in sizing employee equity grants. However, this blog post also contains multiples that were “market” when I originally wrote this post in 2010 but are no longer close to market. These multiples have at least doubled and in some regions, they have increased even more in the time since I wrote this post.
This is the key part: “move away from points of equity to the dollar value of equity”.Then comes the point about answering the employee question – “what % of equity does this mean for me?”. I’ve deflected it by saying that the focus should be on the upside, and regurgitating almost what you’ve just said about focusing rather on 3-5X or 10X over the 3-4 year horizon.I feel better that my last allocations were pretty close had I used your formulas, but without using them. I applied a mental ratio tied to salary/position, as that made sense to me. The formulas will sure help for normalizing the process. Thanks for sharing this insight.
I’d be very interested in % of outstanding shares in any equity and last valuation for any funded or revenue based startup job. It’s hard to understand dollar based equity grants without a revenue model. They are only as good as x% of a company. I wouldn’t want a much lower equity grant because of a spike in valuations, as there will come a reckoning where valuations will be not as inflated in later rounds (not necessarily down rounds, but much lower growth). Interesting that with Fred’s formula hiring and equity grants should happen right after a lofty valuation.By the way .1% of a company is meaningful in this perspective, certainly if the company is attractive and growing fast. An exit in 4+ years of $100 million results in $100k for .1% grants. Framing equity in probabilistic exit sizes is just as hand waving as any other estimation method. It’s not like working for a BigCo or Banking job and getting bonuses but it’s not insignificant to a lean lifestyle.
It’s about the upside that the employee has to buy into, and their respective role in helping to make that happen. If an employee expects to be given 3-4% of a company, whereas they only received .x instead, then it’s not the right hire.
Wow. Really useful Fred. Thanks.
Fred, one thing that never ceases to amaze me is notwithstanding my experience in the business, you and others continue to teach me almost daily.What I most like about the USV approach is the multiplier concept applied by level. While some quick math shows that our “banding” of grant levels (in % of FDSO) by role gets us essentially to the same place, there is an elegance to your formulation and messaging that is appealing. It provides a ready starting point for all negotiations, and is less variable than the banding approach we currently use. It also forces a relationship between cash and equity, which is probably not a bad place to start.You and I have had some disagreement in the past about an employees’ ability to trade cash for equity, e.g., if they more heavily weight equity than cash, accepting a lower base salary in exchange for a larger option grant. I personally am ok with this, within a range, as even entrepreneurial people can have different utility functions. But absent this, I think your framework is a great starting point.Thanks again. Btw, you should rename your series from MBA Mondays to VentureEd Mondays. Because believe me, this is the kind of stuff you do not learn in Business School.
I’m going to have to quickly defend the title “MBA Mondays”….we learned very similar goodness in b-school at Wharton. 🙂 Granted, Fred has a very clear way of communicating the material.
Fair enuf. Mine was circa 1993. Maybe that’s the reason…!
“Because believe me, this is the kind of stuff you do not learn in Business School.”That’s why I didn’t go into business school – and I’m happily enrolled as a full-time student at FredSchool (mind you I cheat and go to a few other schools too…)!
The cash for equity trade is highly appealing. While it converges the alignment between founder and employee, it’s also likely that early employees that prefer sweat equity over cash would also found their own company. But opportunities to team with fantastic cofounders don’t grow on trees, so enabling this type of compensation is an advantage over startups that don’t.Taking lower pay in lieu of equity is like doubling (or tripling) down on a job. You make the company successful or go bust :).
I think Fred has seen from experience that while it sounds highly appealing, when it comes to employees (he specifically excludes founders) you have to have a structure and mainly stick with it. There will always be exceptions for superstars.Going away from the structure seems to cut both ways. If the company is doing poorly the employee will be pissed and want to renegotiate, if its cranking the other employees will be pissed and want to renegotiate.
It depends on your point in life. My mom doing that is silly. Me doing that is smart
MBA stands for “My Best Advice” 😉
true, they didn’t teach me this in business schoolbut i think i am stuck with MBA Mondays nowthanks for the awesome comment roger
Very helpful, now I am wondering how to negotiate from the other side, ergo if I am the one being offered equity how to make it larger for the least amount contributed.
excellent post fred. I’ve seen you lay this out in board mtgs and it’s great that you are passing it along to everyone else too.
What other pro tips is Fred holding back on? Do tell. 😉
i’ve seen him levitate but I don’t think he wants that getting out.
he wasn’t levitating bijan, you were probably just sinking 🙂
keep reading AVCi hope to get them all out by the time this thing is over
Wow…great info. Thanks.Honestly in many years coming on as marketing and sales exec (bracket 1) I thought the founders just made the number up 😉 Felt emotional not analytical.
that’s probably because they were making it up Arnold. Fred’s version is the gold standard!
It would always shock me at how much equity you’d give employees to start, but realizing how important having a superstar team and a team that sticks around is invaluable.You explained the same thing at the Miami FOWA conference in a workshop, but it’s nice having a hardcopy to review and go over later when the time comes.. 🙂
I like the $ value approach to equity – it is how I’ve done it for a long time. I do still feel strongly that employees should be told their % ownership, preference structure and any other pertinent details even if the $ value is (rightly) the number emphasized. I am constantly amazed how many companies say % ownership (or equivalently # of outstanding shares) is a trade secret or whatever.
This area, even at a ‘VP’ level is information that in the past you had to ask and pry to get to. This transparency is inspiring.
Huh? Only an idiot would accept an offer based on “X number of shares”, or “$X worth of shares”, without knowing what percentage of the company that represented.How do I know that the “value” of my grant isn’t based on an assumed “best value” of “$100 billion trillion”, or if the company has a billion outstanding shares *cough* *Facebook* *cough*!?!?
Of course.My point is that the transparency that we experience as ‘must have’ today was not commonplace prior. The transparency and disclosure that we have now, based a lot on the power of the social web, is exhilarating and has changed both the process and people’s expectations…likewise the people themselves. Good stuff.
I completely agree Chris – if I’m giving equity to somebody it is with the goal to have them become long term, active members of the TEAM. Transparency and trust is key, sharing those details helps you build that trust early.
I agree completely, except how far in the weeds do you go with preference structure?If you price the options at the value of the last round as long as you have a 1x non-participating its irrelevant. For the preference to trigger the option is out of the money.Now there probably are a ton of terms that could affect the company but I’ve never wanted to get into those.
Whenever I’ve been responsible for issuing employee stock options as part of a compensation package, I’ve always shared the raw number, the percentage, and enough information to compute the dollar value in the Employee Stock Agreement. I’ve gone as far as to provide a spreadsheet to analyze the offer, always suggesting that they consult an employment attorney and ask questions. Adding in the anonymized cap table details or some other document for understanding preference structure is very important also.
it would be great to have your spreadsheet!
Yeah the $$ makes sense. I wonder who didn’t use it before though. You own .05% of the company not only sounds lame, but is not really meaningful metric or way to compare offers.http://tech.rawsignal.com
Do you think there is a point when you scale up enough that you should stop telling % -it will hurt morale in a way
totally agree and i have stated that numerous times in this employee equity series.how can you expect employees to feel good about working at a place where they aren’t even told the basics about their comp?
Very informative post; thanks! As a finance nerd who recently joined to the startup world, I’m very interested in reading about the co-founder version of this discussion. I hope you will include that in MBA Mondays soon.
This is great practical knowledge for any company that grows beyond founders. What I’m curious about is job categories and titles, they always felt weak compared to what a person contributes. As startups grow they require increasingly specialized roles, ie the CTO for a 2-10 man company is very different from the CTO of a 50-100 person operation. Founders would like trusted team members to grow into certain roles, but career paths are unpredictable animals. Off-topic: Samurai and RoninI was curious from a founder and board perspective on fantastic early employee leaving before full vesting is earned, or how vesting changes with role switching (from a CTO to a VP or Product lead). One concern I have of employee number one roles is having little influence on decisions (vs founders) and maintaining shares in a rapid growth company (because of my work). It appears that if 5-10% of a rocket growth company would be cause for founders and board to terminate employee #1 before vesting with no recourse. I’d never want to be at odds with what’s best for the company long term (having increased employee equity available). A rapid growth company will likely obtain and train a core of tech folks that are all highly familiar with the infrastructure and scaling path, especially if the tech lead is doing their job right (remove all single point failures).
Providing the actual formula is super-helpful. Thanks, Fred (and big compensation consulting firm who is now pissed!) ;)Forgive me if this was covered in an earlier post already, but I’m curious about the protocol for increasing an early employee’s equity.Are there any common practices here and/or specific cases why you’d do it?
many approachesyou can make a one time grant like you’d make a spot bonusor you address it in the refresh grant process if that is coming up soon
got it. typically, used as a reward for good performance/longevity or arethere other circumstances that are common? (retention in hard timesperhaps?)
Any chance of you posting the spreadsheet – no handholding requests, I promise !
nope, it’s a beast and we aren’t putting it out theresorry about that
Turn MBA Mondays into a book and I’ll buy it, even if the content is the same with the blog.
Vruz is working something up already
Please let me know when you have the book. We tutor MBA students at http://www.graduatetutor.com and would love to spread this to our finance students!
Hi FredVery interesting! I wrote a bunch of code to calculate grants for a previous startup in a fairly similar way. One thing I added that you don’t is that I also multiplied by two slowly decreasing exponentials.One was e^(-0.0003 * company_day_number) and the other was e^(-0.021 * employee_num)The reasoning was as follows: – If you hire 2 great programmers with the same salary one after the other but 6 months apart, the former should get a little more because they took a higher risk. – If your company has 10 people for a year and then you hire someone 2 years later, that 11th person in should get less because the 10 person team has been holding things together for 2 years without additional help.The exponent constants are obviously open to discussion (higher negative constant gives more aggressive decay), but I think the motivation is a good & fair one.Terry
That one was a masterwork Terry. Your focus on alignment and performance was unique in my experience.
Terry, you can adjust for for the time value of employment by altering the strike price of the employee stock options. If the value of the company has increased during the 6 month period, the risk has been reduced, and the strike for the same number of options should be higher. Simply value the company appropriately, set the strike, and you’re good. This also adjusts for growth that doesn’t follow the path of your assumed exponential function. This is exactly how it’s done at a public company, why not follow best practices?
Hi GB!> why not follow best practices?Because a startup isn’t a public company. Figuring out what an appropriate valuation is is very difficult & subjective. Did it go up? Down? Not move? Getting an external appraisal (the safe way to do it, legally speaking) runs you $5K-$10K. Having a change in strike price likely requires board agreement. Basing an option agreement on a guesstimate is asking for trouble – what if you were way off, and the employee sues you down the line? It’s not nearly as clear cut as a public company, where you have an in-theory very recently market determined price at any point in time.Miss your smiling face around the BW offices… 🙁
Of course valuations are hard, especially pre-A-round, pre-revenuevaluations. Independent of your approach Terry, you still have to set thestrike on those employee stock options – setting them the same at time t andt+6months for two different employees would open you to more potential legaltroubles than a mistake in valuation. But I’m not an attorney, and neitherare you. I miss your face too my man. FluidInfo 4 Life!
Terry, dare I say your algorithm isn’t realistic. Risk is contextual and time is just one of many considerations. I’ve been part of at least one startup that was flush with capital and opportunity squandered by the existing team. New hires were brought in to get the ship back on course. I ask you, who took a higher risk? In the context of your example…developers starting with a clean slate have it easier than those who might inherit the consequences of earlier decisions. If early architectural decisions later put a company’s viability and competitiveness at risk, possibly forcing a complete redesign of its product(s) which it may or may not be able to afford…who takes a higher risk?Of course I have the benefit of hindsight. New hires have no such luxury. They often realize that they’ve stepped into a minefield after they hear and feel the click.You might want to rethink your approach. I can think of numerous realworld examples where it would not fly.
Hi JosephI didn’t mean to argue that it’s particularly realistic. But I think the default should be to have a go at including some kind of factors for these things. Of course if the company has gone pear-shaped or non-linear in some odd way, the formula could be revised heavily (same might apply if a founder leaves with a lot of unvested equity).If you *don’t* make any adjustment for these things, it’s also unrealistic. If a startup company hired you for $X and you worked your butt off for a year, and then they hired me for exactly the same salary and gave me the same options package, don’t you think you’d be a bit miffed?Some of this adjustment can be made, as in Fred’s workings, based on valuation. But if it’s a year since your last investment, that’s a hard call to make. Having a gently decaying multiplier can smooth things out in the interim.Anyway, yes, I agree with you 🙂 But, in the absence of non-linear weirdness, I think it’s better (and fairer) than nothing.
Oh I don’t disagree with you Terry. Which is why I wrote that time is just one of many considerations. I think yours is as valid a starting point as any I’ve seen. The challenge with the “weirdness” is that some of it cannot be anticipated in advance, or is simply ignored/overlooked. So, in fact, new hires may be walking into a much riskier situation than their predecessors and they won’t always be fairly compensated.Equity/compensation should be more closely tied to one’s contribution to the company. These days it’s largely tied to one’s role and “attendance” (i.e. I’ve been here longer than you have, therefore I deserve to receive more).
Hi again JosephStartups are inherently weird, I guess 🙂 And agreed completely re walking into a mess where things are worse than you could have known.With your last point you’re highlighting what I think is the most intractable problem of the lot. Equity arrangements are made up front, and they’re always wrong to some degree, in practice and in perception. Therefore, if a company has granted a worse-than-expected employee too much equity, they should (in some sense) be looking for a better use of that excess equity (firing? re-distributing it?). Whereas OTOH if a better-than-expected employee is granted too little, they are likely to at some point be thinking that things are wrong (resigning? asking for re-distribution?). Those scenarios are the norm (mathematically) – fortunately not many people (at least that I know) spend much time obsessing over them. But it does mean the dynamics of making equity grants ahead of time (even with the safety net of vesting) is inherently very difficult (i.e., impossible) to get exactly right.There, I’ve written 3 paragraphs and said “inherently” in all of them. I guess it’s one of those days….
I agree with you that stock/options are awarded based on a very basic assumption “I hope you will add the value I expect you to add”. Overperformers and underperformers are not known ex-ante (no difference is made) but should be treated very differently ex post, when all the info (value added) is available. There are some good provisions to deal with this.
Hi again Joseph.Here are a few data points on what I meant by “gentle”. If you plug in company_day_number values of 10, 365, and 2 * 365 into my formula, you get values of:0.997, 0.896, and 0.803.I.e., if you signed up with salary $X right at the start and I signed up with the same salary 2 years later, I’d get a 0.803 multiplier (from that part of the formula) on my number of options.
there are all sorts of twists you can take on the basic methodologyi like yours
I’m putting on my employee advocate hat for this post.For the sake of clarity Fred, you are talking about employee stock *options*, not employee equity, correct? Your explanation/calculation has set the number of shares controlled by those options and standard vesting, but hasn’t set the strike or expiration (assuming ten year – standard-ish). Would love to hear your best practices on these.The part here that is *critical* for potential hires from a negotiations standpoint is that there are 3 employee stock option numbers reflecting the grant total that can be expressed to a new employee. Each expresses something different about the entity making the offer and about you.1) Grant expressed as options on a number of shares – will you be wooed by just seeing a big number (thousands, tens of thousand, millions of shares) without any context in terms of fully diluted shares outstanding?2) Grant expressed as options on points of equity (%) – will you be wooed by thinking about that percentage in the context of a 9 figure exit (wish factor)?3) (Fred’s offer) Grant expressed as present value in dollars of shares, assuming fully vested fully exercised options today (ie. actual equity) – will you be wooed by what looks like a signing bonus, but should probably be divided by 4 and discounted a year to represent what it’s worth after the one year cliff/lockup?Fred’s offer, as presented, appears to align an offer today with the value today (commendable and I support that approach), but the devil is in the details when calculating the value today.And if you aren’t getting the Employee Stock Option Agreement at the time of the offer, raise an eyebrow. With this, you can calculate all three for yourself. This is why good employment attorneys are necessary – and if you consider yourself a key hire, have the employer pay for your legal fees (can’t hurt to ask). If you consider yourself a *really really* key hire, ask for the cap-table while you’re at it (a good lawyer can walk you through why).Back of the envelope thinking shouldn’t supplant doing the work, hence, I’d still love to see Andrew Parker’s spreadsheet on an as-is basis. I can back out any Excel nerdery, not a problem. Heck, I might even post my explanation. Any takers?
Does the Employee Stock Option Agreement always show the fully diluted shares outstanding? (which i assume an employee could use to see their % ownership). Any idea if this is a requirement by law to do?
I am not an employment lawyer, but if there are any in the house, this a great way to drum up business. 🙂
you have to take this post in the context of the entire employee equity postwe’ve talked about every form of employee equity out there
Understood. Let me go back and read the entire series. Would be helpful if you hand links to them all at the end. It’s a fascinating topic for sure, and any effort to demystify total compensation helps everyone.
Hi Fred – Thank you for this very informative post on equity. Quick question – Why are the CEO and COO options granted by the board as opposed to the same manner as the other brackets?
Who else is there to sign-off the CEO’s comp package?
Good point about the CEO, but couldn’t the company president sign off on it (assuming the President and CEO are different people)? Also, why is the COO grouped with the CEO as opposed to the others?
it’s because the top execs comp is usually a board matter
Got it – Thanks for clarifying!
As a retained executive recruitment consultant specializing in start ups and growth companies with a focus on VPs and C-level, I like this value method. It is worth mentioning it should be applied to what the candidate/employee would make not at a start up. A lot of candidates consider less cash to have a stronger equity position. For example what a candidate would make as VP or Director staying at Google vs. the lower cash compensation your start up is offering. For this method to be effective the dollars or the multiply need to reflect the market.Mark [email protected]
This is a great post Fred. Saving it for later.
Keeping in mind, of course, that as a manager you have to have the usual discussion about what happens if things do not go well, how often they don’t go well, etc….Else that folder full of pretty stock certificates would be holding the titles to my many Ferrari’s….-XC
Fred,Nice post, and as a general rule I think this is a reasonable way to approach this. Frankly, half the battle is having a formula to start with and to create some consistency around the equity you are offering new hires. Obviously, there’s no single formula for anything and there are scenarios where you would break with this formula (perhaps dramatically) in order to bring the right stars onto your team. I can think of numerous examples where companies I’ve been around have “overpaid” for top notch talent and everyone involved has been richly rewarded.I think you are right to stress the focus on value of the grant vs. % of equity. What you don’t address in this post is whether or not you recommend sharing the % of equity as well – even if the focus is on the value…or if that’s being withheld. Even in later stage companies, my experience is that savvy hires (at any level, but particularly more senior folks who’ve been involved with startups in the past) will not be satisfied with the “value” of the stock grant based on the boards best efforts at things like fair and best market value if the percentage of equity is withheld. How are you proposing startups deal with this issue? – especially expansion stage startups which are past the founding stage but have not yet acheived a scale where they can pay market rates and where the value equity is widely understood (i.e. facebook, zynga, etc.)
Hi Mikenice to hear from youi do think you should share everything including % ownership with the employeesi just think you should explain that the company makes grants based on dollar value not %s and that the board approves them that way. build it into your culture to talk about them in dollar valuesone thing about this post is that it is a part of a series on employee equity and i addressed this issue about how much to say about options in another post. i should have referenced that.
Great insights. Thanks.I am trying to understand the logic of enterprise value vis-a-vis employee salary – should there be a multiplier other than 1 in the formula and when?I hope the Thisweekin.com invites Andrew Parker to share the excel sheet Fred refers to on a video so that we can watch and learn
Yes and no. I understand what you’ve written, but my reality has been somewhat different. I don’t know. Perhaps the startups I participated in were exceptions and not the rule. Let’s take OPS Inc (name changed to protect the guilty), a private tech firm, as one example. As one of the first 14 or so “key people” I was issued several thousand shares common. More than half had vested by the time we parted ways (company-wide layoffs). Through a bit of creative accounting gymnastics during out-processing, I was told that I had to either fork over a payment for the shares not yet vested (over $25k) or surrender an equivalent portion of vested shares to the company. In other words, I couldn’t just voluntarily surrender the shares that had not yet vested…even if I didn’t want them. The company expected to get paid. And, frankly, I wasn’t interested in pursuing the legality of it all. Several thousand shares evaporated in an instant.Several years passed along with a couple rounds of additional VC funding and further dilution. I received a letter informing me that common was reverse-split 5-to-1 (with no corresponding increase in value). More than a thousand shares reduced to a couple hundred.When the company was finally acquired a decade later–and the dust settled–all that remained was a check for less than a couple thousand dollars. The founders and investors walked away with many millions, as did the senior managers who joined later in the company’s lifecycle. As for the original group of “key hires” who took the company from nothing to its first several million dollars revenue and $50+ million in funding…well, I would imagine they shared in my experience. New hires must clearly understand that all is not what it seems with equity. They tend to get fixated on anticipated or estimated value (best, fair or otherwsise). In a startup, equity dollar values are as meaningless as percentages. With the stroke of a pen employers can–at a later date–dramatically alter one’s equity stake upward OR downward. If equity is their primary motivation (as it is for many even though they’ll deny it), then I suggest they’re either in it for the wrong reasons or need to find a line of work in which the rewards are well defined. Otherwise they may find themselves disappointed later in life.
I just think in all these cases when you get screwed you just have to accept it as par for the game.A lot of VC’s will screw youin every way possible if they can, to think otherwise is wrong.Very rarely will you come across a VC who wants to be fair, if and when you find one you make sure you hold on to the relationship.If and when you ever join a startup and are issued a offer letter make sure you have a lawyer ( not their lawyers) go through it and explain to you what you are getting into. Every time the terms change you need to have it reviewed, it is sad that you have to do that as one would hope it is all kosher and fair, but as I have seen many such transactions with bad outcomes I will say you have to be on top of things and be a hawk looking out for your interests even if you have altruistic thoughts.Not everyone believes in doing the right thing always, only when forced to do they do so.
“A lot of VCs will screw you in every way possible”true and the people they like to fuck with most is other VCs
May be you can write about the various tricks VC’s use to fuck other VC’s. I am guessing you have seen your share of tricks and have become wiser.As entrepreneurs it may be useful to know how VC’s think they will outsmart the rest of us.As many in the government think that it is best to have the fox gaurd the hen house with regards to having ex Goldman Sachs folks be treasury secretaries or federal reserve bank governors like Bill Dudley etc…So you are the right person to shed light on the way VC’s fuck people including other VC’s over. A checklist of things to do and look for in a term sheet that is fair.
I will try to work this into my routineFucked Over Fridays?
yes, there are complications. we’ve gotten into many of them in this series on employee equity. check out the one called dilution, in particular
Thanks Fred,As always an excellent post. I use a similar structure when working with my clients. As other posters mentioned, this methodology allows for clear process and clear communication. Something that is missing in many companies equity compensation plans.This formula, modified as needed fr each specific companies specifics should work well for a few years into a start-up. Once a company’s growth takes off, some of these calculations should probably be grouped into salary ranges. I am assuming that you don;t expect someone making 78.000/yr to get a different number of shares than someone making $81,000/year.I think it should also be mentioned that these formulas are designed for companies who expect some type of monetization event in 3-7 years (give or take). If the companies goals is much shorter or longer term, things may be quite different.Lastly, as companies succeed, or don’t, they should look at past equity grants to determine if the formulas being used need to be adjusted. As you mentioned you generally expect a company to multiply by 3-5 times. If that is the initial assumption and the company proves to grow much faster, or slower, companies need to adjust accordingly. Sometimes companies make millionaires out of people they had no intention to. Other times companies communicate potential values that are simply not realistic.Thanks again for this post. It provides companies with a great foundation.
Oh man… I remember this one all too well.This is absolutely an algorithm in this approach that could be automated. An aspiring financial programmer should totally build this. Companies would use it. A management consulting company could resell it an a nice premium.But, I don’t think Excel is the right platform to build it. The flexibility and special cases required to do this in a “fool proof” way is thick enough that this should be built in a real programming language with constrained inputs, probably in a web app.
Shoot me your spreadsheet!
That’s Fred’s call. I built it while at USV and on their dime. It’stheir property.Also, if it wasn’t clear from my initial comment, that spreadsheet wasa beast. It’s more of an “example” than a “model.” It implementsFred’s algorithmic approach, but it really doesn’t scale properly atall and would take hours of customization to apply it to a differentcompany other than the example company it outlines.
i think we should keep that spreadsheet to ourselves andrewas you say, it is a “beast”
Ditto here – would love to see a web app with inputs and outputs that made this model friendly and comprehensible not just for owners/execs, but for employees to help value the stock/options they’re being offered (or already own).
well, can we see the sheet and the algorithms you have stuck in it already
i suspect you are going to get a few requests for that model Andrew
Private Company Analysis Tool…online app at http://www.vcexperts.com that is more powerful than an Excel spreadsheet, and being utilized by some of the industry’s top professionals. It can take the guess work and what if out of the equation.
Suppose the company starts and starts hiring and tells a candidate new employee “The Board is working on the employee stock plan and should be done within two weeks. The stock will be proportional to salary and position in the company, and that will mean that you will get one of the largest amounts of stock.” Suppose the offer letter to the employee says that the stock plan is not yet finalized but that the employee will be included in it. Suppose the employee joins, does important work that is well regarded, gets promoted to Director reporting to a SVP reporting to the CEO, gets a significant salary increase, more than once literally saves the company from going out of business, but after two years there is still no stock plan. On his last day the Founder, COB, CEO and the SVP confirm that the employee is “in line for $500,000” in stock.The employee remembers the promise within “two weeks”, remembers the two years of often 80 hour weeks, sees no additional details on the stock plan on paper, and resigns.Later the company is quite successful, does an IPO, and the price of the stock increases by a factor of over 100 from the IPO price so that the $500,000 in pre-IPO, founder’s stock would be worth over $50 million, maybe $500 million.Does the company owe the former employee stock?If not, then it would seem that a founder could just string along new employees with promises of stock but never deliver any until the company was solid and then push out the employees. Else it would seem that the company owes any such employee who got promises of stock, did well for the company for a significant time, and then left due to no stock.Where and/or to whom should such a former employee go for a solid opinion on an answer to this question?Uh, with one answer, I can win as a founder. With the other answer I can win as a former employee. Heads I win; tails they lose; unless the coin falls into the river.
Nothing happens in a business until it happens. Why would you join without a real equity contract?
Why did I join? I was young and naive. My parents never had any experience with founder’s stock and didn’t give me any advice.
IANAL, but if you still have the offer letter I would think you would have the basis for a lawsuit.
Like every business person says buyer beware. The employee is promised something within 2 weeks, but does not see it at the end of the time period. He/she can ask about it and if there is no definite answer they should have the ability to say thanks and walk away.If they wait along that is their choice and so they bear the consequences. They don’t get anything from the employer if they quit.Similar to Jason Calacanis and Tech Crunch, he quit before it got sold to AOL and therefore he is not owed anything even if he may feel justified.
i don’t know the legal answer here, but you have to get your house in order early and keep it in orderdoing stuff like this is the sign of a badly run company
“Badly run” — yup. But now he’s fairly high in the Forbes 400. The flip side is. can mess up and still be successful.”Have to get your house in order early and keep it in order”: Yes. I have to believe that this summary is based on some legal horror stories for some startups and founders somewhere in recent history.I have to suspect that some of what I received orally and on paper could amount to legally enforceable ‘contracts’. Yes, I have the offer letter, pay stubs showing the salary increase and period of employment, office memos showing work and my promotion to Director, some software I wrote that “solved the most important problem facing the start of” the company, was the last thing the Board needed to raise $55 million in funding, and saved the company, some math I did that got two crucial Board members to come back and, thus, saved the company, some people I know who could vouch for the facts, etc. For the amount of money involved, there was the founder’s $500,000.For me there were several issues:I was naive; likely for a startup to play ‘fast and loose’ promising stock was more common then; at the time I left the actual cash I was due then was not huge; later I concentrated on my own career and caring for my wife in her long illness; now there may be a legal issue of the elapsed time.I’d rather make my own money than get into a legal fight, but business can’t avoid all legal fights, and $50 million or much more is significant. So, I should collect the papers and ask some lawyers I know who have appropriate backgrounds.As a founder, I’m very concerned about the potential problems of promises, offer letters, and formal contracts about stock for additional employees. And, I don’t like some assumption that my project will need a lot of new hires, highly qualified or not, early on.Besides, I fail to ‘get it’ on hiring lots of highly qualified people, who might want stock, early on: For one, getting such a person on board and productive can take a lot of effort from me and a lot of time and cash. For another, with ‘Web 2.0’ businesses based on ‘defensible’ core technology and the rest routine, the core work is for the founder to do.Actually the first hire I have in mind is not programming or sales but an ‘office manager’: The US is awash in people who’ve been there, done that, for organizations from a few dozen to a few thousand. So this person can keep me out of trouble and let me concentrate on the technical things and getting feedback from the paying customers.Actually for the needed ‘help’ there is a theme: In this technical work, it’s easy for a person to spend more time in overhead learning material used at most a few times. So for, say, some tricky configuration of SQL Server, Cisco LAN switch, intrusion prevention system, or virtual machine support, calling a full time expert can make more sense than calling someone in my company.E.g., so far in my work, ALL the technical work unique to my project has been EASY for me, but I’ve spent maybe nine times more time on technical work, e.g., SQL Server configuration, not unique to my company. BUMMER. What makes sense is to get that expertise I need infrequently at Microsoft, Cisco, VMware, etc. Net, this situation greatly reduces the number of highly qualified technical people, and their stock, a company like mine needs.
Communicating in dollar values instead of percentages is crucial.
Wow – really useful info – here’s a question though – imagine you’re starting a company that hasn’t taken any equity or even incorporated yet. You’ve found a tech lead who would likely be your VP of Tech – but you don’t yet have any value for the company. What would be a good approach here? Just assume a value for purposes of equity, and assume a number of shares outstanding? Any approach here appreciated!
You treat them as a founder and give them a significant stake in the venture. At the stage you are talking it is an idea and they are going to be instrumental bringing it to life, thus they should be an equal in the venture.
And what is significant?
Generally in the stage where the person coming in is going to take the idea and bring it to life, “significant” is >= 50% i.e. greater than or equal to 50%.Some folks will argue that everything is about execution and therefore they should be given even more than 50%, I would say that having an idea and a completeness of vision has significant value too.Before the ipod came there were/are many other mp3 players, but it was the idea that Apple had and the completeness of vision along with their ability to execute it that led to it’s success.So Go with 50%, that would be fair.
i would not make it equal until you are sure the co-founder and you are totally compatible. until then you want to control things. i’d start with 40% and then take him or her to 50% after a year or two
Fred – like many others here, I really appreciate this advice.One lingering question I have from this – how do you recommend “re-balancing” a company’s distribution of stock ownership at these stages. In particular, if you have employees who are under-compensated in stock or you’re seeking to add new, high value, senior members to a team but the option pool is constrained or tied up?
do a refresh grant to everyone and get things in balanceit can be expensive in terms of dilution to the company overall, but it is really important to have everyone in balance
if that’s representative of the actual grants being given out by companies these days, that’s the reason everyone and their mother is starting their *own* company. you can get more options, or RSUs, at a public company on a yearly basis just to stick around.fred, i think a post looking at the historical share grants would be quite interesting – it seems like enron, and our govt’s response, really screwed the average worker out of a lot of wealth opportunities / possibilities.
That may be a problem long term- we need to grow larger companies at some point (they employee more people doing more things than everyone sitting there doing something by themself)
you have to factor in the upsidegoogle might give $3.5mm in RSUsbut the options the first employees got in Twitter, Etsy, Zynga, and a few other of our portfolio companies are worth well north of that number
but those companies are not representative at all – they are the major success stories of the past 5 years. it doesn’t seem like the risk your average start-up worker is taking is accurately reflected in options grants. straight out of college, 14 years ago, with the very limited info available back then, i got more favorable terms than you describe in your post. i think sox, despite targeting large public companies, has seemingly trickled down the ecosystem and has had a detrimental impact on non-founders.
Great post as usual!”You get that by dividing the fair value of your company ($25mm) by the fully diluted shares outstanding (10mm).”I think you meant to say “best value” and not “fair value”
right, will make that change now
Great post.One exception to this rule that I’ve seen before is equity in lieu of cash. There are some rock star employees who might have made $175K in their last job but you’re able to attract them for less cash (say $125K) in exchange for more equity in a hot startup.If that is truly the case, you may end up basing the multiplier off of $175K, as well as adding another $50K in equity to the total to truly compensate this person for the risk they’re willing to take.
yup, that’s additive to the numbers i described above
In my view they’d ask for more. The total cash comp they would give up over a 4 year period would be almost $200K (or $100K before the refresher kicks in) so the addition should be $100K and not $50K.
In my view they’d ask for more. The total cash comp they would give up over a 4 year period would be almost $200K (or $100K before the refresher kicks in) so the addition should be $100K and not $50K.
Good luck getting someone for .5x of 1st year salary,,,,that is laugable
That was my impression, too, especially at the director level.Unless you’re paying them at least market rates — and the implication is that as a startup, you’re paying *under* market — you’re asking the employer to accept the equivalent of an annual bonus which is:1) At signing, only worth 1/16 of their initial salary;2) Is illiquid; and3) Has a very high chance of being worth $0.And the upside isn’t so great either. Let’s say a person has to choose between a $100k/yr job at an established business or a $90k one at a startup. The $100k one has a 10% bonus opportunity; the startup comes with the 0.25 options multiplier. Assuming the exercise price of the options is zero, the option grant is $22,500 at signing.Just to get to even — assuming no bonus paid to the established business employee, the shares need to be worth 1.78 times the grant amount. If the full 10% bonus is paid, the shares have to be worth 3.56 times. Seems dangerously close to even-at-best for the startup.
most of our portfolio companies pay market in cash comp, a few don’t
That really does change things a lot (no sarcasm implied). Thanks.
i don’t need good luckthese numbers are based on actual data in our portfolio
Wow! this post is both timely and excellent, thanks Fred!
Totally agree on the basic framework. But using salary as the basis seems unfair; startup salaries are usually reduced significantly, and sometimes the most senior people make the least. So this method double penalizes them. Instead, you could substitute their “market salary”, or you could just take the difference between what you’d expect their total comp to be down the road (i.e. when the company is thriving) and their present comp and use that as the basis for the grant.
use market salariesmost of our companies pay market on cash comp anywayit is expensive to live in NYC
Any chance we will get advice on the “co-founder” split? I realize this is much more subjective and an art form, but it would certainly be great to hear any examples you might have.I am currently starting a business, and one last internal hurdle to get over is the break-down of ownership amongst the 4 founders. I realize there are always going to be different circumstances, but a guideline would be useful.
Ditto – would love to hear Fred’s take on co-founder equity spilt too.
My favorite resource on the co-founder equity split issue is “Cutting Up the Founder’s Pie” by Carnegie-Mellon (Tepper) entrepreneurship professor Frank Demmler. It’s on my list of links at http://bll.la/9n along with the CompStudy report (lots of empirical data on equity and cash compensation at startups).
somebody has to be the boss and be able to ask the others to leaveand have vesting on the founder shares
This was really a good methodology to adopt, the insight about first few employees is interesting to say the least.
“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.” Are you suggesting $87.5k equity (a) each year or (b) vested over 4 years (i.e., $21.875k equity per year)?
$21k of equity per year but most likely it will appreciate 3-5x over the four year vest if you are working at a good companyso you can walk away with $250 to $400k of equity valuethe whole point is equity goes up in value tax free until you sell it
How Does One Get An Investors Attention?. OK … lets say an investor is enjoying a fine day at the museum, totally captivated, standing close up observing a painting called “WATCH OUT” which features a row of ducklings waddling across a grassy field headed toward a pond, where a hungry fox awaits behind a tree.. and … lets say, I too am observing the same painting, but from a distance. . from where i stand i can see an object, perhaps a large metal weight fastened to a rope, swinging toward the investor who is still captivated by the painting, . do i yell out “DUCK!” or “WATCH OUT!” ??? ………………………………………………………………………………. . well i have a cause .this has nothing to do with ducks so i’m yelling “PLEASE LOOK AT MY TECHNOLOGY!” http://champressed.wordpres…Frank E. Smith
not by spamming the comment threads at AVC
Thank you for the post.A request for another MBA Monday topic at the bottom of the comment pile:Non-cash remuneration for advisors in early stage companies (lawyers, accountants, and in the case of me, presentation and pitch designers. I often get requests for non-cash payment but I have not found a simple/workable solution.
how about give the advisor the option to bill in cash and take stock calculated at the cash obligation divided by the share price (as calculated in my post)?
Makes sense.My next issue would be rough valuation guidelines for very early companies as an advisor, not an investor (i.e., much less money at stake) on 2 axis:1) How early they are (some ideas I see are at pre-PPT stage)2) My non-VC gut feel of the probability of success [there is a spectrum: I won’t take on “basket cases”, and I will probably work for a company that I think is good, but would not be willing to put my own money in, all the way to highly interesting ideas]If the company has a valuation point, then this will not be an issue anymore.
a few employees – worth less than $5mmproduct launched but no real traction yet – worth less than $10mm
I don’t know
Interesting. I’m not from the valley or for that matter US, but it gives an impression that incentive for non-founders to join a startup is very less. Equity options worth half (and less) the annual salary does not fit the risk and reward balance. Reward is too little for the risk employees take. Well one can count the intangibles of working in a startup but they are the same for everyone, rather more for founders.I think it is only worth working in a startup if you are not a founder after all Google and Facebook don’t happen often. Or may be I’m just plain wrong…
edit: :I think it is only worth working in a startup if you are a founder”
remember that your equity value ought to go up 3-5x over the four year vest if you are working at a good companyso if the options are worth half the annual salary at grant, they ought to be worth 1.5x to 2.5x annual salary after the four year vestand there’s a retention grant after two yearsso over four years, you can double your salary every year with equityand since you can’t spend your equity, its like a forced savings plan. when you finally are vested, you’ve got a “nest egg” that you can use to buy a home, build a portfolio for later in life, etc
Great post Fred, and as usual, the comments were just as valuable. Saving this one to Everlater.
Fred, this is a great post. Thanks for taking the time to do these MBA Mondays, they are extremely helpful.
“….this blog doesn’t come with end user support….” 🙂
This is a really great post that provides a lot of guidance. I have a question about non-equity compensation for founders. At what point do you expect the founders in the companies you fund to draw a salary? And is there a common line of thinking on the amount of that salary?
they should draw a salary once we invest
Hi, Fred- Longtime/first Time…My company extensionEngine partnered with Fidelity’s Exec search firm J Robert Scott on http://www.compstudy.com, a system that gives VCs and entrepreneurs the ability to see what their peers are doing with all aspects of their compensation (base, bonus, stock), including stage, location and type of company (software/tech and biotech are the focus). The data has been collected for the past decade by Harvard Business School professor Noam Wasserman. Let me know if you’d like to check it out (if you don’t use it already…)Interesting research is being done about the relationship between salary and startup success – the recent conclusion is that lower-paid CEO’s (and consequently the rest of the team) lead to higher rates of success. Food for thought!
we do this among our portfolio companies but we don’t share that datawith anyone other than our portfolio companies and we don’t charge foritit would be great if we could create an industry wide data coop thatprovided this data for free to everyone
Is it going to be a trend that reading comments costs 3x~5x time than the actual blog post?Few months ago, I don’t even read comments, but now I have to. I think % is for the board and senior team. If I’m a founder, I’d convert every hiring into %. because it’s easier to track them in a human brain. I’ll leave $ for VCs to worry about.
Hey Fred,I really appreciate your posts on employee equity, has cleared a lot of things up for me. There is, however, a subject that I was hoping you could touch on, which I’m sure will be relevant to entrepreneurs and employees alike.During the on-boarding process, how much transparency should be communicated to the employee regarding the value of their shares?Here’s an example – I recently joined a start up that had raised a 1M dollar round. They offered me 8000 shares at a 30cent strike price over a 4 year vesting period. The CEO was hesitant at disclosing the current value and revenues of the company, but he kept insisting that if the company was to exit, it would be in the next 12-16 months and that I could expect a 10-15x multiplier on my shares. I was quite skeptical of his pitch, as the CEO is always going to oversell you on the value of his company.It is now 6 months later, and I’m starting to realize that a potential exit is further along than I initially thought. If I had more information from the get go I feel that I could have made a better informed decision and negotiated a more equitable package. I realize that a company’s financial information is a very sensitive manner, however, any benchmarks it’s quite difficult for an employee to value his or her compensation package.Having said all of this, what would you say is a reasonable amount of information to request from your employer during the on-boarding process, and what is the best way for an employee to determine the value of their shares when missing key pieces of information?Thanks Fred
i think asking for the last round valuation and current year revenueplan is a reasonable thing to ask
What about equity for co-founders I am trying to recruit? Any advice…..
Thanks for this excellent article !You said : “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.”Could you please write an article about Equity sharing between co-founders in a next artcile? This subject will certainly interest a lot first timer entrepreneurs!