From The Archive: Employee Equity - How Much
I’m skiing this week. It’s snowed two feet in the last two days. So we will continue to dip into the archives until I come up for air, later this week.
I saw this tweet exchange yesterday about my employee equity post.
So I’ve reposted it here below.
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. I am working on an updated set of numbers. 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.
hmmin every early stage company i’ve joined the salary was always below market cause the cash flow wasn’t there. this was compensated with equity as that is what they had.curious how this breaks or doesn’t with the comp time multiple equation you use.answer AFTER you ski!
An “easy” formula is `( 2 x market_comp – actual_comp ) * bracket + fudge`, meaning make up the difference plus a little.But, like Fred said in the post, your formula for the first 1-10 employees is probably less of a formula than a wet thumb in the air.
i find this post really useful and have referred to it and shared it often.personally i’m usually or have been in the first traunch of employees so it is always a different story.
I have shared (and used) that one as well, many many many times.
The framework is extremely helpful – the biggest challenge I’ve found is figuring out the right multipliers. As you say, there’s no hard and fast rules on multipliers and it’s more an art than a science (though it would be helpful for founders if there was more transparency around this).The example used (0.5X for Senior Team) seems to be way below market today (which perhaps makes sense given this way written 7 years ago).
Thank you very much for sharing this Fred. It is cool to get a nuts and bolts breakdown of industry aspects and to see how your team approaches things
This is probably your most popular post, right?One change I’ve seen is strike prices at near zero even when share price is a couple dollars. In effect, no cost to exercise. Tax implications though.
seeing any change in time to exercise post leaving?
Been 90 days at the last few jobs I’ve had…but not seeing any such restriction for current position. Can’t say how common this might be.
i think you are right.when i left RLD their contract was two years to exercise. error obviously. nice for me.
Yeah – I’ve seen these grow from 90 to 180 days (which I think of as standard) to several years (Pinterest famously chose 7). Good trend but I’d be curious if it doesn’t have the opposite effect of retention and instead encourages mercenaries in certain in-demand roles (eg. accumulating a portfolio of 1-yr-cliff vested stocks across a variety of companies and holding longer to exercise).
I don’t think the timeframe to exercise post leaving impacts much and honestly, I’ve never asked.Most don’t and I don’t really remember counseling anyone as anything past the normal is upside.In the list of protections that fall on negotiable with or without board intervention, this is to me a nit. And almost impossible nor advisable to negotiate.Or so it seems to me.
It does for many junior employees or folks who otherwise need to manage cashflow and may find it prohibitive + risky to plonk down cash to exercise. Not many options for loans, etc unless you’re a founder/sr exec. The extension mitigates this challenge and I would naively like to hope it encourages some forward-thinking tax planning, too (a girl can dream).
Hadn’t had any discussions around this during mentoring so thanks!
Yes, no/symbolic cost to exercise and longer time to exercise seem to be two interesting trends. I like both.
do you think these principles of ‘equity’ distribution hold true for the brave new world of ICO blockchain startups and their founders?
If the equity grant for key functions is something close to 10% of annual salary, vested over 4 years, then it pretty much assumes that those positions have to be paid a full market salary, not “startup rate” – the equity can be treated as a bonus to align interests, but even with “We expect our companies to be able to increase in value three to five times over a four year period” the payout is ~40% of annual salary, so vested over 4 years that’s a equivalent to a 10% salary difference – if anybody is taking a 20% below market rate pay in these conditions (and many are) because of equity, then they’re getting a bad deal.And it’s a strictly worse deal than getting these 10% in cash – (a) liquidity; (b) tax implications; (c) it may be a 10x growth, but it’s even more likely to be worth 0 by the time you are able to sell them – which may be much longer than vesting.
This is interesting.”What I Wish I’d Known About Equity Before Joining A Unicorn”https://gist.github.com/yos…
I’ve always used a similar model and expressed and evaluated equity grants in current cash value. On more than one occasion when I asked for similar math from growth-stage companies that were trying to get me to come on board, they were struck by this request as unusual. Was a great signal for me to pass.
If you’re experiencing 2 feet in two days, you might be around Lake Tahoe, where we lost a patroller this morninghttps://www.gofundme.com/sq…
Wow, if you ever needed a living example of how expensive VC money really is for the entrepreneur, I don’t know what it would be.BTW, please be careful skiing. My wife is an orthopod in Denver and we have a lot of money in the bank because of New Yorkers coming out here to ski. Please Please take it easy.
I was thinking that AVC structured library of some kind would be amazing resource for all interested stakeholders. Not to mention a book 🙂 To be honest I was considering browsing and organizing AVC archive for my own needs.. and then share it with community of course.
The snow gods deserve some equity too!!
You can get by for a long time just reposting from your archives. “Thar’s gold in them thar hills.”I recently had reason to look up some things you wrote about culture and retaining employees (two separate posts) to share with a client. Was inspired to send out to a few dozen CEOs on my mailing list. One wrote back and asked “What’s the ask?” I didn’t know I needed to ask for something in return in order to want founders to build great teams and companies.Glad to have this post back on my radar. Thanks.
if you ski and you have two feet of fresh powder no excuses are needed
this is a topic that is never really settled. always negotiated. always some indecision.i’m skiing int two weeks in colorado with asa so hoping for powder.