Equity compensation: Practical guidelines

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Image source: Annie Sprat

Equity is a significant portion of a startup’s compensation package, in fact it is arguably one of the top reasons why people join startups. In spite of the popularity and importance of equity, I’ve seen that the way it is used can vary quite significantly between companies. While I do not posit that there is a right approach to equity compensation, I do believe that there are certain outcomes that should be universally applicable. These are outlined below.

Equity >> Cash

This one should be non-controversial. As an employee joining a startup, I want to participate in the potential economic growth of the startup; equity gives me that. Equally important, a startup needs to preserve its cash, therefore extending its runway and ability to operate without raising more money (and further diluting its current investors and employees). It therefore, seems quite reasonable that a startup would prefer to compensate its employees with equity over cash. Therefore, the balance of equity to cash in an employees compensation package, should tilt more towards the equity component. This aligns the incentives on both sides, the employee and employer.

There are some exceptions to this rule. For example, sales compensation can be cash heavy, although a significant chunk of the cash could be in the form of sales commissions.

Growth of equity >> cash

Most compensation systems evaluate an employees performance, which is then used to determine how much pay the employee warrants. The higher the performance, the higher the pay. Within a startup environment, the rate of growth of equity relative to employee performance should be far higher than cash’s growth. This implies that as an employee’s contribution or impact increases, the equity component of her compensation package should increase at a faster rate than her cash one. This relationship is illustrated in the diagram below.

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As an employee’s contributions increase, so do her rewards. However, the equity component is growing at an exponential rate, while the cash grows linearly. This again, serves to align the incentives of both employee and employer. The employer wants to preserve company cash and therefore prefers to reward high performing employees with outsized equity packages. This also serves in retaining those employees since most equity packages come with 4-year vesting periods. Similarly, the employee should prefer more equity compensation to participate in the company’s growth. This is obviously predicated on having a good balance between cash and equity — after all equity is illiquid for most pre-IPO startups and employees need cash to pay bills and so on.

Equity should be risk adjusted over time

Consider the following scenario of Laura, a senior engineer who joins an early stage startup at the seed round. Laura gets 100K shares, corresponding to 0.25% of the outstanding shares (common) at the time. Over the years, Laura is often overlooked for additional equity grants because “she already has 100K, which is more than most of the other employees”

I’ve seen this scenario unfold numerous times. The main argument being that employees who joined earlier in a startups life already have a hefty equity package and thus shouldn’t get more. That’s simply wrong and overlooks an important factor: risk.

An employee joining a startup at the seed stage is taking a far greater risk than someone joining at a later stage. Therefore, their equity compensation has to be risk adjusted and evaluated in terms of the current company risk. One way I have used to adjust for this risk is to normalize employees shares and evaluate them in terms of the company’s latest funding round. An example might help.

Consider two employees, Laura and Bob, who received shares at different stages (rounds) of their startup. Laura joined at the seed round while Bob at the series-B stage. They each have shares received at different series which are shown below

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The shares that Laura and Bob received need need to be normalized in terms of the most recent series; series-C. One way to do that normalization is to adjust all shares in terms by using the company’s valuation, or some derivative of that, over time. The company was valued at $1M at the seed round and $120M at series-C, therefore seed shares should be risk adjusted to 1/120 of series-C shares (0.83%). Said otherwise, 120 seed shares are the equivalent to 1 series-C share after adjusting for risk.

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With the risk adjustment, you can normalize all shares to be evaluated in terms of series-C shares; the most recent round. This yields the results shown below.

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Normalizing shares to the latest series, allows you to compensate your employees fairly, both for new hires as well as comp increases for existing ones. For example, if Laura’s impact is the same as Bob, then she warrants receiving an additional ~16 series-C shares to bring her up to the same equity compensation as Bob. This assumes that their cash compensations are equivalent and that that the comp structure intends to compensate two employees with the same contribution equally (it better!)

Similarly, if you are extending an offer to a new employee and deem her to be at the same level as Bob, then she should expect to get an equity package worth ~26 series-C shares.

Always be vesting

You always want to have your employees to be vesting shares and therefore have a strong economic incentive to remain at your company. There are two manners in which you can adjust employee equity over time: merit increases and equity refreshers.

Merit increases recognize an employee’s contribution by granting her more shares and/or a salary increase. You can assess the number of additional shares to grant an employee based on her contribution if you are able to compare her equity package to other employees at the same level. This requires equity to be risk adjusted, as was described earlier.

Similarly, equity refresh grants should be risk adjusted with the number of new grants adjusted to the latest series. Back to Laura’s 100K seed grant which expires in 1 year. Those share are worth 833 series-C shares (1/120 * 100K). Therefore, issuing Laura an additional 800–1000 shares as a refresher for her 100K seed shares would be appropriate. It keeps Laura vesting at the same risk adjusted rate of her about to fully vest 100K seed shares.

Originally published at https://karimfanous.substack.com.

Written by

Tech leadership at various early stage startups: Qumulo, Dremio and now Kheiron Medical

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