How Much Equity to Compensate Early Employees
Compensating Early Employees with Equity
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Table of ContentsHow Much Equity Should I Give my First Employee?Compensating an Employee with EquityEmployee Value to the CompanyOther Considerations for Equity Awards
How Much Equity Should I Give my First Employee?
The first employee of a startup, outside of the company founders, is a major milestone for the business. The company has reached the point where it believes it has an economically viable idea. The founders now bring in individuals to help develop the concept into a commercial feasible business or to help deliver the value proposition to the customers or clients. In either case, the startup may need to use alternative forms of compensation to incentivize and motivate the new employee.
In this article, we discuss awarding equity to the company’s first employee.
Back to: Entrepreneurship
Compensating an Employee with Equity
Startups ventures are generally growth-based. This means that the business has a scalable and repeatable value proposition. The startup generally cannot generate the amount of revenue necessary to take full advantage of the company’s growth potential. As such, the company would sacrifice company value because of lack of resources. This is why the company generally seeks capital from outside investors.
The company can use the outside investors resources to create more company value than they receive from the investors (I.e., each dollar invested returns far more than one dollar of company value). With this understanding, availability of cash is of utmost importance to the startup. It must conserve capital for growth-based functions, such as marketing and brand awareness. Paying an employee is an expense that may or may not directly relate to revenue.
As such, it is common for startup companies to pay bellow-market salaries to its early employees. Instead, the startup incentivizes the employee to work hard and stay loyal to the company by granting equity ownership of the company.
Employee Value to the Company
The amount of equity to award is determined by the compensation that employee forgoes and the value of the employee’s services rendered. It also depends upon the number company shares issued and the company’s valuation. If the company has a potential future valuation of a certain amount, then this amount can be used to calculate the present value of the company’s shares.
For example, if the company has a potential $1m valuation, 1% of company equity is $10,000. Because of the uncertainty associated with the company’s performance, it is common practice to award shares with a potential value that exceeds what a market salary would be. Most companies use a combination of salary, non-monetary benefits, and equity to compensate the employees. Per our research, most equity awards vary between 0.1% - 3.5% of the company outstanding equity annual. 0.01% would reflect compensation for administrative staff, while 3.5% would be reserved for an indispensable member of the startup team.
Other Considerations for Equity Awards
The type of equity awarded to early employees is generally a restricted form of common stock. Restricted means that the shares cannot be immediately sold or transferred. Further, the shares are generally made subject to vesting on a pre-determined schedule (generally over 3-4 years). If the employee leaves prior to any of the awarded equity granting, she forfeits the shares. This makes certain that the employee stay with the company and is incentivized to continue to perform well.