A startup founder’s guide to allocating equity grants

In the war for talent, equity compensation has become more important than ever, but it’s not the easiest concept to explain, especially in privately funded companies.

Equity isn’t a new concept. Public and private companies have been using stock options (or RSUs) to recruit, motivate and retain talent for decades. However, equity compensation has grown in importance when it comes to hiring, retaining and aligning incentives across all employees, not just senior executives.

This is happening for a few reasons:

• A global shortage of skilled tech workers: Candidates with in-demand skills are now getting multiple offers and can practically name their price. That price, more often than not these days, includes some kind of equity component.
• Wage inflation: The labor shortage and market dynamics are causing significant wage inflation. Companies are looking for ways to increase total compensation while reserving cash. Equity is one way to do this.
• A growing focus on private valuations: The number of companies reaching unicorn status is increasing. According to CB Insights, over 900 companies globally have achieved unicorn status, and 2021 alone minted more than 450 unicorns, up from the previous high-water mark of 111 in 2019.
• Transparency around compensation: Compensation data is accessible. Historically, companies like Glassdoor have provided robust salary data for more mature organizations. Now, companies like AngelList provide both salary and equity benchmarking for startups.
• Expectations: More than half (53%) of millennials say equity compensation was the main reason or one of the main reasons they took their job.

Leaders need to get better at understanding and articulating not just why equity is important but also how it’s determined. So let’s start at the beginning.

An ownership mentality is good for both business and morale, which is why many founders choose to allocate some level of equity (even a small piece) beyond leadership roles. Leaders may have the vision, but they need a team to execute and concretize their ideas.

Designing your equity program

Once you’ve decided stock options are going to be a component of your total rewards package, it’s time to define your philosophy and design your equity program.

Sizing the equity pool

First, you’ll need to determine the size of your employee option pool. You will want to formulate your thoughts prior to discussions with investors, who may require the creation of a larger option pool than is necessary if your proposed pool is disconnected from your hiring plan.

The pool should include all allocated options and unallocated options for key employees you think you will need to hire in the next 18 to 24 months. At a typical venture-backed startup, the management and employee equity pool in the seed and Series A rounds is 10%-20% of the total shares outstanding.

Allocating the equity pool

Let me be clear: There is no one right answer for allocating your equity pool. There are many schools of thought on this topic, but let me point you to one approach from Fred Wilson, co-founder and partner at Union Square Ventures. I’ll summarize it below, but it’s worth reading the whole post on his blog. A lot has changed since he wrote this many years ago, so the multipliers are simply a placeholder at this point, but I like the overall structure for its simplicity and ability to communicate the value of shares to employees.

First, determine the “best value” of your company. It should be the value of your company that you would sell or finance your business at today. This can be based on an actual offer that you have received or standard valuation techniques (e.g., public comparables, transaction comparables). For example, let’s say that number is $25 million, and the number of fully diluted shares outstanding is 10 million.

Break your organization chart into brackets. The brackets should be inclusive of all roles or levels that are eligible for your company’s option plan.

Then, when allocating an initial equity grant for new employees, multiply the employee’s base salary by the multiplier to get to a dollar value of equity. Let’s say an account executive earns $150,000 per year. The dollar value of equity you offer them is 0.1 x $150,000, which is equal to $15,000.

(The multipliers here are placeholders only; get advice from an employee equity consultant before choosing the actual multipliers you will use.)

Obviously, the earlier someone commits, the more risk they will accept. This naturally begs the question: Won’t that early employee face unfair dilution as the company grows and more people get equity? The beauty of Wilson’s “dollar value of equity” method is that it avoids this.

Here is a fictional example of how this works for early-stage employees and those who join later.

Jenny, who joins in year one

• Account executive earning $150,000 per year
• She is in Bracket 3 (0.1x)
• The “best value” of your company is $25 million, and the number of fully diluted shares outstanding is 10 million
• The dollar value of equity you offer Jenny is 0.1 x $150,000, which is equal to $15,000
• This translates into 6,000 shares or 0.06% of fully diluted shares outstanding

Jerry, who joins in year three

• Account executive earning $150,000 per year
• He is in Bracket 3 (0.1x)
• The dollar value of equity you offer Jerry is 0.1 x $150,000, which is equal to $15,000
• But … the “best value” of your company is now $50 million, and the number of fully diluted shares outstanding is 10 million. This translates into 3,000 shares or 0.03% of fully diluted shares outstanding
• So, the dollar value of Jenny’s equity is now worth twice as much as Jerry’s because the company is worth double

The vesting period

The standard vesting schedule for employees at early-stage companies is a one-year vesting cliff, which means employee shares are vested on the first anniversary of their start date. The vesting schedule then moves to monthly for a total of four years.

In a bid to attract talent, some companies are beginning to abolish or drastically reduce that one-year cliff. In a recent tech pay survey, more than 20% of managers and employees surveyed said their stock begins to vest right away or after the end of their third month of employment.

Some potential employees may seek a reduced cliff and overall shorter vesting schedule, but the standard vesting period is standard for a good reason: It helps ensure you retain the talent you need.

Communicating to employees

You’ve defined your philosophy, designed the program and vetted your decisions with an expert. Now comes the hard part: Communicating it to employees in a simple and consistent way so they understand the value of this piece of their overall compensation package, and how it can grow as the company performs.

Here are the types of questions you should prepare for:

• What is the company’s current valuation? How is that determined?
• How much is my equity worth today?
• What is the potential future value of my equity?
• How large is the option pool?
• If the company raises equity capital, how will that dilute my shares?
• When can I exercise my options?
• How do these options vest over time? What happens to my vested shares if I leave before my vested options are exercised?
• What happens to my unvested shares in the event of an acquisition?
• What are the tax implications of these options?
• Is there an opportunity for a compensation increase instead of options?

Spend time with your leadership, board and HR team to draft answers in writing to these questions. Consider an FAQ guide to address standard questions and work with recruiters and hiring managers to make sure they understand the nuances of these conversations. Do a dry run.

The bottom line

Think strategically, think ahead and communicate — make sure you’re offering the right equity allocation, for the right strategic reasons, and to achieve the right goals.

Don’t treat it as a “check-box” item — this has more far-reaching implications than buying a beer tap or a foosball table. Put in the effort to get this right.

Ask for help. Bringing in a good equity compensation consultant or lawyer can help you make good decisions early on, and a communications or HR expert can help explain it to the people who matter: your employees.

In the end, how you think about and allocate equity is unique to each firm, and the value of the equity is the product of all the big and small decisions you make along the way.