Attract, Motivate, and Retain: The Role of Equity in a Startup

So, you’ve got a brilliant startup idea, a solid business plan, and some seed funding to get you off the ground. Congrats! Now all you need is a crack team of smart, driven employees to help you execute your vision and build the next unicorn. Easy peasy, right? Well, not so fast.

In case you hadn’t noticed, the battle for top tech talent is fierce. Every founder and their dog is out there trying to woo the best engineers, product managers, and salespeople with promises of high salaries, cool perks, and the chance to “change the world.”  So how do you compete?

Could employee equity be your secret weapon for attracting and retaining the best of the best?

By offering stock options, you give your early hires a real stake in the company’s success. They’ll be motivated to work their butts off, not just for a paycheck, but because they stand to share in the massive upside if your startup takes off.

But equity is a double-edged sword. Structure it wrong, and you could end up with a disgruntled team, a cap table mess, and a bunch of worthless options. Structure it right, and you’ll have a loyal army of owner-minded employees who will move mountains to make your startup succeed.

In this guide, we’ll walk you through everything you need to know to use employee equity like a pro. We’ll dive into the nitty-gritty details of option pools, vesting schedules, and tax implications. But more importantly, we’ll share some hard-earned wisdom on how to use equity to build a world-class team and a company culture of ownership.

So grab a coffee (or a beer – we don’t judge) and let’s get started.

 

The Basics of Employee Equity

First things first – what exactly is employee equity? In a nutshell, it’s ownership. When you grant equity to an employee, you’re giving them a small slice of the company pie. If the company grows and becomes more valuable, so does their slice.

Usually, this equity comes in the form of stock options. An option gives the employee the right to buy a certain number of company shares at a fixed price (known as the “strike price”). The hope is that by the time the options vest and the employee can actually buy the shares, the company’s value will have increased and the shares will be worth a lot more than the strike price. Cha-ching!

So why offer equity at all?

Why not just pay high salaries? Well, cash is king for sure, but equity has some unique advantages:

• It aligns incentives. Equity turns employees into owners. They have skin in the game and a direct financial stake in the company’s success. This can do wonders for motivation, productivity, and retention.
• It’s a valuable recruiting tool. Top candidates have their pick of job offers. A compelling equity package can be the thing that sways them to choose your startup over a cushy corporate gig.
• It preserves precious cash. Paying sky-high Silicon Valley salaries is tough when you’re a scrappy startup. Equity lets you compete for talent without blowing your burn rate.
• It can lead to life-changing wealth. If your startup hits it big, owning even a small percent can mean millions in your employees’ pockets. That’s a powerful incentive to stick around and give it their all.

Of course, equity is not without its risks and downsides. There’s no guarantee the shares will be worth anything. And giving up too much ownership can come back to bite you as a founder. But used wisely, equity is a powerful tool in your compensation toolbox.

So how much equity should you dish out?

A typical employee option pool is around 10-15% of the company’s total shares. That may sound like a lot, but remember, the pool has to cover all your hires up to and often beyond your Series A funding.

As for individual grants, a lot depends on the role, seniority, and negotiating mojo of the employee in question. But a rule of thumb is:

• 1-2% for early C-level execs (CTO, COO, etc)
• 5%-1%+ for VPs and other senior leaders
• 2%-0.5%+ for directors and key individual contributors
• 1%-0.2% for early employees and junior roles

Again, these are just ballparks. You’ll want to do your homework on what’s standard for your location and industry. Tools like the Index Ventures option calculator can help. And always leave room for negotiation with those “10x” candidates that can really move the needle for your startup.

 

Key Terms and Conditions to Understand

Alright, time to get into the weeds a bit. To really use equity effectively, you need to understand some key terms and concepts. Grab another coffee and let’s dive in:

Vesting: Vesting is like unlocking your options over time. It’s how you make sure employees stick around and earn their equity. A standard vesting schedule is 4 years, with a 1 year “cliff.” That means the employee has to stay for at least 12 months to get any equity at all. After that, their options usually vest monthly or quarterly until they’re fully vested at 4 years.

Why not just give them all the options up front? Well, what if they quit after 6 months? Vesting protects the company and ensures employees are committed for the long haul. Plus, it gives them a strong incentive to stay and keep contributing to the company’s growth.

Strike price: This is the price per share the employee pays to actually buy, or “exercise,” their options. It’s usually set based on the company’s latest 409a valuation (an independent appraisal required by law). The lower the strike price, the better for the employee – they’ll get more bang for their buck if the company’s value goes up.

As a founder, you want to keep the strike price low in the early days. This makes the options more attractive and valuable to employees. But be careful – if you set it too low, you could run into tax issues or have to give out more options to make up for it.

Exercise window: This is the period of time an employee has to exercise their options after leaving the company. It’s a critical term that can make or break the value of the options.

A short exercise window (like the standard 90 days) means the employee has to come up with the cash to buy their shares very soon after leaving, while the company is still private and the shares are hard to sell. This can make the options feel much less valuable, especially if the strike price is high.

A longer exercise window (5-10 years is becoming more common) gives the employee more flexibility and preserves the value of the options. It shows you care about your team and want them to benefit from the company’s success, even if they don’t stay forever.

As a founder, you want to balance being fair to employees with protecting the company’s cap table. But in general, longer is better. Don’t be stingy with exercise windows if you can afford not to be.

Tax implications: Ah, taxes. The bane of every founder’s and employee’s existence. When it comes to equity, there are a few key things to keep in mind:

• ISOs vs NSOs: There are two main types of stock options, each with different tax treatments. ISOs (incentive stock options) are usually better for employees, as they can potentially avoid paying tax until they sell the shares. NSOs (non-qualified stock options) are less advantageous tax-wise but easier for the company to administer.
• 83(b) elections: This is a way for employees to pay tax on their options upfront, rather than when they vest. It can be a smart move if the options are granted at a low value, as it locks in the tax bill before the shares (hopefully) appreciate. But it’s a gamble – if the company fails, you’ve paid tax for nothing.
• AMT: The dreaded Alternative Minimum Tax. Exercising ISOs can trigger AMT, a parallel tax system that can result in a nasty surprise bill. Make sure employees understand the risks and plan ahead.

As a founder, work with your lawyers and accountants to structure your options in a tax-efficient way. Communicate the tax implications clearly to employees – they’ll thank you later. And if you can afford it, consider footing the bill for their 83(b) elections or AMT bills. It’s a nice gesture that shows you have their backs.

 

Advice for Founders

Now that you’re an equity pro, let’s talk about some best practices for using options to build an amazing team:

1. Do your homework: Before you start doling out equity willy-nilly, make sure you understand what’s standard for your industry, location, and stage. You don’t want to be seen as stingy or out of touch. Use tools like the Index Ventures calculator and talk to other founders to get a sense of the market.
2. Be transparent: Equity can be confusing and overwhelming, especially for first-time startup employees. Take the time to explain how the options work, what they could be worth, and what the risks are. Use plain language and concrete examples. The more your employees understand their equity, the more they’ll value it.
3. Reward performance: Options aren’t just for new hires. Consider giving “refresher” grants to high performers as the company grows. This can keep them motivated and feeling valued, even as their initial grant gets diluted by new funding rounds. Just be sure to tie these grants to clear performance metrics so there’s no favoritism.
4. Standardize (but stay flexible): It’s a good idea to have a standard equity plan that you stick to for most hires. This keeps things fair and saves you from having to negotiate every grant. Platforms like Carta can help with this. But be willing to make exceptions for those truly exceptional candidates that could be game-changers for your startup.

 

What Employees Need to Know (a bit of a recap)

Alright founders, listen up. If you want your equity to have the desired effect – attracting and retaining top talent – you need to make sure your employees understand and value their options. Here are a few key things to communicate:

1. Percentage ownership: Don’t just tell employees how many options they’re getting. Tell them what percentage of the company those options represent. That’s the number that really matters. If you’re offering 10,000 options out of 10 million outstanding, that’s a very different story than 10,000 out of 1 million.
2. Vesting and exercise terms: Make sure employees understand how vesting works and how long they have to exercise after leaving. No one likes surprises when it comes to their hard-earned equity.
3. Strike price and potential value: Help employees do the math on what their options could be worth in different exit scenarios. What if the company sells for $100 million? $500 million? $1 billion? Paint a picture of the potential upside so they can get excited about their stake.
4. Tax implications: Don’t let taxes be a nasty surprise. Explain the basics of ISOs, NSOs, 83(b) elections, and AMT. Encourage employees to consult with a tax advisor before making any big moves.
5. Market comparisons: Employees, especially those new to startups, may not have a good sense of what a fair equity grant looks like. Share some benchmarks and help them compare your offer to market standards. The Index Ventures calculator is a great resource for this.

 

Conclusion:

Phew, that was a lot of info! But don’t worry – you don’t have to become an equity guru overnight. The key is to understand the basics, communicate clearly with your team, and use equity as a strategic tool to build a company of owners.

Remember, your employees are taking a risk by joining your startup. They’re betting their time, talent, and career capital on your vision. Equity is a way to acknowledge that risk and reward them for it. Treat it with the respect and thoughtfulness it deserves.

When done right, employee equity can be a massive competitive advantage. It can help you attract world-class talent, align incentives, and build a culture of ownership and shared success. Your employees will be more motivated, more loyal, and more willing to go above and beyond for the company.

But is just one part of the compensation puzzle, alongside salary, benefits, and culture. And it’s not right for every employee or every situation. Use it judiciously and in combination with other tools.

 

*This article is for informational purposes only and does not constitute legal, tax, or financial advice. Please consult with appropriate professionals before making any decisions about your equity program.