How much equity should I give to employees & consultants?

QUESTION:

Hi everyone – great site!  I’d love some insight regarding compensating different employees with equity.  I have had a web-based product in beta for just over a year. We are completely bootstrap (i.e. no outside funding). We are an LLC, though plan to become an Inc. at the end of the year.

I have 3 different scenarios for potential equity:

  1. I recently took on an operations person at a small salary. He is interested in working for equity. I want to incentivize him, but am not sure equity makes sense without real metrics. There is some room for him to lead up sales efforts so I was thinking about linking equity to sales performance.
  2. I also outsource my development. The owner of the development firm has asked for 10% equity in exchange for technical business advice; i.e. he’d be actively conceptualizing our partner integrations and outlining technical proposals, but he does not code.
  3. The coder I work with is also interested in working for a mix of cash and equity. He is my only programmer right now, and we really enjoy our working dynamic.

I like the idea of not paying out of pocket for a salary, but how do I figure out how much equity to allocate? The amount requested to date by my development firm owner (10%) seems high. Should I wait until we are incorporated to allocate equity?  Thanks so much for the help!

ANSWER:

Naomi Kokubo

Naomi Kokubo

by Naomi Kokubo, Cofounder of Founders Space

Yes, I’d wait until you are incorporated.  You should also consult with a lawyer and set up a proper stock option plan.  You don’t just want to give out equity without proper paperwork in place.  You need to have stock options that vest over a period of time, so if the person doesn’t deliver or stops working for some reason, their shares stop vesting.

1.  For anyone involved in sales, offering commissions and cash bonuses also works well.  If this person is helping bring in business, you can reward him/her with a combination of stock, cash bonuses and commission tied to performance.  There is no set amount.  A lot depends on how you value this person and what % make sense for your business.  I like to structure compensation packages that are tied to actual goals and deliverables.  That way if the person is highly effective and really helps grow the business, he/she reaps the benefits.

2.  I agree, 10% does seem high for someone who is simply giving advice, rather than doing the work.  Typically, an advisor will get around 0.5% in very early stage companies like yours.  If this advisor will truly be putting in the time, then you can up the %.  It all depends on how much time and resources the advisor is willing to commit to.

3.  It’s hard to get any programmers to work for free, so a combination of cash and equity makes sense.  Again, if you can tie the equity to actual deliverables and milestones in the project, that’s a smart thing to do.  At an early stage, like you’re at, people tend to get a lot of equity, especially if they’re full-time.  For any full-time staff, who are taking a serious pay cut, you may consider as high as 5% to 10%, but for a part-time consultant, I’d go much lower.

A good idea is to work out a stock option table, that lists all the employees you plan on hiring in the next 18 months and what stock options each of them will be getting.  Most companies allocate 15% to 20% of the company for employee stock options.  The 15% to 20% is reserved for paid employees, and usually doesn’t include founders’ shares or employees working for mostly equity.  This should give you a rough idea of how to plan things out.

Again, talk to a lawyer when setting up your stock option plan.  There’s a lot of paperwork and other details you need to consider.

I hope this helps!

Comments & Advice:
  1. Good answer. I would add that although you can implement milestone-based vesting for stock options, it is complex and can cause various accounting and tax-related headaches down the road. For that reason, most companies I work with end up using straight time-based vesting for stock options. (The Silicon Valley standard is monthly vesting over four years with a one-year “cliff.”) For the operations person who may also lead sales efforts, I'd recommend a combination of stock options or founders' stock with simple time-based vesting, and work out a cash commission structure tied to sales made.

    Note that options are not the only option (pun intended) for equity compensation. At an early stage, it can often make sense to issue shares outright under a restricted stock purchase agreement (RSPA). The employee essentially buys the stock for a low (near-zero) price, but the shares are subject to vesting, meaning that the company has the right to buy back some of the shares at the original (near-zero) price if employment terminates before the shares are fully vested. Consult a good startup lawyer or tax advisor to learn more about the advantages of the different types of equity compensation.

    In terms of the percentage offered, one excellent resource is the CompStudy 2008 Report on Equity and Cash Compensation at Technology Startups, with data collected from more than 1,600 executives across a wide range of companies. You can find links to this report and several other resources for early-stage entrepreneurs on my blog at http://bll.la/4j.

  2. The topic of “how much equity is right” is, and will likely always be, contentious. The answers provided are an excellent starting point. I would also suggest considering synthetic equity vehicles such as Stock Appreciation Rights (SARs) and Phantom Stock (sometimes called cash-settled restricted stock units).

    I have posted a recent presentation that I did in April 2010 at the National Center for Employee Ownership annual conference. (equity comp – who and how much http://bit.ly/9U2hwh). I also made available a matrix covering the main type of euity compensation instruments, the types of company and individuals that use them and the high level legal, accounting, tax and administrative issues for each (Equity Compensation Design and Use Matrix: stock options, restricted stock, espp, rsu and more http://bit.ly/dedCyu)

    The presentation above discusses the topic of who should get equity compensation and how much they should receive. The answer is more slippery than ever before.

    The NCEO also offers some great reference books on the topic (http://www.nceo.org). In particular there is a recent book covering equity compensation for LLCs.

    Feel free to contact me directly if you have additional questions.

  3. Ossicle says:

    You folks know far more about business than I do, so I'm a little embarrassed by the ignorance and naivete of my question. I apologize in advance.

    I'm starting a Web service with two partners. I am Partner A and bring x to the table. Partner B brings y to the table. (The nature of x and y aren't important for purposes of this question.) Partner C is our tech person and programmer. He's an invaluable resource — years in the industry, past CTO of a successful internet company, etc. We're lucky to have him aboard.

    We're all going to launch this business out of our own pockets, i..e, there'll be no compensation for anyone until sales start coming in. We envision “owning” this company, in whatever fashion, in equal share, i.e., 33% for each of us.

    Now, my question related to Partner C. He wants, after setting up the business and seeing it commence operations, to be able to walk away from the company but retain an equity share in it. It's an open matter what, if any, technical assistance he'd provide after his departure.

    Can anyone suggest even the barest hint or outline of what might be rational terms for us to permit him along these lines? I think the starting point is the notion that he'd like to retain 33% of the company ever after, without committing to provide further technical support once we're up and running. That seems unreasonable, and in fact I doubt he expects us to accept that. However, because of my inexperience (I flatter myself — perhaps it's due to my insufficient intelligence) I'm at a loss as to the right way to go about thinking of a reasonable proposal to make.

    If this is too elementary and/or poorly framed question for anyone to comment on, I understand. Thanks, regardless.

  4. Stan says:

    Hi,

    I am confused about how much equity I should give to my partners and I would love to hear about your feedbacks.
    I am a non tech founder that has a business idea (collaborative work market place), made the business plan, brought the team together, invested a little bit of money for the server, domain, brand protection, logo, …
    I am also dealing with potential partners, investors, and everything that is related to the good development of this startup.

    I have a technical partner that is basically creating the market place based on my ideas, he invests the free time he has on the side of his job and personal life. We are launching the beta version in September and he will be with me on the long term.
    I am also planning to collaborate with a community managers and a traffic acquisition manager and the idea is to give them equity to get them on board.

    As mentioned above I am not sure about how much equity it would be appropriate to give to the person that is creating the market and will maintain it and optimize it over time.

    Thanks in advance for your time,

    Stan,

  5. Alex B. says:

    I am starting a business with two friends based on an idea that we’ve stumbled upon. The problem both my friends are full time employed whereas I am the one who will be dedicating full time to the business, and therefore running the show. We haven’t yet come up with an operational agreement, and at this point, I am not sure how to address the equity sharing. On one hand, they are co-founders of the company, but on the other hand, the risk will be mostly mine since I am the only one who will be dedicating full time on the company. I thought about giving them share on the basis of work as consultants, but I am not sure what rate of share/hrs I should follow. I’d be very happy, If you could shine some light on this dilemma. Thank you.

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