Standard Equity Compensation for Startups: A Guide

One out of 5 startup companies fail in the first year. One reason for their failures is financial struggles. Unlike larger corporations, startups have budgetary constraints that limit their operations, such as attracting and hiring valuable employees.

This gives way to an alternative: equity compensation. Offering equity compensation provides startups the chance to succeed through acquiring top talents while not having to extend their tight budget for employee salaries.

Here is a comprehensive guide on equity compensation for startups, how it works, its types, pros and cons, considerations, and some frequently asked questions.

What is startup equity compensation?

Startup equity compensation is when early-stage companies offer their employees company stocks or shares as part of their compensation and benefits. Employees can earn a part of ownership of the company, usually through stock options, restricted stock, or performance shares.

Since startup companies must invest extra effort for business success, it is best to have a tool like Compensation Planning Software that can help in easier and automated equity planning and tracking.

How does startup equity compensation work?

Equity compensation works depending on what types of equity organizations give to employees. Startups usually use equity compensation to attract and retain top talents since they are paid lower salary than those in bigger and more established companies.

First, the initial ownership is divided among founders and investors. Next, early-stage startup employees usually get a larger share since they take higher risks, and the later-stage employees might get less while the company gains stability.

Typical equity percentages for employees

Startups usually give 13% to 20% of equity to the employee stock option pool. Here is a breakdown of the typical equity percentages for employees:

• Highest-level executives: 0.8% to 5%

• Vice Presidents: 0.3% to 2%

• Directors: 0.4% to 1%

• Independent Board Members: 1%

• Managers: 0.2% to 0.33%

• Other employees: 0.0% to 0.2%

Types of equity compensation

There are multiple types of equity compensation that companies offer to talents. These types come with contracts alongside terms and timelines to provide protection for both parties. Here are the types of standard equity compensation for startups:

• Stock options

There are two sub-categories for stocks that employers can choose from: incentive stock option grants (ISOs) and non-qualified stock option grants (NSOs).

These stock options are subject to exercise, or when the employee buys the company shares as part of their pay package, and vesting schedules, or when the employee can take full ownership of the stocks.

• Restricted stock units (RSUs) and restricted stock awards (RSAs)

With RSAs and RSUs, employees have no need to exercise as they are the legal owners of the shares once they are issued.

Workers with RSAs own the shares when they accept the grant and meet the purchase requirements. Meanwhile, workers with RSUs are usually from more established and successful startups.

• Performance shares

Once startups reach their financial performance targets, stocks are usually given to company leaders like executives and managers.

No matter what type of equity compensation best fits your company, managing it can alleviate a lot of stress when using tools like Compensation Planning Software. It has workflow automation and versatile workbooks to maximize the efficiency of equity planning.

Pros and cons of startup equity compensation

Equity compensation can benefit startup companies in terms of financial and talent management, but it can also provide risks in the long run. Here are the advantages and disadvantages of having a standard equity compensation for startups:

Advantages

• Efficiency in cost: Since startups do not have unlimited resources, they offer lower salaries for talents and have to stick to their budget. They can make up for this by offering employees compensation through equity.

• Attractive to employees: Equity compensation gives a sense of ownership to startup employees, pursuing a substantial payout once the company stabilizes and gains financial success.

• Retention of workers: Since equity comes with vesting schedules, or when employees can take full ownership of the stocks, workers tend to stay longer in the company to achieve this requirement.

• Motivation to prosper: The value of a company’s equity is based on its financial success. This means that the potential to have a larger equity payout sparks inspiration for employees to be more productive and efficient in their jobs.

• Lower taxes: When equity is sold at specific requirements, the tax for this financial gain is lower compared to the ordinary income tax.

Disadvantages

• Higher offer from competitors: Best job candidates who aim for higher salary offers will not go for startups with lower pay and make up for equity compensation that is still up for payout in the future.

• Risk in failure: The worth of equity compensation is based on how successful the startup is going to be. This poses a higher risk if the business trajectory goes south, leading to worthless equity compensation for employees with lower salaries.

• Little room for liquidity: Depending on the terms and conditions of a company’s equity compensation, its conversion to cash is more complex than regular monetary compensation.

• Dilution of shares: Founders might reconsider granting stocks to employees since this dilutes their control and ownership over the organization.

• Tax implications: There are tax terms and conditions, such as strike price, fair market value, and income taxes, that need to be met to run a smooth equity compensation system. Granting equity for employees means more time, effort, and resources to abide by its complex implications.

Considerations on startup equity compensation

As stated above, establishing an equity compensation has many implications when it comes to laws and regulations. To have an effective system, here is a startup equity compensation guide and considerations:

1. Determine the type of equity compensation.

There are various options you can choose from based on the necessity of your company. The most used types are stock options, virtual stock options, and restricted stock units.

2. Decide on equity allocation.

Create a balance between giving employees substantial shares and regulating control. Typically, founders allocate 5% to 15% of equity to employees in the early stages of a startup.

3. Choose vesting schedule.

Vesting is the process of employees taking full ownership of their shares over a period, rather than immediately, giving companies time to assess a worker’s value in the company and strengthening employee retention by giving them a time requirement before owning stocks.

4. Define exit strategy.

An exit strategy is a plan on how to sell stocks in the company. After the founder and employee meet all the requirements set by the contract and law, they must come up with an exit strategy that maximizes returns.

5. Use compensation software.

Let go of manual tasks and utilize software backed with data, HR integration, and expert consulting. Plan compensation, have access to competitive pay information, and get automated communication through Total Compensation Management.

FAQs

Here are some frequently asked questions about the startup equity compensation guide:

How much equity should employees get in a startup?

Typical equity grants for employees in a startup range from 1% to 3%. This value depends on the company’s status and the employee’s roles and contributions.

Is employee equity compensation right for startups?

Equity compensation for startups is efficient in costs, attracts and retains employees, and motivates them for growth without offering the highest salary from the get-go. However, startups also need to consider the legal and tax requirements, dilution of control for founders, and higher risks for employees.

Is 1% equity-based compensation good at a startup?

It depends on where the startup company currently stands and the employee’s contribution to its status. The average granted equity for employees of startup companies, with teams of less than 12 workers, is 1%. The first hires can have greater shares, with 2%, as they can be considered founders.