The first ten employees of your startup often lay the foundation for the company’s future success. They shape the culture, execute the vision, and drive growth. If you mismanage these early hires or fail to offer a favorable compensation structure, you could risk failure.
Cash is a major roadblock to building a favorable compensation structure for early hires. When cash is tight, equity can be used to attract and retain key employees. Offering them a stake in the company’s success creates a sense of ownership and shared goals. In fact, a survey found that 78% of employees are more likely to stay with an organization that commits to pay equity.
While you, as the founder, deserve a significant share of the company, you must build a culture where key employees can win alongside you when the company succeeds. By thoughtfully structuring equity packages, you can build a motivated and aligned team that drives growth and success. In this article, you’ll learn how to structure equity for the first ten employees while balancing the company's needs, the founders, and key team members.
Key takeaways
- Offering equity can help you attract and retain key employees, especially when cash is tight. Equity offers several benefits, like helping your startup stay within budget. However, if the startup fails, employees could face losses.
- To structure equity effectively, follow these key steps: Create an Employee Stock Option Pool (ESOP), choose the right type of equity, and set a vesting period—typically four years with a one-year cliff.
- Startup equity also has tax implications. Ensure you understand the taxes associated with granting options and other forms of equity and help your employees understand how these taxes work.
- Equity decisions should be made early and thoughtfully. Balance your company’s needs with your goal of attracting and retaining top talent. Ensure the contract is clear and legally binding.
What is startup equity?
Startup equity represents ownership in a company through shares of stock. It can be used to secure funding or offered to employees instead of cash to attract talent and build a sense of shared ownership.
Startup equity compensation involves paying employees a portion of the company's ownership. This approach is common in early-stage startups that cannot afford to offer large salaries.
When and how employees receive equity depends on the type of equity compensation you provide.
Early-stage employees typically receive more equity than those hired later. This happens because the company’s risk is higher in the beginning. As the company stabilizes, you’ll usually give later hires less equity.
The key takeaway for employees is that if the company’s value increases over time, their business stake can become a significant financial asset.
Written by Omoruyi Edoigiawerie, a seasoned startup attorney with over a decade of experience. Learn more.
Give it a try, you can unsubscribe anytime. Privacy Policy.
How equity for the first ten employees works
The equity agreement for each employee can vary, but generally, you offer stock, shares, or partial ownership as part of their compensation for committing to your startup.
Equity compensation typically comes with a lower upfront salary than the market average. If your startup succeeds, employees can profit from their shares while initially accepting a reduced salary.
A vesting period is when employees must work to earn their allocated equity. A typical vesting period is four years.
You might also set a cliff—the initial period before vesting starts—such as one year from the employee’s start date. Employees typically earn equity gradually during this period, such as a percentage each year after the cliff.
This approach helps you manage your budget while keeping talented employees invested in your company and its success.
However, equity compensation comes with strict rules and regulations, especially taxes, that you and your employees must follow. Before making any agreements, ensure you and your potential hires understand how startup equity works, including its benefits and risks.
Types of startup equity
Startups can offer new hires different types of equity, such as stock options with specific terms and timelines.
Stock options
As an employee in a startup, you may receive stock options. These options give you the right to buy a set number of shares at a specific price, called the strike price. The strike price is pre-agreed.
You typically exercise stock options when certain triggers occur, such as an initial public offering (IPO), a merger, or an acquisition. At that time, the stock price may exceed the strike price, making it a valuable opportunity.
Stock options often come with a vesting schedule. This schedule may be time-based or tied to achieving certain milestones. For example, a vesting schedule might span four years, with 24% of your options vesting each year. The stock agreement you sign with your employer will outline this schedule.
It’s important to understand that you don’t actually own the stock until you exercise the options. Many employees mistakenly believe they already own the stock because they don’t fully understand the terms or how stock options work.
Performance shares
Startups typically offer executives, managers, and other leadership roles performance shares. These shares vest when the company meets specific performance targets.
Restricted stock awards
Restricted stock awards give you stock grants with conditions you must meet before you receive the shares. Unlike stock options, you own the shares once the company issues them rather than having the opportunity to buy them later.
Common restrictions include adhering to a vesting schedule or staying with the company for a period. Sometimes, transfer restrictions apply, meaning you need permission or may be unable to transfer the shares.
Restricted stock units (RSUs)
In addition to early-stage startups, established or profitable startups may offer restricted stock units (RSUs). RSUs are stock grants that the company agrees to issue on a specific date, often with conditions you must meet before vesting occurs.
RSUs can be beneficial when stock prices are too high for employees to buy shares outright. Typically, RSUs come at no direct cost to you besides tax liabilities.
However, RSUs are not always recommended for startups due to their potential tax implications and the potential impact on cash flow.
Equity compensation isn’t always the right fit for startups. If you want to limit the amount of equity you give away or retain more control over your business, offering equity compensation might not align with your business plan.
However, in many cases, equity compensation provides valuable benefits for both startups and their employees.
Why startup equity matters for early employees
Equity compensation can attract potential employees, especially if they believe in your company’s mission and long-term vision. As an employee, startup equity compensation can offer:
Earning potential
If the company succeeds, your equity compensation could exceed what you might have earned with a higher salary alone. However, if the startup fails, you could end up with minimal earnings or even capital losses from your shares.
Ownership
Even though the percentage per employee is usually small, once your shares vest, you become a partial company owner. This ownership may give you voting rights and the ability to influence the company’s direction over time.
Motivation and job satisfaction
If the company’s mission and values align with your own goals, equity compensation can offer greater fulfillment, motivation, and overall job satisfaction.
On the other hand, equity compensation offers several advantages for startups, especially when they have limited funds. By offering equity, you can:
Stick to a budget
One of the biggest reasons to offer equity compensation is to save cash. This non-cash payment allows you to off repetitive job offers without exceeding your budget. Since cash flow problems are a leading cause of startup failure, staying within budget is crucial.
Attract top talent
Insufficient cash can make it hard to attract top talent, who may find higher offers elsewhere. By offering equity compensation, you give employees the potential to earn more in the long run and become invested as partial owners of your company.
Moreover, when employees can earn equity by reaching certain milestones or timelines, they often stay longer and feel more motivated to help your company succeed.
Startup equity for your first ten employees: Best practices
Key factors for founders
- Have an option pool: Reserve a portion of equity for employees, depending on cash and talent requirements.
- Consider average salary: You can decide on a below-market salary and compensate with equity or offer a competitive salary with less equity.
- Consider levels and fields: You may consider giving premium equity compensation to C-level executives, top engineers, and in-demand fields.
- Clear communication: Ensure clear communication and expectations for each role to ensure fair equity distribution and no misunderstandings.
Considerations for employees
- Exit strategy: Understand how you'll sell your ownership shares, including any predetermined conditions and plans for selling shares.
- Taxes: Remember that vested equity makes you an investor, and you'll be responsible for paying tax when selling the shares.
- Equity vesting schedule: Understand the rules governing your equity, including the vesting schedule, and consider if the proposed schedule aligns with your career plans.
How to structure equity for the first ten employees
Step 1: Create an employee stock option pool (ESOP)
Set aside 10-15% of your equity for your ESOP. You can increase this pool as you distribute equity and the pool diminishes.
You can use this to create an ESOP pool: Comprehensive guide and template to create an ESOP pool.
Step 2: Decide on the type of equity to grant
Choose from different types of startup equity to offer employees.
- Stock options allow employees to buy or sell a defined number of shares at a predetermined price between the vesting and expiration dates.
- Stock warrants: similar to stock options but with longer expiration periods.
- Stock grants: These have no vesting or expiration date, allowing employees to sell their shares immediately.
Other types of startup equity include performance shares, restricted stock awards, and restricted stock units.
Step 3: Set the vesting period
Define a vesting period and set a schedule.
Also, plan for situations where employees leave before their equity fully vests.
When an employee leaves a company, their equity options typically have a limited time to be exercised. This period is called the "post-termination exercise period." The length of this period varies, but common ranges are 30-90 days and can be longer. The goal is to give departing employees time to exercise their options without allowing them to hold onto options for too long, potentially diluting the equity of remaining employees.
You can also repurchase unvested equity from departing employees at the original issuance price. Ultimately, the aim is to maintain fairness between departing and remaining employees. You should have a clear plan to manage such situations.
Step 4: Decide how much equity to assign to each employee
Assign equity based on factors like position, skill level, or other criteria. You might decide to offer equal equity to all early employees. For example, you could grant 1% equity to the first ten employees each and 0.5% equity to the next set.
If you don't have an equity plan, the number of shares allocated to new hires may become inconsistent.
To avoid this issue, you can establish an equity plan that reserves a certain percentage of the company for employees. This creates a separate pool of shares for employees, ensuring that each employee's ownership percentage remains consistent, even as new employees are hired.
Step 5: Document in a cap table
Don’t just write down equity allocations informally. Instead, document them in a capitalization table (cap table). This table tracks all equity holders, including employees, advisors, and investors.
The cap table records stock options exercised and shares still available in the option pool.
Regularly update your cap table to reflect changes in ownership.
How much startup equity to reserve for the first ten employees
Startups typically reserve an equity pool of 10% to 20% for employees. You should determine how much equity to allocate to employees before you accept funding like Series A funding or any other investment where investors become shareholders.
If you want to allocate startup equity based on level, experience, and time they joined, you can follow these guidelines:
- C-suite 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%
- Junior-level employees and other hires: 0% to 0.2%
Beyond role and hierarchy, the size of your equity pool can also vary by industry. Here's a general breakdown:
- Consumer: 8% to 10%
- SaaS: 10% to 15%
- AI: 15%
- Healthcare: 15% to 20%
- Biotech: 20%
Tax implications on startup equity
When it comes to employee equity, taxes can be complex. As an employee, exercising your startup equity can trigger taxes, depending on the equity you receive.
For stock options, two common types are incentive stock options (ISOs) and non-qualified stock options (NSOs). Their main difference lies in their tax treatment, while both can qualify for long-term capital gains.
When you exercise NSOs, you pay taxes at the ordinary income tax rate. In contrast, ISOs aren't taxable when you exercise them. However, ISOs are limited—you can only receive up to $100,000 in options per year. Any excess is automatically converted to NSOs for tax purposes if the value exceeds this amount.
As a founder or company leader, you should carefully consider the tax implications of granting options and other forms of startup equity. Also, help your employees understand how taxes work with startup equity to avoid surprises later.
FAQs about structuring equity for your first ten employees
How much equity should I give my first ten employees?
The amount of equity to give your first ten employees depends on factors like their role, average market salary, and level of involvement.
A typical range for early employees is 1-3% of the company's equity.
What is the ideal vesting schedule for early employees?
A standard vesting schedule for early employees is a four-year vesting period with a one-year cliff. This means that 25% of the equity vests after 1 year (the cliff), and the remaining 75% vests over the following years.
Can I change the equity distribution after it's set?
Yes, you can, but it’s not always an ideal situation.
Things often don't go as the founders expect, and a binding contract exists. Common approaches include discussing and working the issue or involving an advisor to help you navigate the situation.
Conclusion
When cash is tight, offering startup equity to your first ten employees can be a smart way to attract and retain talent.
It's important to understand startup equity, how to structure it, and the types of equity you can offer and their implications.
Also, determine and set a fair percentage, keeping in mind equity needed for future funding rounds and what is left for the founders.
Importantly, make sure the contract document is clear and legally binding. You can consult legal professionals to avoid misunderstandings later on.
Finally, make equity decisions early and thoughtfully, balancing your company's needs with your goal of attracting and retaining top talent.
Disclaimer: This publication, review, or article ("Content") is based on our independent evaluation and is subjective, reflecting our opinions, which may differ from others' perspectives or experiences. We do not guarantee the accuracy or completeness of the content and disclaim responsibility for any errors or omissions it may contain.
The information provided is not investment advice and should not be treated as such, as products or services may change after publication. By engaging with our content, you acknowledge its subjective nature and agree not to hold us liable for any losses or damages arising from your reliance on the information provided. Always conduct your own research and consult professionals where necessary.
