Perspectives on Equity for New Hires

by Fred Wilson, Union Square Ventures (NYC)

While aimed primarily at startups and from a Venture Capital perspective, we believe this counsel is as valuable today as it was when Fred first delivered it in 2010.

The most common comment in this series on Employee Equity is the question of how much equity should you grant when you make a hire. I am going to try to address that question in this post.

First, a caveat. For your first key hires, three, five, maybe as much as ten, you will probably not be able to use any kind of formula.

Getting someone to join your dream before it is much of anything is an art not a science. And the amount of equity you need to grant to accomplish these hires is also an art and most certainly not a science. However, a rule of thumb for those first few hires is that you will be granting them in terms of points of equity (i.e., 1%, 2%, 5%, 10%). To be clear, these are hires we are talking about, not co-founders. Co­founders are an entirely different discussion and I am not talking about them in this post.

Once you have assembled a core team that is operating the business, you need to move from art to science in terms of granting employee equity. And most importantly you need to move away from points of equity to the dollar value of equity. Giving out equity in terms of points is very expensive and you need to move away from it as soon as it is reasonable to do so.

We have developed a formula that we like to use for this purpose. I got this formula from a big compensation consulting firm. We hired them to advise a company I was on the board of that was going public a long time ago. I’ve modified it in a few places to simplify it. But it is based on a common practice in compensation consulting. And it is based on the dollar value of equity.

The first thing you do is you figure out how valuable your company is (we call this “best value”). This is NOT your 409a valuation (we call that “fair value”). This “best value” can be the valuation on the last round of financing. Or it can be a recent offer to buy your company that you turned down. Or it can be the discounted value of future cash flows. Or it can be a public market comp analysis. Whatever approach you use, it should be the value of your company that you would sell or finance your business at right now. Let’s say the number is $25MM. This is an important data point for this effort. The other important data point is the number of fully diluted shares. Let’s say that is 10MM shares outstanding.

The second thing you do is break up your org chart into brackets. There is no bracket for the CEO and COO. Grants for CEOs and COOs should and will be made by the Board. The first bracket is the senior management team; the CFO, Chief Revenue Officer/VP Sales, Chief Marketing Officer/VP Marketing, Chief Product Officer/VP Product, CTO, VP Engineering, Chief People Officer/VP HR, General Counsel, and anyone else on the senior team. The second bracket is Director level managers and key people (engineering and design superstars for sure). The third bracket are employees who are in the key functions like engineering, product, marketing, etc. And the fourth bracket are employees who are not in key functions. This could include reception, clerical employees, etc.

When you have the brackets set up, you put a multiplier next to them. There are no hard and fast rules on multipliers. You can also have many more brackets than four. I am sticking with four brackets to make this post simple. Here are our default brackets:

  • Senior Team: 0.5x
  • Director Level: 0.25x
  • Key Functions: 0.1x
  • All Others: 0.05x

Then you multiply the employee’s base salary by the multiplier to get to a dollar value of equity. Let’s say your VP Product is making $175,000 per year. Then the dollar value of equity you offer them is 0.5 x $175,000, which is equal to $87,500. Let’s say a director level product person is making $125k. Then the dollar value of equity you offer them is 0.25 x $125,000 which is equal to $31,250.

Then you divide the dollar value of equity by the “best value” of your business and multiply the result by the number of fully diluted shares outstanding to get the grant amount. We said that the business was worth $25MM and there are 10MM shares outstanding. So, the VP Product gets an equity grant (($87,500 ÷ $25MM) x $10MM) which is 35,000 shares. And the Director level product person gets an equity grant (($31,250 ÷ $25MM) x $10MM) which is 12,500 shares.

Another, possibly simpler, way to do this is to use the current share price. You get that by dividing the best value of your company ($25MM) by the fully diluted shares outstanding (10MM). In this case, it would be $2.50 per share. Then you simply divide the dollar value of equity by the current share price. You’ll get the same numbers and it is easier to explain and understand.

The key thing is to communicate the equity grant in dollar values, not in percentage of the company. Startups should be able to dramatically increase the value of their equity over the four years a stock grant vests. We expect our companies to be able to increase in value three to five times over a four year period. So, a grant with a value of $125,000 could be worth $400,000 to $600,000 over the time period it vests. And of course, there is always the possibility of a breakout that increases 1.0X over that time. Talking about grants in dollar values emphasizes that equity aligns interests around increasing the value of the company and makes it tangible to the employees.

When you are doing retention grants, I like to use the same formula but divide the dollar value of the retention grant by two to reflect that they are being made every two years. That means the unvested equity at the time of the retention grant should be roughly equal to the dollar value of unvested equity at the time of the initial grant.

Source: This material is a lightly edited version of material that came from the Union Square Ventures website [www.usv.com].

IMPORTANT DISCLAIMER – This material may be dated from a tax, legal or accounting perspective. It is not tax or legal advice. Readers should consult the appropriate experts before taking any action.