A close relative received her option plan offer and asked me to have a look. She got X number of options at an exercise price of $Y per share. I asked her, “How many shares are there altogether, or what’s her percentage of the company? What’s the company valuation (in the last round) or what was the PPS (Price Per Share) in the last round?”
She didn’t know any of the answers. She wasn’t given this information and there was zero transparency on the part of the CEO, so she didn’t know how to find out.
An equity incentive plan will usually have two purposes: Making the employees part of the success and achieving retention.
At Waze, everyone had share options. For 75% of the employees, it meant becoming millionaires, and it was a life-changing event for everyone — not just the 75%.
My father used to say that if you don’t know how much you’re paying, then you’re paying too much, and I would suggest similar logic applies here for what you’re getting. If you don’t know how much you’re getting, then you’re getting too little.
I’ve noticed this lack of information and knowledge on the employee’s side multiple times, but also CEOs, and in particular those at early-stage startups, are not building the right strategy for employee equity compensation.
In this article, I’ll present the right strategy to use equity or option plans as a tool for employee compensation and retention, for both CEOs and employees to understand what to do and to set their expectations accordingly.
Your employees are your most important asset
Let’s start from the beginning. An equity incentive plan will usually have two purposes:
1. Make your employees part of the success.
At the end of the day, they are the ones who are going to make you successful, and you want to share the success with them.
2. Keep them.
The equity incentive plan is part of your retention strategy. While your company is moving forward and its valuation increases over time, what may look insignificant today, may be a life-changing event for your employees in years to come.
A side bonus, particularly for the early-stage startups, may be allowing them to reduce the burn rate, and hire people with lower pay enabled by giving them higher equity. In many cases, there is or might be also a tax advantage for equity-based compensation.
Out of all your stakeholders and shareholders, board of directors, customers, partners, employees, etc., your team, your employees are the single most important stakeholder. They are the ones who will do the heavy lifting and make you successful or not. You should invest in them. You want them to be part of your success, and in the same way that you hope to change the world and that this journey will be a life-changing event for you, you want it to be for them too. It’s a win-win situation.
When deciding on equity, you should be the most generous person on earth. I always prioritize ensuring my team is well compensated, and I strive to be incredibly generous when granting equity. In every board of directors meeting where equity is granted, there is not a single time that I’m not asking the question, “why so little?”
The last part is transparency. If you’re a public company, then the share value is clear and everyone knows it. In a private company, when you tell an employee that they are getting ten thousand options at an exercise price of $X and that they will be vested over four years, it is meaningless since the employee has no idea what it means. Is the number of shares or share price a fair market price?
This is what the information about the equity shares plan should look like
“You will be getting 10,000 options and, as of today, there are 10 million shares.”
“The exercise price, which is the price that you will be paying to buy those shares, is $X.”
In the last financing round, the share price was $Y, and it was back in [date].
“If we execute our business plan successfully, we expect to be able to increase the value of the company fivefold in the next few years – the value of your options would be $Z = (5Y-X)*10,000 which is equal to about XYZ% your annual pay.”
Guidelines to allocating share options to employees
Here are some perspectives that can be used as a guideline.
Build a budget, look at the equity pool that you, and the new hires and existing employees that need to be beefed up, for the duration of between now and the next funding round.
Now build a budget for all those, based on your pool with the general guideline of granting 95% of your budget (keep 5% spare). The next funding round will create a new pool, so don’t worry about running out of equity to grant.
Imagine that someone is making an investment offer to you that you would like to take, say 3X the last round valuation. You look at the table of all of your team and their current equity position and figure out what it means for them. Is it significant enough, as they were doing the heavy lifting to get you the deal that you want? Are they generously rewarded for it? The scale should be around annual pay, so for example, if someone has worked with the company for the last five years and now there is a successful acquisition, that someone should certainly see 2X to 3X of their annual pay as a reward.
Give them more…
Say that you negotiated with a new hire, X shares, ask the Board to approve 120%X or 110%X, and by the time that the grant happens, which could be a few months after they have joined, ask yourself one question, “Knowing what I know today, would I hire this person?” If the answer is no, then fire them immediately, but if the answer is yes, give them the higher grant. They will be grateful, you win their loyalty, and they will continue to deliver value to the company and its future success.
The journey to figure out product market fit is extremely long, and those who take part are also taking significant risks. In many cases, the pay cut over those challenging years deserves a very high reward for that.
Think of my relative’s CEO – the company is at A round valuation and you grant an engineer 0.02% in options vesting over four years? If someone offers you 3X the current valuation to acquire your company, you will be making a fortune, so why not your team too?
And what about the board and shareholders? In my mind, it is much simpler. Your role is to create value, and it will be easier and with a higher likelihood if you have a strong and loyal team. You should be taking care of your team, even if the shareholders or board of directors push back.
In some places, the regulation requires the board to approve each and every grant. In Israel, this is the tax authority requirement, so, each grant needs to be approved, based on the following parameters: name, vesting period, amount of equity, tax ruling, and exercise price.
From a business perspective, nearly all relevant information is missing. For example, how much is it in percentage? what’s the position? Is it this person’s first grant? If not, how many of the previous ones are still vested? How many shares are left in the pool? And how does this grant align compared to the planned budget?
Why do we even have this equity-based reward and not a plain vanilla significant bonus? Two main reasons, this is directly connected to the value that those people are creating – the value of the company, and the main reason is taxation.
In many places, there is a very different taxation mechanism for wages versus capital gain, and equity-based compensation is usually capital gain, so the result if someone is compensated for value increased by a bonus versus equity, the gross amount might look the same, but the net amount can be significantly different if it is equity-based. The difference is in the taxation.
A call for clarity
Returning to my relative from the start of the article, and for the sake of the discussion, any employee – you cannot afford to be in the dark and not know what your entire compensation is. Imagine that I will tell you your pay is based on $X + Y vouchers of XOYDASKAH, obviously, your next question would be, “What in heaven is XOYDSAKAH? And how do I translate that into dollars? It’s awkward that you didn’t even notice that I misspelled XOYDASKAH in the second instance.”
It should be the same case if your stock options or equity-based plan is unclear.
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