Feb 2015
(Based on an Office Hours with a lawyer)
“Be generous with equity but have a clear sense of how someone is going to help you build your company before giving them a piece of it. Go for it, have success, but bring others along with you. Take as many people with you on the ride as possible.”
– Doug Leone, Sequoia Capital
“It is amazing what you can accomplish if you do not care who gets the credit.”
– Harry S Truman, 33rd US President
There is a particularly bad habit in the startup world of founders giving equity to people who help their company very little. Usually people who call themselves investors. And not enough equity to the people who help their company the most like employees or friends or early services. If somebody helps a startup succeed, they deserve to be compensated for it.
The way they help you succeed can be erroneous. It could be as simple as they did some work or provided a service that you couldn’t afford to pay for at the time. When Facebook was a young company they hired an artist to paint murals in their first office building. Instead of cash payment, they gave the artist shares in Facebook as payment instead.
This worked out very well for both Facebook and the artist. Facebook received a free office design and artwork, which is valuable for them as a young company, and the artist did their work for free and received shares as payment instead. Those shares went up in value and eventually they could sell their shares for money.
Every startup can do this and should. Because most startups have people helping them who do so without any reward. Early employees who take a salary cut to work at the company. Close friends who help out. Advisors who give lots of feedback and make key introductions. In many cases, these people create a huge amount of value that goes uncaptured by them. And this should change.
I’ve always subscribed to the idea that anyone who helps a company succeed should receive a piece of it. How much should they get? Is the question this essay is trying to answer. Broadly, I think the formula looks something like this:
For a person who helps a company:
(what is their time worth) X (number of hours worked) + (how much money they spent) — (how much they were paid) + (amount of additional value created) = (how much equity to give)
The dimensions you want to compensate a person for is the amount of time they spent, the amount of money they spent, any serious opportunity cost they forewent for helping you and any extra value that was created.
The additional value created is the hardest to measure since it is a qualitative heuristic and depends on the context of the situation. It should be worked out on an ad-hoc basis. Someone may not put in many hours but create a huge amount of value. For example someone might be external and doesn’t do anything but helps get a key deal, introduction or partnership. Or they present a great idea or write some key piece of functionality or design something important.
They, even though they did not quantatively work a lot of hours, in the earliest stages this creates value. A good rule of thumb is anybody present at the earliest stages of a company should get a small stake in it. The only wrong answer is nothing. Conversely if two people work the same and contribute the same but one creates 100X the value of the other, they should not be compensated equally.
To avoid the politics of this scenario, usually companies will measure this using a system of KPI’s (Key Performance Indicators). It’s basically a big list of pre-assigned things that create value and the more you do or higher you score, the more value you are creating and compensation is frequently linked to this KPI list. But this can sometimes be overkill at a small startup since there should be as little bureaucratic overhead as possible.
To work this out we need to figure out what the shares are worth, to be able to issue shares to people as equity you need to know their price. But you only know how much shares are worth if the company has an established valuation. Because it has already raised money meaning the shares have a price. If they don’t, then largely you don’t know what the value of the company is. And in the early stages it’s particularly hard to figure out a valuation.
Instead I’ve heard as a rule of thumb if the company is a high growth tech startup and is too small to yet have a valuation, you should value the company at $1 million dollars and each share at $1 when giving equity grants. This will work for most startups.
It is because it attempts to price in the lifetime worth of the company. And then every year, increase the share price by $1. And that should last until you raise money and have a formal valuation or are sustainably bootstrapped to pay for everything. If you already have a formal valuation, then just use that.
But what if you are valued too high? Some companies these days receive mind boggling valuations from a relatively young age. If this happens and you want to compensate someone you can vary the amount of shares you issue until it feels right. So you can increase or decrease the number of shares issued as you need to. Or you can increase the discount on the shares.
When you arbitrarily increase the number of shares you issue to a person, you call this a grant. So you can issue shares to someone and if you feel it’s low, then issue a grant of another 1,000 shares. Another method is by adding a discount to the shares. This is when you sell the same shares but at an arbitrarily lower price. So a $1 share with a 10% discount you would sell to someone for 0.90 cents. Or with a 20% discount would be 0.80 cents. With a discount, since the shares are cheaper to buy, more shares end up being issued.
Both of these can be done as needed but shouldn’t happen too frequently or it will invalidate the integrity of the entire process. People who help your company and employees will think you’re playing favourites and will resent you for it. It’s better to err on the side of equanimity.
What you should not do though is reduce the valuation to issue more shares. As this can signal problems to people that the company is actually losing value instead of gaining it. And it could destroy the value of anything people have used their shares for. Such as collateral for a loan etc.
The class of these shares should be the same as the founders. It’s not cool for a founder to have preferred shares while their employees have common shares. This is founders screwing over employees the same way investors screw over founders and is not ok. Whatever happens to the founders class of shares should happen to the shares of everyone in the company.
Now let’s put some numbers on this. If someone spends 100 hours doing something for you and they charge $30 per hour. Then you should issue $3,000 worth of shares for that person. If the shares are worth $1 each. You would issue 3,000 shares.
But if the shares are worth $2 each, you would issue 1,500 shares. By contrast, if their time was worth $100 per hour or $250 per hour, at $1 per share, they would be issued 10,000 shares or 25,000 shares. At $2 per share it would be 5,000 shares or 12,500 shares. This is also inductive reasoning for why it’s a bad idea for a young startup to hire expensive consultants.
You then add any expenses the person has made. So if someone spends $500 on something for the company. This converts to another 500 shares being issued to them at $1 per share. This is why it’s important for companies to keep good records and keep track of expenses. To be able to keep accurate track of this.
So far we’ve assumed you haven’t paid the person who helped you. If you did pay them then you don’t need to issue any equity since you paid the market rate for their services. Equity should be issued when you are unable to pay the market rate and so you make up the difference using equity.
If you’re able to pay the market rate, then there’s no need. If you’re paying employees really well, then there’s little need to issue stock beyond an incentive for them not to leave. That’s frequently why companies issue stock options and not stock directly.
This formula is for issuing stock directly. But If you go through this formula and the number you get feels wrong, then you can always make up the difference using stock options. And then give a big discount on the stock options which employees then need to exercise.
A stock option is just the option to be able to buy a certain amount of shares. So they pay the company the price of the shares, and the company issues the shares to them. It’s literally like they are buying shares from the company. But you can vary the discount on the options. Which means you can sell options to them at a discount of 20% or 50% or 90% less than they’re worth while setting a restriction on how many they can buy.
So if a share is worth $1, and you give stock options with a 50% discount, you are selling every $1 dollar share to the person for 0.50 cents. You then set a limit on how many shares they can buy like this. So if you go through the formula and it sounds low, you can then issue stock options to the person for the difference. This will probably only happen if they create lots of hard to measure value like they single handedly refactor a codebase or built a new product.
You don’t actually need to issue these shares immediately but there should be a contract stating they’re owed. This is to avoid any negative tax or legal consequences. And then when the company is in a better position, it can issue them formally. I’ve always thought share issuances were better done as a batch process. To avoid excessive meetings.
Giving equity to people in exchange for stuff works extremely well for cash strapped startups. Cash poor startups can use their stock as incentive for people to be rewarded for doing work for the company. So our hypothetical person did 100 hours of work for the startup and is fairly compensated for this effort.
They now own 3,000 shares in the company in exchange for 100 hours of help when their value is $30 per hour. If the company value goes up dramatically, these shares will be worth a lot as they received them at a price of $1 per share.
Over the next few years if the company value increases 10X to $10 per share, the value of this work is $30,000. And if the value goes up 100X to $100 per share, the value of this work is $300,000. One day if the company goes public on the stock exchange and becomes a huge company with their shares going up to $400 per share, our hypothetical person just became a millionaire.
This potential increase is to compensate for the risk of the company failing and the shares not being worth anything. So to offset the person having effectively wasted their time and done all of this work for free and missing out on the opportunity cost of what they could have been doing. Which is the much more likely outcome as most startups fail.
It is also inductively why it is so important for employees to pick successful companies. And the goal for those successful companies to share their wealth with as many people who are likely to create the most value and increase the likelihood of them being successful in the first place.
Additional
For founders trying to calculate equity splits, it is much more difficult. Because there are N scenarios with each one having Y optimal outcome as the ideal equity allocation. In situations like this I’d be more inclined to advocate using an equity calculator such as this one. Or to have a broad rule such as a 50 / 50 equity split with one founder having the pre-assigned role as the dominant founder who takes a leadership position.