Leveraging Equity Compensation: A Synopsis for Tech Startups

Tech entrepreneurs face considerable hurdles while turning their ideas and ambitions into viable business propositions. They must address the issues of raising capital, recruiting talent, developing the product, and even creating markets at times. Investments and talent are critical resources that are scarce in the business’s early days. Equity is the best chip for startup founders to attract capital and key employees. For tech startups, equity compensation plays a significant role in hiring and retaining professionals with the skill sets needed for growth.

Revisiting The Fundamentals

Equity compensations or equity grants are non-cash benefits. Frequently, early-stage startups cannot offer competitive pay packages to the key staff they wish to hire. Equity compensation makes the perquisites attractive to future team members in that scenario. Stock options offer employees a stake in a potential multi-million dollar company and a chance to benefit from its success.

Owning equity encourages core employees to feel more invested in the company’s success and more responsible towards the firm. Equity compensation encourages personal growth that parallels company interests.

Some Factors Affecting Equity Compensation

Understanding the nuances of equity compensation can prove advantageous to tech startup founders. Let us examine some of the important concepts and factors that affect the allocation of equity compensation.

1. Equity Type– There are different ways to award employees equity. Stock options are the most common type in which employees get the right to purchase company shares at a predetermined price over a specific period as set in their agreement with the firm. The second type is Restricted stocks which are shares granted to the staff based on the fulfillment of some predetermined conditions of timing or performance.
2. Vesting Schedule and Cliff– The vesting schedule determines how and when an employee can exercise his stock option. Cliff refers to the minimum time a person must work for the company to exercise stock options. A typical vesting schedule has four years with a one-year cliff.
3. Strike Price– It is also called exercise price and is the price at which an employee can exercise his stock option. This price is based on the stock’s fair market value at the time of the option grant.
4. Option Pool– Every startup planning to use equity compensation must create an option pool — a set of company shares reserved for employees. As a rule of thumb, tech startups allocate 10%-20% of total equity for the option pool. The depository gets adjusted during each funding stage.

Significance of Granting Equity 

Equity compensation offers multiple advantages for startups. Some of them are listed below:

1. Preserves cash flow– Stock options fill in for deficiencies in the cash benefits of a pay package. Firms on shoestring budgets can direct funds toward critical activities like research and development, enhancing facilities, etc.
2. Compensates for the risk of joining a startup– Early, high-impact employees bring technical expertise and business acumen to the startup, allowing it to sustain and scale. They might be forgoing a secured recruitment-to-retirement benefit program for a more innovative career path in the startup. A stake in the company compensates for such risks more adequately than monetary benefits.
3. Helps arrest employee attrition– Equity compensation incentivizes employees to stay with the firm. An ownership stake in the company motivates key personnel to support the firm continuously.
4. Rewards performers– Equity compensation is a tool to reward well-performing employees. Firms may award additional equity to employees who are promoted to key roles or have performed exceptionally well.

How to Make the Most of Equity Compensation

Careful handling of equity compensation enables founders to create a win-win situation for the company and its employees.

1. Create a Stock Plan Administration– Stock plan administration involves creating a legal framework for managing stock options and tracking and managing equity grants to employees. Shareholders approve option plans, and the Board of Directors authorizes option grants. In a startup, founders often play the all-in-one roles of majority shareholders, the Board of Directors, and the CEO. Ensure you don the correct hat at each step so that the process is technically correct and legally binding.
2. Actively manage the option pool– Determine the size of your option pool based on your recruitment plan. At any given time, the option pool should have enough equity to handle all the existing option exercises and new allotted equity grants.
3. Be open to customizing your compensation plan according to employee preferences– Use salary negotiations to understand the candidate’s requirements. Remember that exercising stock options carries a cost for the beneficiary. They may prefer more equity at lower prices than buying a few shares at a higher value. In such cases, opt for stock splits which will increase the number of shares without changing the total value or percentage of shares in the option pool.
4. Include exit options and vesting schedules– The founders may want to protect the firm’s interests and avoid future power struggles and takeovers. Always include vesting schedules for an equity grant and a provision to prevent the sale of unvested equity. Also, the Right of First Refusal (ROFR) clause will ensure that the company knows about the sale and gets the first chance to purchase it if a beneficiary wishes to sell their vested shares.
5. Use the Capitalization Table to guide the equity grant process– An updated Capitalization Table or Cap Table will list the equity capitalization of the firm. It presents an accurate picture of the option pool, helping its management.

Summing up

Equity compensation is a cost-effective technique to run your startup. It bridges the gap between the market price of a firm’s talent and its budget constraints. A tech startup should not stretch its limits and grant employees compensations that are close to those offered by tech giants. Instead, they must create customizable compensation packages that consider the needs of their staff and the firm’s interests and focus on increasing the company’s value.

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