Editor’s Note: A version of this article was previously published by Forbes.
If your early-stage startup is looking to bring on passionate, dedicated employees, equity compensation can help you build a team that is committed to making the business a success.
Employee equity is the practice of granting stock to employees as part of their compensation packages. If the value of this equity multiplies year-on-year as the startup’s valuation grows, having a stake in the business can become a huge financial asset for the employee in the future. By offering equity to new hires, startups can conserve their cash and attract top talent who have a longer-term vision for their role with the business. Plus, because employees who own equity are invested in the success of the startup, you can be confident they will work hard to ensure it scales.
In this article, we’ll cover the basics of how your business can grant startup employee equity.
5 Steps To Offer Startup Employee Equity
1. Create an Employee Stock Option Pool, or ESOP.
A general rule of thumb is to set aside around 10-15% of your equity for your Employee Stock Option Pool (ESOP) which is dedicated for future employees. However, you can increase the amount of equity assigned to the pool as you distribute the equity and the pool diminishes.
For example, post your Seed round, you may assign half the available stock options in the pool over the first 18 months of operation, leaving only 5% of the ESOP remaining. To allow enough equity to accommodate future employees, you can allocate more equity to your employee stock option pool by diluting the shares of existing shareholders—slightly reducing the percentage of the business they own. Startups often replenish the employee equity pool as part of a funding round.
2. Choose the type of equity to grant.
Startups grant three main types of equity to employees:
- Stock options are the right to buy or sell a defined amount of shares from the founders at a predetermined price. The employee can exercise this right between the vesting date (once the employee has earned their stock options) and the expiration date. This is the most common type of equity that startups choose to distribute to employees.
- Stock warrants are the right to buy or sell a defined amount of shares from the company at a predetermined price. Warrants can also only be exercised between the vesting and expiration dates, but they usually have longer expiration dates than stock options.
- Stock grants are the ownership of a defined amount of stock. There is no vesting date or expiration date on stock grants, so the employee can immediately sell the shares, if they so choose.
3. Determine the vesting period.
The vesting period is the time during which an employee must earn (or vest) their allocated stock by working for the company. The typical startup equity structure is graded on a four-year vesting period, which means the employee earns ownership of 25% of their stock each year. The vesting period also often includes a one year cliff period—the minimum time the employee must stay with the company before the vesting schedule begins. A small number of companies choose to have longer vesting periods or increase the percentage of equity that employees vest each year to disincentivize employees from leaving the business.
4. Decide how much equity to assign to each employee.
How much equity should a startup employee get? Some startups determine the amount of equity they grant to each employee based on the seniority of their role, while others offer equal amounts of equity regardless of hierarchy.
Because a high percentage of startups fail at an early stage, early startup employees take on a significant risk when they join the company—and most businesses offer more equity to early employees to reflect this fact. For example, you might offer 1% equity for the first 10 employees and 0.5% equity for the 50th employee.
Read more and check out their calculator tool on the Carta blog.
5. Document startup employee equity in a cap table.
A capitalization table (or cap table) is a record of all the shareholders of your company, including any employees, advisers, or investors who have equity (this might include friends and family, angels, or VCs who’ve invested in your business along the way).
Your cap table should include the total number of stock options that have already been exercised and the total number of shares still available in the option pool. Make sure to regularly update this document to ensure it’s an accurate reflection of the company’s current ownership. As well as being a key financial document to share with potential investors, an up-to-date cap table will help inform strategic business decisions about the fundraising process.
Need guidance from startup experts as you grow?
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Our experienced team of experts knows the world of startup finance inside and out, and can guide founders through every aspect of business accounting, from building your financial model to choosing the right software for your business. Plus, with Zeni’s CFO Plan, you’ll get a dedicated CFO advisor with experience in your business vertical who can manage your financial planning and analysis, prepare key financial reporting, and advise on startup equity and the fundraising process.
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