Are you figuring out the equity incentive plan basics for your startup?
Thinking about offering equity incentives to key players in your startup business? Why would you? What are the basics of an equity incentive plan that really works for everyone?
Equity can be a highly valuable and powerful tool for entrepreneurs. Even early-stage startups can find it unlocks incredible value for them and makes so much possible, far faster than many could imagine. Equity incentive plans can also be a tricky beast. They can bite you back or limit your potential, or at least throw some serious wrenches in your vision if you aren’t careful
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So, when should you offer equity? Who should get it? How much should be given? What contractual and negotiating tips can help founders maximize the upside and minimize risks?
Here is the content that we will cover in this post. Let’s get started.
What Is An Equity Incentive Plan?
When understanding the equity incentive plan basics it is important to note they are a way of offering value and compensation. This is in the form of stock, stock options or the ability to earn shares in the company. This is in contrast with upfront compensation and cash now. In virtually all cases it is a motivating incentive based upon what the value of equity in your company may be worth in the future.
Equity incentive plans are most common among the earliest hires in a startup, both pre and post Seed round, as well as for executive positions.
It is important to note here that prior to fundraising investors would expect that you have the equity incentive plan in place to avoid having them getting diluted.
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Why Use & Offer Equity Incentive Plans?
There can be many reasons why you want to understand the equity incentive plan basics, including the following.
Keep Company Financials Strong
Overhead can not only cause cash flow problems, but debt and commitments to big salaries can weaken your overall financials, profitability, and flexibility. This can cause problems every day, and specifically when trying to raise financing. Giving equity in lieu of some compensation means lowering regular expenses, and only really paying out when things are successful.
Attracting Strong Talent For Less
The startup with the best talent wins. Obviously the best talent isn’t cheap. This leads many entrepreneurs to sabotage their own startups by either hiring cheap labor or trying to do everything themselves. They don’t feel they can pay big salaries or bonuses to lure good talent. Of course, if you can’t afford good talent, you probably can’t afford to be in business
Equity incentive plans are the tie-breaker here. You can offer recruits a split of base salary and a piece of the company. If your business succeeds that equity could end up being worth millions of dollars, or even a billion one day. It’s a way for you to get the edge, and afford awesome people.
This can apply to talent for daily work, remote and fractional roles, and advisors. You can imagine how much it would cost to recruit a top executive or advisor, even part-time. That’s probably more than your first-year revenues. Giving them equity can help bring them in, without cash out of pocket.
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Recruiting great talent is just a small part of the battle. The rest is getting them to work hard and well together. Union Square Ventures’ founder Fred Wilson has been quoted as saying that equity “reinforces that everyone is on the team, everyone is sharing in the gains, and everyone is a shareholder.”
It means everyone with equity benefits from making the company successful. They aren’t there to just fill a seat and take a paycheck. It motivates them to work harder, give more, do their best, put in all the extra hours, and deliver more satisfaction to customers.
Of course, you also need to be careful with your equity. It may not feel like you are giving up much now, but it can be millions and billions of dollars later. For some repeat founders, creating millionaires with each company is something that drives them to start companies. Yet, do understand how it can dilute your ownership and may impact the ability to get financing and raise money from the most desirable investors later on.
Types Of Roles For Which You May Offer Equity Incentive Plans
A critical factor when tackling the equity incentive plan basics is to know the different roles. There are a variety of roles for which you may find it beneficial to offer equity incentives in the days of an early-stage startup.
As a young startup and founder, you need all the advice you can get and that is where an advisory board comes into place. You won’t get much for free. Others who have been there and done it may want to generously help. They also have a responsibility to maximize their time and what it can do for others. Their time and advice can be worth a lot. Where you can’t afford salaries and coaching, you may offer an equity percentage to compensate them for their time and expertise.
This can also be critical for recruiting early evangelists and to build credibility in your pitch deck.
When thinking about the equity incentive plan basics, one of the most common things entrepreneurs say they would do differently if they could start over is that they would focus more on recruiting executives earlier. This makes everything easier, from not only harnessing their expertise but then leveraging their time to build out departments and teams. It sure beats trying to build and manage everything from the ground up yourself.
You probably can’t afford too many $200k plus salaries in your first year, but you can afford to offer equity.
Cofounders and executives can bring a lot of missing expertise and talent to the team. Yet, you still need team members to be in the trenches and be executing everything else on a daily basis. Marketing experts, engineers, developers, and others may not be cheap, but you can’t afford to have them either. Small equity percentages can help bring them in and give your venture an advantage.
How Much Equity To Give
As part of the equity incentive plan basics, knowing how much equity you decide to offer or need to give up can depend on several factors, including:
- Stage of business
- How big the opportunity is
- If you are already funded or not
- If you have revenues or profits
- Your path to an exit
- How soon this equity will really be worth something tangible
- Who else is involved
Your advisors and lawyers will also advise you to protect yourself and other shareholders by spreading the vesting of equity out over several years. You may not want to just give it all up front, and then have that person leave, and continue to benefit from your hard work. Instead, in the case of giving 2% equity, you may choose to spread it out over 2-4 years in 0.5% to 1% increments.
Guy Kawasaki has recommended giving engineers 0.2% to 0.7% in equity, and 5% to 10% to CEOs. Angel investor Vijay Rao says he has seen department heads, including CMOs and sales and marketing pros, get 1.5% to 2.5%, and CEOs 7% to 10% in equity.
Hopefully, this post provided some visibility into the equity incentive plan basics. also you may enjoy the video below where I cover how venture capital works in detail.