Equity Compensation - Pros, Cons, and Vesting Decisions

What's the Deal with Equity Compensation?

Let’s say you have the cash you need to get things set up – but you’re hurting for cash flow (i.e. additional money coming in every month). This can make it pretty hard to pay your employees, particularly skilled marketers, programmers, and engineers who may rake in more than six figures a year at a more established company. Equity compensation is one way to get them on board.

The general idea of equity compensation is to offer employees a share of the company’s future profits in exchange for lower (or sometimes zero) salaries up front. Of course, as with equity financing, we highly recommend consulting a lawyer before making any formal offers.

The Pros and Cons

As with any form of compensation, there are pros and cons to offering equity compensation.

The Pros The Cons

Motivated Employees –Equity compensation not only lessens the up-front financial burden of paying out sky-high salaries, but it also attracts employees who are committed to working harder in order to ensure their financial wellbeing and the success of the company.

It’s Complicated - The most obvious con with equity compensation is that it requires giving up small portions of ownership of your business. This is decidedly more complicated to handle than a traditional salary – and when you’re starting a small business, more complicated is exactly what you DON’T need.

Types of Equity and Vesting Terms

If you decide that equity compensation is something you’d like to offer, then your next move should be to figure out exactly what type of equity to use.

Here are four major types of equity used by small businesses:

  1. Common Stock – a small portion of ownership in the business that pays dividends (a percentage of profits) when the company makes money.
  2. Preferred Stock – similar to common stock but dividends are paid FIRST to preferred stock holders, then to common stock holders. Preferred stock is essentially common stock with a “skip to the head of the line” guarantee.
  3. Issuing Shares – common stock that is given for free to employees (they don’t have to buy a share, you give it to them as a bonus or gift).
  4. Warrants – also known as “stock options,” warrants convey the right to purchase stock at a future date for a set price, determined at the time the warrant is issued. For example, a company might offer an employee the ability to purchase five shares of stock at $100 a share in five years. If in five years a share of the company is worth more than $500, the employee has the option to buy it at $100 a share and sell it the next day for $500 a share.

In addition to the different types of equity, there are also variations in vesting terms. Vesting terms are just a fancy way of saying how long an employee has to work for you before they can collect their equity benefits. Outlining a vesting term protects you from an employee that signs on, takes their cash the second the business turns a profit – and then high tails it outta there two months later.

If you have a business partner or co-founder, you can set up a vesting schedule to ensure you’ll both stay on board.

Most companies require about 12 months of employment before employee benefits (equity, 401k match, etc.) are fully vested – but of course, that’s up to you to decide!

Who Gets What and How Much

Now that you’ve decided what type of equity you’re going to offer to your employees, it’s time to figure out how much they’re going to get.

If you offer too little, they might say sayonara and take a job where they get paid cold hard cash. Offer too much – and down the road your employees end up making more money than you. Not good.

The first decision you need to make is whether to offer your employees 100% equity compensation or a combination of salary and equity. On the plus side, offering employees equity alone means you’ll end up with employees who truly believe in your business and are willing to work hard to see it succeed. On the other hand, it may eliminate qualified employees who simply cannot survive without some cash flow during the time it takes to make the business profitable.

Once you’ve sorted out the percentage of equity vs. salary, it’s time to negotiate the amount of equity. While there are no specific guidelines as to how much equity each type of employee should receive (every business is different) there are a couple things you should consider.

  1. The amount the employee will receive in salary pay (and how much lower it is than a typical salary for an equivalent position).
  2. The employee’s predicted impact on the success of the company.

Ideally, you’re able to calculate (approximately) the amount the employee is worth to the company, and offer them an amount of equity that is equal to their worth – based on your predicted profits in 12 months.