Equity Incentives for Startup Teams

Joining a startup feels risky to many, yet the upside potential of making a difference and sharing in the financial rewards of building a success can be enticing. Startup founders and leaders should consider how to incentivize their team using equity as part of an overall compensation package.

While founders often start a venture and invest their personal time and capital to get it off the ground in exchange for significant ownership stakes in the company, the calculus is a bit different when applied to non-founder hires, which is the focus of this post.

Non-founder hires expect to be paid for their contribution to building an early-stage company. Once a startup moves past its initial founder-led stage, the startup leaders must find ways to compensate their team members by using grant, early revenue, or investor funding sources. One option that usually does not work is asking new, non-founder hires to work solely for equity because most potential team members do not have enough personal wealth or other sources of income to pay their monthly bills (exceptions might be those who have the support of a spouse, parents, or accumulated wealth). This means they need to get paid some cash.

Equity is not a stand-in for cash. It is an incentive. It is an important incentive that holds out the carrot of the possibility of securing an exciting “payday” when they help grow the company big, quickly, and get to participate in a positive upside win along with the founders and investors.

This incentive works because the common stock of a startup is worth very little in a startup’s early stages, enabling startup leaders to issue stock options or stock grants at a low price. Suppose the company is ultimately sold for a much higher price. In that case, those employees holding equity benefit from receiving the company’s sales price per common share (after any preferences and payouts to the preferred stockholders and fees for transaction advisors) less the lower value strike price of their stock option or purchase price of their stock grant.

Philosophically, given the risks of joining a young and fragile startup, I believe giving every employee a stock option grant is essential. In one case, when the company had a great exit, many on the team got a payout that was typically close to their annual cash compensation.  Equity grants help everyone on the team be aligned with the possibility of a company sale, when there is hope for a payout if that happens. However, I like to describe these incentive stock option grants as “lottery tickets” to emphasize that many things can happen to a startup that can derail its progress. While we all hope for an excellent financial outcome, one should not count on it until it happens. The “lottery ticket” metaphor helps new employees understand this is potentially good while still not communicating excessive confidence about whether the payout will be realized. This significant uncertainty about the liquidity timing and ultimate value of a startup’s common stock is also why it is inappropriate to represent stock options as a substitute for cash compensation for team members.

Some additional considerations for startup leaders when using equity compensation:

• When used well, equity encourages alignment: When all the stakeholders (founders, employees, investors, etc.) have equity that pays out when there is a strong exit, everyone is aligned in contributing to achieving that strong exit. This is why investors want to see founders and startup management teams with a significant stake in the company and grant employees stock options. Using equity as an incentive is considered one of the best ways to motivate the team to push for fast, strong success and to be willing to sell when a good deal comes along.
  
  
• Worrying too much about 409(a) valuations of common stock: Typically done at least annually and every time you close a priced round, a 409(a) valuation is a third-party analysis of the value of a startup’s common stock. It can be distressing to an inexperienced founder when, after raising some funding, the valuation of the common stock comes in quite low relative to the price paid by the preferred shareholders and sometimes even drops. However, this makes sense because, in the event of an exit, the preferred shareholders get paid first (sometimes with a multiple of their investment), so adding preferred investment to the top of your cap table depresses the valuation of the common stock. This happens because the risk of realizing a return for common shareholders increases when there are preferred investors who would get paid out first. The reality to remember is that it is all paper gains and losses until an exit, so these numbers are just estimated numbers at a point in time and do not tell you what your startup is actually worth. Plus, remember that, for team members, a lower 409(a)-supported valuation for their stock options is a better incentive because that reduces the amount the team member needs to spend to exercise their options and creates a better opportunity for a future gain (buy low–sell high!).  I recommend not trying to aggressively drive the 409(a) valuation up, as there is little to gain from that, and it undermines the strength of the equity incentive.
  
  
• The risks of trying to use equity to pay for services: Sometimes, a cash-strapped startup will try to use its potentially most valuable asset (equity) to pay for services such as a consulting or software development firm. In doing so, the founder will sometimes think of their equity like cash. However, early-stage equity is often worth very little (e.g., par values of $0.00001), which could mean giving up huge chunks of shares to compensate the service provider (amount of compensation divided by par value equals number of shares).  To adjust, some founder consider valuing their shares at a higher level, but by creating a valuation like this they may (a) make it difficult to provide low-strike price options to other team members and (b) create a dead equity problem where short-term contributors end up owning far more of the startup than they should, creating issues for future fundraising and team incentives. “Dead equity” refers to equity held by parties who are no longer actively contributing to the development of the startup, and can weigh down your fundraising efforts. Finally, while you can certainly choose to grant some options as a “bonus” for service providers, be mindful of not accidentally pricing your common stock with some weird valuation, as that can cause headaches for both raising money and pricing your stock options.
  
  
• Make sure to use vesting for all options: Standard vesting terms like a four-year vesting term with a one-year cliff are designed to give reasons to employees who receive a stock option grant to keep contributing to the company’s success. If someone leaves “early”, the unvested or unexercised stock options revert into the pool to be used to hire and incentivize the next employee who joins the team. Large equity stakes held by former team members (for example, if there was no vesting) who leave early can make it challenging to incentivize new employees. Equity incentives are intended to motivate people to contribute for the long haul as they build value and vest their shares.

The potential future value is one way that joining a startup can be exciting, so it pays for founders to learn how to use this tool wisely.

Reminder: I am not a lawyer; this is not legal advice. Check in with your lawyer on anything related to your capitalization table to stay within legal and tax rules.