Let me start by saying that building a total compensation package is HARD! This is an extremely important component of business planning, but many executives end up “winging” it. Instead of taking time to do the math and some modeling, we just slap something together and pray our compensation structure won’t crumble.
For me personally, building an appropriate compensation package is a very hot subject, because I believe operations executives have tremendous impact potential by harnessing the power of well motivated and managed teams. Companies that take care of their employees rarely have challenges finding talent for their “constellations of stars” (see my article “Stars vs. Constellations – 3 Steps to Building Solid High-performing Teams”).
There are many “carrots” we use to incentivize our employees, but equity is one of the ultimate aces in our pockets. Run a quick search through sites like answers.onstartups.com, Quora, or others, and you’ll notice the equity question is a popular one. Nothing creates a heated conversation like bringing up equity! I have seen many companies fall flat on their faces when they attempt to put together proper equity compensation, even when they have the best intentions. I know I have made some mistakes too.
So where do we fall flat during equity compensation planning and how we can iterate for version 2.0? First, we should stop hiding behind the “industry standards” copout excuse. Anyone who has put together options/grants plans knows that it’s easier to locate the Holy Grail than to find these “standards” by region, industry, functional area, and role. Why?
- Sub-100 employee companies, which encompass most of our startups and emerging companies, represent 5.7MM US businesses and employ 40MM people. Imagine the reporting burden and centralized effort that would be needed to collect all the information from these companies.
- Even if you scaled the data collection down and arrived at a somewhat acceptable sample size for the data to be credible, I highly doubt most reports would bother with the full compensation structure details. How many of you have put all the requested data into Harvard and other surveys just to get access to the data? Many of us may put in the bare minimum just so we can get access. Garbage in = garbage out.
- Maybe you can get some semi-decent equity compensation data if you are backed by VCs with an extensive portfolio of companies in your industry, but I doubt they would share that with the rest of the world.
Then there are those of us in pre-B round companies on our proverbial high horses and self-erected pedestals (yes, founders, I am looking at you). Don’t forget that founders would be alone in coffee shops for years and years without a team of talent that chooses to invest in their vision. Our first 15-20 employees are not just employees; they are “junior co-founders”. Companies that have not changed the business model and/or have not hit some really bad times are as rare as jackpots. Yet we plan out equity compensation as if our businesses will only go in one possible trajectory – the “hockey stick”. Early employees are jumping on the grenades for us – stop being cheap bastards and take care of them! Their “risk premium” is always higher than most of us are willing to admit.
So now that we got the elephants out of the room, let’s get down to business!
Equity compensation framework 2.0
I highly stress the iterative nature of this framework. As a founder you may start with something really simple to just get you started. That is fine, but you need to build out the plan and related details stage by stage, step by step. We shall crawl, then walk, then run.
Let’s start with where there is no need to re-invent the wheel:
- Everyone vests and everyone has a year cliff! Yes, that includes founders. Four year vesting with a one year cliff and then monthly vesting – simple, clean, fair. It usually takes four years for a company to build a repeatable and scalable model. Any employee who does not stick around for at least a year does not really deserve to share in the bounty.
- Equity should only be available until the company becomes profitable. The only caveat is that the company should be profitable for a full year. After the company is self-sustainable and profitable, we should switch to profit sharing.
Decide how much of the company should be owned by employees. Here is the 2.0 part: the total of the company owned by the employees should not be diluted. If you think this will be too extreme for your investors, and you don’t have enough brass balls/ovaries to show your investors the value of your team, then at least create predefined percentage points for each round of funding. And yes, investors put money to work for you (you know, insert the usual spiel here to appease them), but your employees are putting in their time, often take a ridiculously low “startup salary” for the impact they bring to the company, and are likely are sacrificing in many areas of their lives for you company. Grow a pair and stand up for your team! With every new funding round they are investing too, hence they should get additional options/grants.
Create two options/grants pools: Employee Impact and Company Milestones. Why am I separating the two? Because one is purely tied to the stage of the business (which can regress) and the risk premium of someone joining at that stage. The other is more of a bonus/celebratory reward.
For the Employee Impact pool, create employee bands based on when they joined and at what level they contribute.
- Junior co-founders – proof of concept to first paying customer stage
- Early team – first paying customer to repeatable business model (or product/market fit) found stage
- Execution team – repeatable business model to first year of profitability
- Non-founder C-level executives
- VPs and directors
- Managers and senior individual contributors
- Junior individual contributors
For the Company Milestones pool, you will need to define your most important goals. Some that I find extremely crucial are:
- Reached X paying customers (you should do several levels of this)
- Major profit margin increase (e.g. 10% margin is not 40% margin)
- Major sales number increase (e.g. $1MM in sales)
- Round of funding “top-ups”
Here is a quick illustration of what the plan might look like in a chart.
(Planned) Step 2(c)
For the 2.1 iteration I am working on adding a third pool called “Market Discount/Salary Concessions”. I believe we need an easier way to grant options to those willing to help the company conserve cash by taking bigger salary concessions. This should really be a formula that is built into our compensation plan spreadsheets.
Hopefully this post will set you on a more structured path when setting up the total compensation plans. My next post will address the cash compensation portion.
If you have time, I highly recommend viewing this full video on Maslow’s Hierarchy of needs I often mention in this blog when analyzing the motivations of our employees.