People are a fundamental pillar in creating a successful organization. So how should you appropriately structure incentives in order to hire and retain a top-notch team?
Before You Even Consider Offering Equity….
How much of the company do you need to give away in order to lure the best players for your business needs?
As a frame of reference, most companies typically net out with somewhere around 10-20% equity in employee hands. However, prior to making any decisions about offering equity and how much, it’s critical to have a very good capitalization table (or “cap table”) in place. This is one of the most important building blocks for any start-up or early stage venture and it will help guide many key decisions.
Your cap table serves as a “budget” for all the equity you’re ever going to issue. In its simplest form, it’s a ledger that tracks the equity ownership of a company’s shareholders, outlining each investor’s percentage of ownership in the company, the value of their securities, and dilution over time. Eventually, the cap table will become more complex and include items like SAFE’s, convertible debt, options, and warrants as well as the impact of phantom stock if used.
Once your cap table is fully fleshed out, and you’ve projected how much of the company the founders are going to own, how much investors are going to own, and what rates of return are available to investors, you can then build in a section for employee ownership and predict the future payout to any employee. This will help you create incentive plans that have real value assigned to each position and contributor.
After you’ve pinpointed how important a given employee’s contribution is to the growth of the company and have a good equity budget and solid projection of the future value of the company in place, it is much easier to assign a certain number of shares to an employee and determine how much you ultimately want them to net.
Top Five Mistakes to Avoid
There are a few areas related to employee compensation and classification that many start-ups get wrong.
- Giving away too high of an equity percentage to a founding employee who is not a key business driver. Laying the groundwork of the cap table early on prevents you from unintentionally handing over millions of dollars to an employee whose role does not require a high level of strategy or who isn’t interested in investing a significant amount of time to help build the company from the ground up. Your cap table will help quantify the potential future returns that would go to each employee, allowing founders to leverage their equity appropriately, use it to get the best people on board, and reward those who offer the highest levels of value, work and time commitment.
- Hiring the cheapest person in the room. A far better approach when it comes to retention, output and overall employee happiness is to pay people the most you can afford instead of the least, and combine that with a company culture that holds everyone accountable to high performance standards.
- Assuming every employee wants or needs to be a shareholder. You may think you’re doing a wonderful thing by giving everyone equity, but the reality is that a lot of employees just don’t care. If you structure your cash compensation to be gracious and fair, then you won’t have to give away as much equity, and can save offering company shares to those who truly value that benefit. In addition, instead of straight equity, there are several other ways you can capitalize on the appreciation of the stock and use it to enhance compensation. These could include profit pools, phantom stock plans and more.
- Holding back too much equity. Many times founders go too far and hold back almost all of the equity for themselves in order to maintain voting control. This is a common concern, but one that can easily be addressed by making employee shares non-voting, or varying voting rights on preferred shares.
- Exposing your company to financial and legal risk through improper employee classification. Often, in an effort to save on paying benefits, taxes, paid time off, etc., start-ups and early stage businesses prefer to use independent contractors instead of full-time employees. The danger with that approach is ensuring alignment with the very strict IRS guidelines governing employee vs. independent contractor classifications.
If the Department of Labor and/or IRS were to determine that contractors are doing the same work as a full-time employee would do, you will be subject to the types of back taxes and fines that can quickly and negatively impact your cash flow. As such, as your business grows, it’s important to always be looking for the inflection point when it makes sense to reclassify workers from contractors to employees.
There’s an additional and important fairness component related to whether to make team members contract or full- or part-time employees. While executive level or gig workers commonly understand what a 1099 is and what their personal tax implications are, a warehouse worker or receptionist may not. In those instances, it is best to treat your people fairly and provide them with a W-2.
Now that we’ve covered the first pillar of success—setting up the appropriate legal structure—and the second pillar of how to use equity wisely to hire and incentivize the best people, we’ll move on to how to obtain financing without giving the company away.