Many startups begin with a founder that spends part-time on the idea while still having a paying job. Another common approach is to secure a small amount of funding via “friends and family” or even to self-fund with personal savings. These super-lean methods of starting can be great for focus during the early validation stage but once the idea is proven and more resources are needed, how does the startup go about hiring the first employees with zero/little cash in the bank and not enough revenue to self-fund? The answer probably lies in equity but it’s not as easy as some think. In this article I will explore the various nuances and give some specific examples and recommendations.
To best use equity as a compensation tool, most US-based startups should incorporate as a Delaware C-corporation so they can setup a traditional stock option pool and related plan. There are ways for Limited Liability Corporations (LLC’s) to emulate stock options but that can get a little complicated and can later cause the legal costs of a C-corp conversion to be higher. Worst, they aren’t viewed by prospective employees as typical or standard. So go ahead and spend $3000-4000 to convert from an LLC to a C-corporation. It’s even less expensive if converting from a sole proprietorship.
Deciding how much of your company stock to issue to yourself and other co-founders versus placing into a company stock option pool is a topic for a different article so we will just assume you have enough available stock options to grant to newly hired employees. Your startup attorney will help you get all of this setup (see related article titled “10 Tips for Controlling Legal Costs”). And with this new compensation weapon you have an alternative to offer versus cash. But it’s not quite that easy. Here are common questions I get related to this topic followed by my thoughts and recommendations for each:
- How do I properly message the equity portion of the compensation so that it is appropriately valued?
- Which types of people will consider reduced cash compensation in exchange for equity?
- How much equity should I offer versus cash?
Messaging Equity-Based Compensation
If you are still in the early phase of your company’s evolution and don’t have much cash to use as compensation, you must first set the stage to prospective employees and I recommend doing this early in the interview cycle. Of course, you should first spend time explaining your grand opportunity and how you’re going to take over the world while climbing to $1B in revenues and eventually a large IPO or acquisition exit. But before spending 2 hours with an employee candidate that seems ideal for your company, you need to set some expectations.
I like to use the word “currency” to describe the situation because it is a generic reference to something of value. For example, people sometimes barter items and services with each other as a method of exchanging currency – based on equivalent value. That’s the environment you want to describe regarding equity in your company, which doesn’t have any tangible value today but will have TONS of value in the future when you’re wildly successful.
Early in your interview cycle, say something like this to set expectations: “As a very early stage startup with huge prospects for success, the best currency we have for compensation is equity. Until we close a seed round of funding, we aren’t able to pay market rate cash compensation. So instead we offset with equity.” Notice that I also introduced the phrase “market rate” as it pertains to cash compensation. It might already be clear but what this statement essentially does is communicate that you won’t be paying $80,000 for a position that is typically considered worth that at large or established companies. But it also suggests that you will be giving considerably more equity (as a % of company ownership) than established companies typically give.
After making the statement you’re obviously seeking a reaction from the employee prospect as to whether your compensation method, in general, is a deal killer. A lot of people focus on the fun and excitement of working for a startup without thinking about compensation implications. So don’t be surprised if you see some jaws drop or eyes widen. Your statement might eliminate quite a number of candidates, but not all of them. And it’s better to eliminate them before spending excessive time with them.
Who Are Your Candidates?
Let’s start by describing the candidates whose jaws will drop or eyes will widen after you tell them you can’t pay anywhere close to market rate cash compensation and are instead hoping they’ll see huge value from the piece of paper you can give them called a stock option grant.
- People with a home mortgage or other high demands on monthly cash flow
- People with children still living at home and worried about saving for a university education
- People working at large companies that pay at the upper end of the market range for cash compensation
So who does that leave as viable candidates?
- Young professionals freshly graduated from college and without high monthly cash flow demands (they might actually be living with their parents again until they get self-sufficient)
- Part time employees that have another job that pays them cash but they really like your business opportunity
- People that have recently gotten a big pay-day and can afford to go without cash compensation for a while
- People that already have most or all of their retirement savings set aside
At the risk of over-simplifying the attributes from the two lists above, your best candidates are either very early or very late in their financial career. I say “financial career” because the big exception to my rule of thumb is those that have had a big pay-day and can afford to go without cash compensation for a while, which could happen at any age or career stage. Also don’t underestimate the possibility of bringing on part-time candidates because you might be able to hire a few of them and later convert only the best ones to regular, full-time employees when you have cash to compensate with.
How Much Equity is Enough?
There are no hard rules on this since every situation is different – both for the company and the employee prospect. But let’s start with an easy rule of thumb: the closer to market rate cash compensation the less equity. The opposite holds true if you’re trying to hire people at zero or extremely low cash compensation. There are plenty of online articles with guidance on stock-based (equity) compensation.
What I recommend is that you and your co-founders create a set of equity compensation guidelines to be used for the next several months. In the early days you will want to review and update these guidelines every 6 months or upon significant company milestones (such as reaching a new revenue plateau or completing a new round of financing – both of which suggest less risk to new employee candidates).
An easy way to structure the guidelines is based on job level. For each level, list the amount of equity you are willing to give. I recommend listing amounts that are at the upper end of what you are willing to give. With this, you can start your job offers at about 80% of that amount and use the difference for negotiating room. Here are some examples just to give you an idea of what I’m talking about. I have no idea if these amounts are appropriate for your company’s culture, your geographic location or your stage of evolution. What’s important is for you, your co-founders and your advisors (see related article titled “Selecting an Advisor“) to debate and agree on a compensation strategy that appropriately mixes cash and equity.
- Entry Level Positions $20-30K cash + 0.10% equity
- Professional Positions $30-50K cash + 0.25% equity
- Sales Professionals $40-100K cash + 0.10% equity
- Manager Positions $30-50K cash + 0.5% equity
- Director Positions $50-70K cash + 1.0% equity
- Vice President Positions $65-85K cash + 2.0% equity
One interesting nuance amongst the list above is the numbers I’m suggesting for Sales Professionals. I’m showing higher cash compensation and lower equity than you might otherwise assume. That’s because the best sales professionals are usually “coin operated” and put much more value in cash compensation, including upside potential, versus equity (see related article titled “5 Golden Rules for Setting Sales Compensation Plans“). The range of cash compensation for those positions is also quite wide because of the different demands for lead development reps versus inside sales reps versus enterprise field reps. Because of this, you might want to split that category based on the sales-related positions in your company.
Also realize that for positions in extremely high demand (like software engineers in some cities) or for any “rock star” candidates you want to hire, you might easily be forced to go above your cash and/or equity guidelines to get them.
The numbers shown above might be appropriate before the first round of institutional equity financing. After that you probably need to bring up the cash compensation by 30-50% while reducing the equity compensation by 20-30%. But all of this should be debated by your co-founders, board members and advisors because every situation is very different.
Responding to Objections
You will almost certainly come across candidates you really want to hire but that cannot accept cash compensation that is half of the market rate. There might be times when you have the cash to respond and decide to do exactly that. My main recommendation is to adjust the equity accordingly. For example, if you find a bad ass marketing manager that needs $65K to meet their basic monthly needs (versus the $30-50K I have suggested above) and decide you want to make such an offer, then include 0.25-0.30% equity.
If you had previously discussed cash + equity amounts with this candidate, they will see the trade-off and can react. They can’t have it both ways (market rate cash + startup rate equity). Your revised offer will put them to the real test. Are they willing to give up the upside potential that comes with the equity in exchange for higher cash compensation? If so, only you can decide if you want such an employee in your company during the early days. I don’t mean that in a negative context. I truly mean it’s your decision.
Don’t hesitate to try hiring someone for equity only (no cash compensation). I’ve seen it happen numerous times with employees that meet the right criteria (see my list above). It usually doesn’t last long (measured in months rather than years) and might be more viable with part-time or freelance service providers. If you don’t have any cash or if preserving your precious minimal cash is critical, give it a try. Just remember that you might need to offer straight monthly vesting rather than the standard 1 year cliff vesting. Also make sure to ask your attorney about any laws that might require some minimum compensation (ie – minimum wage). You might need to bring on these equity-only workers as advisors rather than employees, but there are also laws that prevent you from disguising an employee as an advisor.
The concepts explained in this article are fairly simple to understand. But since compensation is such a personal and sensitive topic for the candidates you will be making offers to, you might find that it’s more difficult to explain than you think. Practice makes perfect.