In the earliest days of a startup venture, there are no published compensation rates or even good studies to use as guidance. That’s because each company and founder situation is so different. The process of compensating founders and early employees while you’re cash poor involves more art than science.
Many startups begin with a founder or two that spend part-time on the idea while still having a paying job to cover their personal expenses. Another common approach is to secure a small amount of funding via “friends and family” or even to self-fund with personal savings. But what about founders that join the venture full-time and need cash compensation?
Compensation for true founders is anything but standard because each startup situation is so different. Typically speaking as it pertains to cash compensation, the founders should try to pay themselves as little as necessary to cover basic personal obligations and nothing more. It means they won’t be setting aside money for retirement, they won’t be buying a new car anytime soon, and their next vacation will be a nearby camping trip rather than an ocean cruise. Basically, it’s the difference between “need” and “want”.
Remember, the more runway a startup has to progress, adjust and adapt, the higher the odds are they will both survive and thrive. Keeping founder compensation as low as possible helps optimize towards more time (runway).
Because each founder’s personal situation is different, it’s totally possible that one founder will get paid $1,500 per month while another gets $3,000 per month. This also means the founder that carries the CEO title might not be the highest paid member of the team. Actually, that phenomenon might exist all the way to, and maybe through, a Series A round of funding. But that’s because the founding CEO almost always carries the highest percentage of equity and, therefore, has the highest long-term upside potential.
Although this section is labeled as “founder” compensation, the same concepts apply to the earliest employees or executives that are added to the team during the idea development phase or before a real seed round of funding is raised. So even though the first marketing executive and the second software developer don’t show “co-founder” on their business cards, they are likely subjected to the same compensation guidelines mentioned above.
What about equity compensation for founders? Again, there’s no standard approach. That’s because factors like those listed below really complicate things:
- One founder is full-time on the venture while another is part-time
- The second founder didn’t come up with the original idea but has far superior knowledge in a relevant area (industry, business model, etc.) and dramatically helped shape the original business plan
- Three or more founders join the venture at different times over a 6-12 month span
- A founder joins after a big pivot or restart
All I can suggest regarding splitting up founder equity is to discuss it and negotiate it as early as possible in the venture rather than deferring the difficult discussion for a future date. Also make sure to put the equity on a vesting schedule (typically 4-5 years) to impose built-in adjustments if a co-founder resigns or is terminated.
Side Note: Never, never just have a verbal agreement on something as important as this. It’s amazing how people’s reflection of the agreement can change over time.
What about founders that contribute a cash investment into the company? Should that result in a higher salary or more equity? You will need to be very careful in your treatment of founder investments. That means consulting with your corporate attorney to make sure you select a sound approach and follow the letter of the law in terms of documentation, approvals, etc.
A typical approach I see used is to reflect the investment on a convertible note, similar to what is often used with pre-seed and seed stage investors. The key difference is that founder notes might not have a valuation cap and might have a discount that is either higher than normal (30% instead of the standard 20%) or with staggered increases over time to reflect the extremely early timing for the investment and, therefore, the long expected time before it converts to equity. Using this approach, the founders will eventually end up with Preferred equity from their investment just like other investors, and that’s only fair.
Early Employee Compensation
The super lean methods of compensating the founding team can be ideal during the idea development stage but once a product is launched and generating early revenue, how does the startup go about hiring the next batch of employees with little cash in the bank and not enough revenue to self-fund? The answer has a lot to do with equity but it’s not as easy as some think.
To best use equity as a compensation tool, most US-based startups 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 efforts and costs for a C-corp conversion to be higher. You will find many articles debating the best legal incorporation method to use for a new startup but for purposes of this section I will assume you are a traditional C corporation.
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 corporate attorney will help you get all of this setup (see related article titled “10 Tips for Controlling Legal Costs”). And with this new compensation tool, you will 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:
- Are there differences in the equity-related terms that founders and early employees get versus later stages of the company’s evolution?
- 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?
Equity-Related Terms in the Very Early Days
There are some typical differences that I see in the very early days for the equity component of the compensation package:
Equity for founders and employees almost always vests over 4 years. Increasingly, I’m seeing startups implement a 6 yr vesting schedule in the early days. I actually like that approach because it minimizes the future need to grant more equity after just a couple of years just because they’re on the downhill slope of vesting. Once a co-founder or early employees is mostly vested, the retention incentive from the equity is greatly reduced. In other words, they could exercise 65% of their equity for pretty cheap (since the exercise price is so low) and walk away from the company to still get a nice payday if the company grows into a great one. It’s referred to as “dead equity” on the cap table. If the vesting schedule is 4 years long, this risk shows up when employees are only at the two and a half year mark. But with a 6 year schedule, it doesn’t happen until 4 years have gone by. After raising a Series A, most companies revert to the traditional 4 year vesting schedule.
Stock option plans almost always have what’s called a vesting “cliff” and it’s almost always 1 year. It means employees don’t actually vest their equity until they reach the 1 year mark. But upon reaching that mark, their vesting catches up. In other words, with a 4 year vesting term the employees would immediately vest 25% of their equity at the 1 year market and then vesting would continue on a monthly basis through the rest of the term.
Founders can have a cliff period to. It prevents the situation where two founders split equity 60% and 40%, only to have one of them leave after just 5 months and still take a chunk of equity with them. Having a 6 month cliff period for founders could be really helpful. Usually, founders are able to figure out if they can successfully work together within a 6 month period.
Founders are often offered a special right to exercise (purchase) all of their equity up front. Since the exercise price is super cheap at the beginning, they can exercise all of their stock options for only tens or hundreds of dollars. Even though they are doing so before the stock vested, the company has an indisputable legal right to buy any unvested equity back from the founder if their service is terminated or they leave the company. Because there is a “risk of forfeiture” (IRS description), the IRS requires that a Form 83(b) is filed within 30 days of the stock purchase (see my cheat sheet on this on the Resources page of my website). The other benefit of this early exercise is the long-term gains clock starts ticking for more favorable tax treatment when the stock is later sold to an acquirer.
Post-Termination Exercise Period
Increasingly, companies are offering more than the ridiculously short 90-day exercise period after someone’s service is terminated. One approach is to offer a one year exercise period for every full year of service. This only comes into play for employees that aren’t offered an early exercise possibility. For more on this concept, its merits, and it’s implementation, read my article titled “The Unfair Stock Option Exercise Period“.
Summary – Below is a framework to consider for the founding team.
- 6 year vesting term
- 6 month cliff
- Early exercise option and associated IRS 83(b) filing
- Post-termination exercise period equal to 1 year for each year of service
The main difference for the early employees that aren’t considered founders or executives would be a 1 year cliff and no early exercise option.
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 perceived 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, you can 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 Series A round of funding, we aren’t able to pay cash compensation at the market rate. 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 more established companies. But it also suggests that you will be giving considerably more equity (as a % of company ownership) than those same large or established companies typically give. In fact, many large enterprises only give equity compensation to executive-level positions.
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.
Employee candidates that aren’t experienced with equity-based compensation might ask how to place a value on it. You will want to be very careful how you respond because your company’s future outcome is still very uncertain. You could respond with something like, “At this early stage, the range of future outcomes for our company is obviously very uncertain. But here’s one way to think about it. Your position is eligible for 100,000 shares of company stock options that you will be able to purchase in the future for less than $100. And if we reach an IPO or acquisition exit, the shares might be worth $2, $5, $10 or even more.”
Side Note: The $100 cost mentioned above to exercise (purchase) the stock equates to a $0.001 per share fair market value (FMV). For many startups in the very early days before generating revenue, the FMV is as low as $0.00001 per share (equates to a $1 purchase). For more information on stock pricing, read my article titled “Pricing Your Stock in the Early Days“.
Who Are Your Candidates?
Let’s start by describing the most likely candidates whose jaws will drop or eyes will widen after you tell them you can’t pay anywhere close to market rate cash compensation.
- People with a home mortgage or other high monthly expenses
- 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 expenses
- People working another part-time job that generates enough income to offset many/most of their monthly expenses
- People that have recently gotten a big pay-day and can afford to go with significantly reduced income 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 achieving a big pay-day and being set for retirement can happen at any age or career stage. Also, don’t underestimate the possibility of bringing on part-time candidates. 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 more cash to compensate them with.
Maybe this is obvious but, in all cases, your ideal candidates have a passion for startup ventures and both the uncertainty and chaos that comes with them. This is not a compensation-related issue but should also be an important part of your interview process.
How Much Cash & Equity is Enough?
Since every situation is different, there are no hard rules on this – both for the company and the prospective employee. But let’s start with a fundamental 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 75-80% of that amount and use the remainder for negotiating room.
The cash and equity compensation amounts for idea-stage and pre-launch startups varies so widely based on the company’s situation and the employee candidate being considered that I am not able to provide any guidelines. However, for seed-funded and Series A funded startups there are some general guidelines to start with (see reference to my resource below this paragraph). 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.
See my Compensation Guidelines for the Early Days resource for specific suggestions on salary and equity amounts during the pre-seed, seed, and Series A stages of a startup.
One interesting nuance that you’ll notice in the referenced resource is the suggested numbers for Sales Professionals. You’ll see 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“). And since they have near-term upside cash compensation potential from their sales commission plan, they don’t also deserve the same long-term upside from a bunch of equity.
The range of cash compensation for sales professionals 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 need 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 both your standard cash and equity guidelines to get them.
What about part-time employees? During the pre-seed and seed stages when part-time roles might be all the company can afford, the most logical methodology is to simply adjust the cash and equity amounts based on the percentage of a full-time role they will serve. The hardest part with that comes from the reality that 40 hours per week is nowhere close to “full time” in a startup’s world. So offering someone 50% of the listed cash and equity rates for a 20 hour per week role doesn’t feel fair to the company. So, instead, you might want to calibrate based on a full-time assumption at 50 or 60 hours per week and feel free to explain the rationale to the candidate.
Again, all of this should be debated by your co-founders, board members and advisors because every situation is very different. And you don’t want to wing it for each hiring situation that you’re faced with.
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 in that case is to adjust the equity accordingly. For example, if you find a bad ass marketing resource and agree to their $65K requirement (versus the $50K that might be suggested from my referenced resource), reduce the equity by 20% (ie – 0.4% instead of 0.5%).
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 actually present them with a real test. Are they willing to give up some of the long-term upside potential that comes with the higher equity in exchange for higher near-term 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.
Also remember that, with moderate or better company success over time, cash compensation amounts should gradually increase. This means the sacrifices the early employees are making shouldn’t last forever and they still get to keep their equity compensation until there’s an eventual exit. Again, there is just a different needed mindset for startup employees.
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). The no-cash period usually doesn’t last long (measured in months rather than years) and might be more viable with part-time employees 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 for the equity 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 hourly wage). You might initially need to bring on these equity-only workers as consultants 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.