The term “capital intensive” doesn’t always mean a need for high levels of working capital for equipment and facilities. For a growing number of startups, the capital intensity comes in the form of equity for talent. Your chances for attracting and retaining the top tier people you need for success are much better with some up front equity budgeting by founders and careful annual thinking about the equity pool you’ll need going forward for both new hires and merit-based awards to existing key contributors.
Equity Still Matters
Even though unicorns and IPOs have become more rare and the appeal of stock options for startups may not be what it once was, I maintain Equity Incentive plans remain table stakes for startups who want to attract exceptionally talented people. More than one founder has tried to dissuade me of this but my experience is that equity and ISOs matter, particularly for those people who have little to no variable component to their cash compensation package, such as a software engineer, versus a sales professional whose total cash compensation increases significantly based on performance.
On many occasions I’ve seen equity awards provide the hook to lure people away from larger, more established companies. There is more inherent power and flexibility in equity awards for recruiting and retention than a lot of founders may realize.
Founders are generally good at thinking through equity allocations amongst themselves and investors but the modeling of options for key employees (especially those yet to be hired) and those to whom you want to give merit grants is something easily overlooked in the early capitalization structure discussion.
The size of the initial option pool you need available depends on the executive team you have on hand and those you will need. For example, if among your founders you already have your CEO, COO, CTO and other key executive team members, you may only need a pool of 10-12% of fully diluted shares available to create a suitable equity compensation plan. However, if you are yet to bring on several key members of your executive team, you may need 15-17% or more of fully diluted equity in the equity pool. I’ve seen founders caught off guard because they needed to come up with 5% equity for the CEO they really wanted.
The earlier an equity incentive plan reserve can be built into an equity strategy, the sooner it can be leveraged, usually in the form of winning a star employee through the draw of equity upside (either in addition to cash compensation or in exchange for a lower salary).
Budgeting for Equity: The Organization You Have and The One You Want
In addition to the executive team, you will need to think through your organization as it is and how you ideally want it to be. A good practice is to map out an entire organization chart and then do a bottoms up budget for granting equity throughout the entire organization. Budget out at least two years or to the next anticipated equity raise.
One example – and this is merely an illustration as equity grants have many moving parts and variables – is if you anticipate the need for a great software engineering team, you may allocate for your Engineering VP 1%; a senior engineer 0.5% and a line employee 0.25% (of fully diluted shares outstanding). Go through the same exercise for sales, marketing, operations and other functions. To avoid confusion at the time of future dilutive events, it is always prudent to detail option grants as a specific number of shares versus a percentage.
Again, not only do you want to create a pool of equity for new hires, but for merit awards; particularly if your horizons for major events (such as IPO or an M&A transaction) stretch beyond 3-5 years.
Equity compensation for employees and key stakeholders under a formal Equity Incentive Plan remains an important retention and motivation strategy for early and growth stage companies, particularly those with longer horizons to an exit, IPO or gaining traction in the market.
Founders should take care early on in their history to ensure that they have a well thought out Equity Incentive Plan and pool.
In the war for talent, equity may be your biggest capital expenditure and you can make your dollars go much further with some forethought and follow through.
Kent Elmer is Managing Partner of TechCXO. He can be reached at: firstname.lastname@example.org. See Kent’s full bio.