Startup Equity: The Most Common Mistake (Part 7 of an n part series)

untitledHere is my 2017 gift to you. I truly believe that equity compensation helped build the technology industry, and therefore the world as we know it. But, an unfortunate number of startups make the same error when using this complex and powerful tool that drive corporate success.

If you browse the internet, ask entrepreneurs or receive guidance from someone at a VC firm, you will get similar answers when asking about equity awards for the first twenty, or so, employees. This information, while accurate at a generic level, is likely to be incorrect for your specific circumstances.

The answer looks a bit like this. Outside of the founders, the C-level hires should each get between 1 and 2 percent of fully diluted outstanding shares. Your key talent (varies based on your industry) should get between .5 and 1.5 percent of fully diluted outstanding shares. When you do the basic math, this means that the first twenty people should get 10-12% of the company. It seems simple. What’s the problem?

Most VCs will tell you that you shouldn’t expect to grant much more than 20% of the company. By following this advice, you will have used half of all of your equity before you have even started to build your staff. The drop off around employee 21 is usually far more dramatic than the drop-off from employee 100 to 101.

Imagine that you’re a startup which has the potential of being worth $50 Billion at IPO. (This used to be insane. It is now theoretically possible.) The calculations above would mean that the first 20 people (not including founders stock) would split around $5 Billion. In a world where billionaires are more common than ever, this doesn’t sound too crazy.

Imagine that this fantastical company you are building requires you to have 10,000 employees at IPO. $5 Billion might be better described as five-thousand chunks of one-million dollars each or one-thousand chunks of five million each. In a world where larger IPOs are the ones fighting hardest for great talent, a $1 Million guarantee makes a big difference in hiring a great engineer. Heck, in this scenario, you could hire 5,000 of the best engineers from most of your competitors combined.

Instead, by following this advice, it will make twenty people rich enough to start a VC firm for themselves. This is where nuance is important. While $50 Billion is possible for some companies, it is impossible for others. In fact, many companies, if they are honest with themselves, have value maximums of $50 Million, $250 Million or some other fraction of our multi-billion dollar example. Other companies may need a staff of only 500 or 1,000 to achieve their goal value. Some may require far more than 10,000. Yet, each of these companies receives the same basic advice on how much to give the first twenty hires.

The biggest mistake startups make with equity is not understanding who they may be when they grow up. It isn’t always easy, but it’s seldom a complete unknown. When you give what “everyone else” gives, you are almost always going to be wrong. The magnitude of that error can be the insurmountable hurdle that stymies your Series B financing, or blocks your chance at hiring the perfect employee or creates a caustic division within your company.

My gift to you this new year of 2017: 1) Know who you, as a company, are. 2) Know who you will need to become to achieve your goals. 3) Know that wasting equity (or conversely, hoarding equity) early on, based on the advice of people who do not intimately know numbers one and two, may be the one thing that stops you from reaching your true potential.

P.S. This was originally to be posted on December 26, 2016, but our frigid winter kept me from the internet for a few days. Please enjoy your belated gift.

Dan Walter, CECP, CEP is the President and CEO of Performensation. He is passionately committed to aligning pay with company strategy and culture and has been deeply involved in equity compensation for a long, long time. Dan has written several industry resources including the recent Performance-Based Equity Compensation. He has co-authored ”Everything You Do In Compensation is Communication”, “The Decision Makers Guide to Equity Compensation”, “Equity Alternatives” and other books. Connect with Dan on LinkedIn. Or, follow him on Twitter at @Performensation and @SayOnPay.