Figuring out the right amount of equity compensation at startups is a challenge. How much should I grant? How big should the grant be? How should I size the grant relative to base pay? Investors, boards, executives, HR and compensation departments at start-ups have conflicts over these questions all the time. In the past I have written about the 11 Reasons Your Equity Compensation Survey Data is Wrong. This article focuses on three common ways to determine equity at startups regardless of your survey source.
% Percentage of FD Outstanding Shares
This is where most companies start. The first 10 or 20 key players at a start-up are likely to have their grants determined as a percentage of “Fully Diluted Outstanding Shares.” It is nearly impossible to determine the real value of a very young company. How much is an idea worth? How about a half working prototype that has only been seen by six people? Since values are usually flat out guesses, percentages make sense. Since values are also very low, it generally makes sense to grant stock options. Options offer more income and tax planning flexibility. Participants should expect these percentages to be diluted somewhat as the company brings in Angel and Venture Capital funding rounds. As value rises and more people join the company it becomes increasingly harder to grant percentages. Who really wants 0.0034123% of the company in stock options? The key is determining when to start changing your approach.
# Number of Shares
Traditionally this is the next step for most companies. This is especially true for grants to non-executives. Executive grants may be primarily determined as percentages until very close to the IPO. Some companies start as early as employee 50 or 60, others may wait until they have 200 or more equity holders. Numbers of shares is an easy way to grant equity. It is also wildly volatile and often very incorrect, especially when using stock options. As the company value grows, so does the option strike price. Then giving one engineer 25,000 stock options with a $0.03 strike price and a later hire the same number of options with a $12.50 strike price is a good way to create retention and motivation problems down the road. The earlier hire may have taken more risks, but in a fast growing company those risks may not represent the difference in future value. Consider this math. Assume the company goes public at $18.00 per share. The earlier grant would have a value of $449,250. The later grant would have a value of 137,500. Those are differences that are hard to squeeze into a compensation philosophy document.
$ 409A Value, Investor Value and Potential Realizable Value
Dollar value is where most compensation professional are most comfortable. With big, established companies this is often a great starting point. With startups this has always been difficult. In today’s world pre-IPO companies may be valued anywhere from less than $1Million to more than $10Billion. Companies may also move to Restricted Stock Units (RSUs) as dilution becomes a concern. Getting rid of the strike price changes the entire equation. But, let’s start with the multiple ways a start-up is valued. First is the IRC 409A value. This value is usually determined by an outside professional. Most companies use the most conservative assumptions they can to keep the value low. The “Investor Value” is typically the price from the last round of funding. This can be significantly higher than the 409A value. Investors are seldom thinking of a conservative, low value. They look at the current value in light of what they hope to gain in the future. It is not uncommon for the Investor Value to be ten or more times the 409A Value. Many investors believe this is the value that should be used for equity compensation. It reflects the value of their investment, regardless of whether that investment may later prove to be overly exuberant. The Potential Realizable Value is based on the value the company hopes to have at IPO or Change in Control. This is the number(s) on the business plan projections. This is best modeled in a variety of scenarios. With some pre-IPO companies now being valued in the billions the difference between reality and hyperbole can be hard to estimate. In the end this is the value that determines a baseline of what participants will “own” at the time of a corporate event.
Detailing all the vagaries and issues with the above would take too many words for this blog. None of these methods is foolproof and I generally recommend that companies model all three methods (and sometimes others) from fairly early in their growth cycle. Modeling each requires many additional considerations including; 1) the number of additional rounds of funding and dilution will be needed to get to an exit, 2) whether there will be a need for a forward or reverse split prior to the IPO, 3) the time that the company expects it will take to achieve its goals, 4) the strength of the IPO or M&A market for their industry, 5) the number of employees they believe they will need at exit and many other factors. There is no simple solution to such a complex set of equations, but understanding all of the above is a good place to start.
If you would like more information on startup equity, please comment below and I will work on creating a series of articles to expand on this topic.
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 a few other books. Connect with Dan on LinkedIn. Or, follow him on Twitter at @Performensation and @SayOnPay.