What’s the Right Size for Private Company Equity Compensation?

T shirtThe most common question asked about equity compensation is only two words: “How much?” For private companies, it is frustratingly hard to answer. The crux of every equity compensation conversation is how much to give. The answer leads to the best equity instrument to use, features of the plan, expected exit strategy, or time to liquidity. Determining levels for private companies is never as simple as it would seem.

Public companies have a wide range of accessible data. For executives there are proxy reports and guidance of shareholder advisory firms. For broad-based programs there is purchasable survey data that, at minimum, provides basic trends and overall equity usage. Even though much of this data is missing critical details like compensation philosophy, vesting, termination criteria, and goals of each grant, you can generally determine a basic path to equity compensation levels.

For private companies, the data is far less consistent. Surveys focus on smaller, more specific groups. The 2012 Private Company Equity Compensation Survey from the NCEO is excellent but emphasizes ESOP companies. Other surveys focus on early stage start-ups, technology firms, a specific geographic area, or other key identifiers. Still other data comes from websites, VC firms, or other sources that provide little insight into the original data and respondents.

How should private companies approach this important issue? The first step is to ask questions. What is the intended goal of equity? How much current and total value, or ownership dilution, are shareholders and investors willing to support? Finally, do you care what others are doing, or is your company unique enough to warrant focusing only on your goals, not on market data?

Commonly stated goals for any form of compensation are retention, motivation, and attraction. Additional goals for equity include creating or supporting an ownership culture, replacing cash that may be otherwise unavailable, and providing alignment between plan participants and company investors. More recently, companies have been focusing on driving performance to a specific event or set of financial or operational metrics.

It is important to note that a single type of equity, and more importantly a single award or grant, will be hard-pressed to accomplish all, or even most, of the above stated goals. With your goals clearly stated, you may need to identify two or three equity instruments that focus on one or more of your goals. How much of each type of equity you give (and vesting or other details) depends on a variety of factors.

If you are a high-tech start-up based in the Silicon Valley or another tech hotbed and in a “hot” industry, you will likely get some great advice from your angel or venture capital investors. Make sure that these resources are basing their recommendations on recent experience and facts rather than rumor. If you are from another region or industry you will need to determine who your corporate competitors are for both talent and investment dollars.

Boutique surveys, often created by industry groups can provide excellent guidance for many aspects of equity compensation. Just remember that survey data seldom provides direct answers. Survey data must be properly translated to become useful information. Company size, location, funding and potential exit strategy may not be completely clear, or fully reported. It requires both experience and creativity to tell an accurate equity compensation story using private company data.

How does a company determine how much equity to give their executives and staff?

  1. Start with the end goal in mind. Understand where the company is headed and the potential value it may have when the equity can be “cashed in.” In very small companies values are unlikely to be accurate. Most companies use a percentage of outstanding shares, converted into a whole number of stock options, restricted stock units or other equity. If your company has a reasonably accurate value, it may make more sense to project the future value, rather than using a simple percentage.
  2. Determine how many employees and years it will take to get you to your goal. Any estimate must project the total equity it may take to support the company’s final goal. Many companies offer far too much to the first 10-20 employees, only to have nothing left to support the growth required to obtain a premium value.
  3. Project the financing rounds, potential funding amounts and levels of dilution it will take to get you to your goal. A company that hopes to be acquired after hitting $50M in revenue will have far different equity needs than a company than knows it will take $1B in revenue for a successful exit or IPO.
  4. Look at current survey data that is relevant to your company type, region, and industry. Ranges vary widely and all survey data should be used only to provide a general understanding, not specific levels. If possible use data from two or three different sources. Free sources may be fine, but if you expect Venture Capital or Private Equity financing you should seriously consider investing in data that is used by companies in similar situations.
  5. Understand the role equity will perform as part of your total compensation package.
    1. Is it an essential element that makes up for shortcomings in other areas? For example, does your company intend to pay lower than average cash compensation, or very limited bonuses?
    2. Is it a sweetener to an otherwise respectable compensation package? Many private companies in “hot” markets now pay cash levels for tough to fill positions similar to publicly traded companies. If you are paying strong cash compensation you may be able to somewhat limit your equity usage.
    3. Is equity being used to drive very specific financial or operational goals that, if met, will create a new multiple of company value? Equity award sizes and performance-based vesting communicate these goals and provide a foundation for your compensation philosophy.
  6. Lastly, be prepared for the overall equity package to take more shares, or value, than you expected. Most companies underestimate what it will take to get to their event horizon. You must carefully budget your equity usage if you expect it to take more than 100 employees or five years to reach your exit. Many companies are surprised to learn that it often takes far more employees and far longer than initial optimistic estimates might have suggested.

The answer to the question “how much” is far more complex than it appears on the surface. One size never fits all. Very few companies and very few employees can be compared on a linear basis. Design your program to suit your goals, philosophy, and time-frames and you will find that it will become far easier to determine how to give to an individual employee. Equity compensation is seldom a successfully do-it-yourself project. The plans are complex, the data is inconsistent and the details can be maddening. But, when done right these plans are be a powerful way to bring in the right talent, keep them driving toward your stated goals and dissuade them from leaving before the job is done.

 

 

Dan Walter founded Performensation, an independent consultant, in 2006. Performensation provides simple solutions to complex compensation with a goal of linking pay to corporate culture and strategy. Dan is also a well-known writer and popular speaker connect with him on LinkedIn or follow him at the Compensation Café, or on Twitter at @Performensation and @SayOnPay