Part 2 of the Equity series. In Part 1 of the Equity series I laid the groundwork for equity allocation by discussing the impulsive entrepreneur who gives away the business to friend and family just to have them involved in the new venture.
Part 2 focuses on equity allocation to key roles in your organization. Unless your entrepreneurial idea is to start a new kind of venture capital firm or become an attorney who specializes in IPOs, discussing employee stock option plan (ESOP) allocations and agreements with potential staff members may seem intimidating.
That’s why I am sharing some key considerations for you to be aware of when you are ready to start that conversation. My perspective is that of a former principal and chief financial officer of a private equity firm.
Equity allocation to Principal Management. The rule of thumb for the allocation of equity to senior management and advisors is 15 – 20%.
The allocation to individuals depends on several factors and even timing. For example, if the founder(s) know they need to hire a CEO/President after they get the entity to a certain level, they should reserve some equity for this position.
Sales executives typically will earn more through commission than most of the management team, therefore should have the lowest allocation of equity of the C-Suite.
Technology and Financial positions are critical in most companies, which means the majority of the allocation should go to these positions.
Equity to advisors is another factor when divvying up equity, and discussed in more detail in Part 3 of this series.
Finally, there is vesting equity ownership as an employee incentive to perform well and stick with it while the company evolves from start-up to success. My advice is to keep it simple – don’t have one-off vesting arrangements for each person – keep it straightforward, make all terms and conditions with all option arrangements pari passu (on equal footing) with everyone – this makes it easy.
Part 3 concludes the Equity series with other key considerations for entrepreneurs considering equity allocation for their startup.
Mindy Barker & Associates (firstname.lastname@example.org) works with entrepreneurial growth companies to help maneuver the many questions of funding, employee compensation and other decisions and is available to discuss your questions on equity.
Part 1 of the Equity series.
Virginity and equity have a lot in common: human beings do not spend enough time thinking through how to give away either of them, but once they do, the results have the potential to be rewarding or devastating.
This article focuses on giving away equity – virginity is a topic for another time, maybe even under a pseudonym!
As an entrepreneur, the day you think of an idea, you own 100% of the equity and intellectual property (IP). The power to give the equity to others in exchange for their time and money is one of the most important decisions you will make. The devastating consequences of misappropriating equity can ruin even the best of ideas.
Giving equity or IP away may start with a conversation over drinks with a friend. When you start to tell friends and family about your entrepreneurial venture, be prepared to hear their version of your great ideas, along with their advice.
The conversation goes something like:
Friend: “That is a great idea and I have been thinking about doing something like that for a long time. You are great at technical development and I can help you with sales and operations. I can quit my job and help you with this company.”
You: “Wow, I am so flattered you think so much of my idea that you would quit your job and help me!”
What you are thinking: “You are absolutely right, I hate to sell and it would be great to have someone help with that. After all, I do need a team to help me launch this idea.”
So your friend then says, “For only 10% in options and a salary of $100,000 a year, which is a lot less than what I make now, I will be part of your team.”
You are thinking, “You are a great sales person at ABC Large Company ABC selling to other huge companies – you will be great at helping me with getting my company off the ground.”
The two of you toast to the future with visions of a wonderful partnership dancing in your head – this is exactly what you need to launch the business.
Stop Right There!
You have just given away 10% of your equity with almost no forethought of the consequences.
Think of starting a business as a real-life personal development plan where you learn quickly how to deal with the ultimate emotional highs and the down deep lows. Most of the down deep lows result from lack of cash. Your friend sounded very generous when they offered to take a lower salary and accept $100,000 per year. However, when cash is tight and you are fighting to find the money to make payroll, it may not feel so generous. In order to pay them you make sacrifices. Paying their salary keeps you from paying yourself, which means your personal finances are in jeopardy, which causes you stress. This stress may turn to resentment toward your friend and cause tension, especially when the sales are not coming in at the rate you expect them to.
You can see where this is going, right?
According to Fortune magazine, 9 out of 10 startups will fail. The exuberant valuation and success realized by Jet.com. Amazon, Airbnb and Uber are clearly the exception, not the rule. If you have boot strapped this Company, not taken a salary for 5 years because you haven’t realized the success you once dreamed of, you are not going to want to pay your friend 10% of the $500,000 proceeds you may be offered for your company after Year 5.
Here is the advice I give to enthusiastic entrepreneurs who are eager to cut their friends and family in on a share of their big idea – think before you give it away.
The allocation of equity should be properly documented early on in a Stock Option Agreement that lays out the terms of vesting and other criteria that work for all. Even simple agreements should be undertaken by a business attorney who can prepare you for scenarios you currently could never imagine.
To help you start a conversation with your attorney about a stock option agreement, read Part 2 of my series on Equity, Considerations for Equity Allocation Agreements.”
Until then – remember that barroom conversation, and think before you give it away.
Mindy Barker & Associates (email:email@example.com) works with entrepreneurial growth companies to help maneuver the many questions of funding, employee compensation and other decisions and is available to discuss your questions on equity.