Founder Equity Compensation

CommonI’ve been asked recently about how to compensate non founder employees at the beginning of a venture.  But there is a lot of confusion on whether to make everybody involved on day 1 a founder.   Most folks agree there is an upper limit on the ideal number of founders.  So taking that for granted, how do you motivate non founders with equity before you have cash?

The usual method is to just give them a big chunk of equity  But that can get real hairy because you don’t always know how to differentiate quality people vs total hacks.  So don’t “give” equity to anyone.  Everyone should earn equity over time.  If you grant it all up front and then find out somebody is a lazy bum the company gets bogged down by a cap table with dead weight.

A more sophisticated approach is to use some kind of vesting mechanism.  Over the last few years I’ve come up with the following idea.  I don’t really have any legal background, so unless you get a good startup lawyer to look at it, consider this a handshake deal.

Give each non-founder an above market hourly equivalent rate.  Say $90 per hour for a software developer.  Agree that the amount will be paid out at a future date in equity.  That future date could be either a funding round or a number of months at a pre-determined valuation.  For practical and motivational reasons, it would be even better to compensate cash & equity 20%/80% .

An Example

Agree to $90/hour with Bill to be paid in 20% cash 80% equity.  The equity portion will be granted in fully vested stock when the first of a)a funding occurs or b)at $1,000,000 valuation in 18 months.

In case A where Bill works 200 hours and a funding occurs at a $3Million post valuation in 6 months Bill would get:$90 * 200 * .2 = $3600 in cash over the course of the 6 months$90 * 200 * .8 =  $14,400 in equity which equals  0.48% equity at $3MM valuation in fully vested stock on the date of the close.  Presumably at this point you and Bill will work out a long term employment agreement with additional cash and options.  Employees who are with the company before the first funding should get a generous option package going forward.

In case B where Bill works 600 hours and no funding occurs in 18 months$90 * 600 * .2 = $10,800 in cash over the course of the 18 months$90 * 600 * .8 =  $43,200 in equity which equals  4.32% equity at 1MM valuation in fully vested stock on 18 month anniversary.  The larger equity percentage in this case is commensurate with the larger risk and timeframe involved in the 2nd scenario.

Equity ain’t for everybody

Equity should be reserved for those folks who will continue to provide future value.  After sending this analysis to a buddy, I got this response: If you issue Bob equity what is your response when he says, “I’m doing all this grunt work for you, I’d like to participate in the strategic vision of the company, and you’re taking that away from me. I’m a highly skilled and dependable and you’d be paying a lot of cash to find someone reliable in NY to do what I’m doing.”

My response: The short answer to your question is you’ve got the wrong person doing grunt work.  Why would you have a richly compensated highly strategic MBA doing that for you?  My college roomate helped me pick up menus when I went out to SF, and he never got anything in return…though I try to take him out to dinner whenever I’m in SF nowadays.  If you don’t have cash, you can do consulting at an hourly rate and use the arbitrage between that consulting rate and the  5 or 6  craigslisters doing grunt work with no equity at all.

So what about Founders?

I remember being in rowing in college on an 8 man team.  It totally sucked.  The worst part is that you were either frustrated because half the team was worse than you, or you were frustrated because you were struggling to keep up all the time.

A fact of startup life is that some folks pull more weight than others.  In extreme cases this leads to a group of founders turning on one of their brethren and excommunicating them.  The process does not generally evoke images of flowers and happy thoughts.   So why not take the model above and adopt it for founders.  Issue some stock for every week of work for each of the  founders.  If somebody flakes out and goes to Costa Rica for a month, they aren’t earning equity.   The  biases the ownership of the business  towards those folks that continue to provide the most value over time