Startup entrepreneur interviews top talent she's recruiting with company equity incentives.

September 16, 2019

How You Can Use Company Equity to Attract Top Talent

Calloway Cook hired a scientific advisor for his new dietary supplements company, Illuminate Labs, but he was disappointed to realize - when his expert quickly left for a full-time position elsewhere - that the cash compensation he provided "didn't properly align" with market expectations.

The next time around, Cook offered equity in his year-old, angel-backed startup to draw in a new scientific advisor with a doctorate in nutrition.

"An advisory role doesn't require many hours of work — often less than 10 per month. By offering equity in my company, rather than cash, I can attract someone who believes in the long-term vision of my company," said Cook, who's based in Northampton, Mass.

Equity is a popular tool for growing startups that need to attract talent and preserve cash, with the particulars depending on the industry, role, region and company growth stage. AngelList data indicate that equity is a regular compensation element at young firms from Silicon Valley to Sweden.

"Startups use equity compensation mostly as a tool to attract and retain key employees, particularly in industries where there is steep competition for talented and highly experienced individuals," said Nichole Walker, City National Bank senior wealth planner.

An early-stage company may not have significant cash on hand to attract, retain and compensate key employees, she explained, "so equity is often offered as a tool to incentivize hard work and retention. "

In addition, startups use equity to reward employees for their ongoing contributions to the enterprise and for achieving certain milestones, and to encourage them to promote the benefits of working at the company, she noted. "It may be used as a marketing tool to attract additional talented individuals."

Types of Company Equity Awards

Startups may also need to provide competitive salaries, benefit packages, deferred compensation plans and perks such as free meals on-site and dry-cleaning services, said Walker.

Many, she noted, offer equity in various forms, including:

  • Restricted stock awards, in which a company grants shares, with employee rights to sell restricted until a vesting period ends or performance milestones are reached. Even though employees can't sell the shares for some time, the awards make them stock owners, with attendant voting rights.
  • Restricted stock units, or RSUs, which promise shares or their cash value to be delivered later — after a vesting period that may involve company milestones or employee longevity, or after a firm goes public or is acquired, depending on the firm's requirements.
  • Incentive stock options, which allow employees to purchase company shares at a discount. Rather than paying income taxes when they exercise the options, employees pay at the more favorable capital gains rate.
  • Non-qualified stock options, which enable employees to buy a certain number of shares at a set price within a certain period. Awardees pay income taxes on the difference between the grant and exercise prices.

Equity awards often vest gradually over a few years.

Employee salaries and benefits are often the biggest expenses for growing companies, so leaders need to manage their "burn rate," said Walker, who cited a CB Insights figure indicating that 29 percent of startups fail because they run out of cash.

"As a company grows — and seeks to expand rapidly — the biggest issue for the leadership team is ensuring that it does not run out of money when attracting and retaining employees," she said.

Startup leaders also must be mindful of the effect on employee equity awards as they expand and seek new investments from VC firms, corporate venture funds and family offices, Walker noted, explaining that subsequent investments will trigger new equity allocations, diluting founder and employee stakes.

"The company needs to ensure that additional dilution does not cause significant employee turnover or attrition. The company must balance the need for additional funding in exchange for giving up additional equity with the need to retain key employees who may see their equity stakes diluted," she said.

Equity awards are likely to be higher, and salaries lower, for early hires at a seed-stage startup, diminishing with later funding rounds and increasing headcount, tech firm-focused publisher Holloway noted. Since the earliest employees often work for salaries well below market levels, they receive "much larger" equity stakes than people hired after a Series A raise or later, according to attorney José Ancer's Silicon Hills Lawyer blog.

For example, a few years ago, social media management software company Buffer publicly detailed the startup's equity compensation formula, which awarded stock options based on employees' roles, their choice to receive an extra $10,000 in salary or about 30 percent more in equity after completing a bootcamp, their "risk layer" — linked to company size when the worker was hired — and seniority.

The formula? Role X Choice/Risk layer + seniority. Employee and executive equity holdings at the time ranged from 0.24 percent for an engineer to 42.7 percent for the CEO.

Aon's Radford, a firm that advises tech companies on employee rewards, reported recently that full-value shares, including restricted and performance-based stock, have become more popular than stock options at most seniority levels. The consulting firm also reported that many companies use different methods to set aside a larger equity pool for top performers.

In addition, Radford found that software firms spend far more per employee on stock-based compensation than do tech hardware firms.

Illuminate Labs' founder Cook decided that he will pay his new, part-time scientific advisor solely with stock options. "I learned from my mistakes the first time. She had no reason to stay with the company if a better cash offer turned up," he said.

His new compensation plan requires little upfront expense for a very young company with only one real employee — the founder himself.

"Equity is only realized upon an acquisition, so a candidate accepting this offer is taking a risk — they'll receive no payment if the company fails, but a large payout if we're acquired," he said.

"This agreement works for both parties. As a pre-revenue startup founder I get to preserve cash on the front end, and for the advisor candidates, they get to realize a large potential financial gain for relatively low hours of work," Cook said. "This way I get someone who's aligned with the long-term vision and success of my venture."

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This article is for general information and education only. It is provided as a courtesy to the clients and friends of City National Bank (City National). City National does not warrant that it is accurate or complete. Opinions expressed and estimates or projections given are those of the authors or persons quoted as of the date of the article with no obligation to update or notify of inaccuracy or change. This article may not be reproduced, distributed or further published by any person without the written consent of City National. Please cite source when quoting.

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