Startup finance can be incredibly tricky, especially when it comes to compensating co-founders and employees, as most startups usually don’t start their journey with money to spend.
And while compensating team members with company equity is a potential solution, it’s still not without its share of intricacies. Luckily, we here at the Founder Institute have created an exhaustive guide that lays out the basics of paying your co-founders and employees - without money.
Equity & Vesting Terms You Need to Know
“Equity” can refer to several different things depending upon which context it is used in, but in general it is, according to Investopedia, “one’s degree ownership in any asset after all debts associated with that asset are paid off”. The type of equity that we’ll be sticking to throughout this article is stock that represents an ownership interest.
In the Silicon Valley Startup Attorney article, “Founders & Startup 101: I) Forms of Equity”, Chris Barsness outlines the most important terms that founders need to know in the world of startup equity and vesting. Below is a summary of the most important definitions you need to know:
Founder’s Stock - the stock issued by the company to the founders of the company.
Common Stock - the general basic form of equity in a corporation, often represented by a physical stock certificate or, in some cases, in electronic form with a broker.
Restricted Stock - a designation that can apply to any type of stock, usually meaning that the stock has some form of restrictions on transfer, such as being unable to sell it without complying with those restrictions.
Preferred Stock - preferred stock has greater rights and preferences than common stock, but is issued in the same manner.
What is Vesting?
Because vesting is such a complex yet important aspect of starting and running a successful company, it’s important to first clearly define vesting and its context within a business. According to Investopedia, vesting “is the process by which an employee accrues non-forfeitable rights over employer-provided stock incentives or employer contributions”, and while that definition is clearly in regards to employees, it also applies to startup founders, as well. Vesting gives those who work for a company an incentive to perform well and remain under the company’s employment, as their rights to employer-provided assets will accrue over time.
What are Cliffs?
To prevent the possibility of numerous co-founders and countless employees from quitting the company and taking a portion of the company with them, vesting employees something called “cliffs”, which means that nobody who works for the company gets their share of the company unless they’ve worked their for an established amount of time. Many companies employ the structure of a four year vesting schedule with a one year cliff. What this means is that an employee or co-founder will receive their share of equity over a four year period and must work for the company for one year before receiving the first ¼ of their equity. If an employee or co-founder leaves the company before one year has passed, they receive nothing, but if they leave after around, say, three years of employment, then they will receive three-quarters of their share of the company (usually earned on a month-by-month basis after the one year cliff).
How to Compensate Co-Founders
When it comes to co-founders, vesting can get extra tricky, as splitting equity can, and often does, ruin a business partnership. For example, if you build a startup with another founder and they decide to leave while you stay with the company, turning it into a successful corporation, it is entirely conceivable that your old cofounder can come knocking on your door demanding that they receive the 50% that you agreed upon years earlier. Countless damaging lawsuits have resulted from these types of agreements, so if you don’t want to join the ranks of founders whose careers were ruined from bad deals, this section is especially important to you.
Typical co-founder agreements generally have a clause that allows the company to buy back a percentage of a co-founder’s equity if they leave within a short amount of time to ensure that they will not claim the full amount if the company exits years down the road. This clause incentivize founders to fully commit to the company, as those who stay through the company’s troubled times will benefit during the company’s prosperous times (if any).
Single Trigger Acceleration vs Double Trigger Acceleration
If in the rare case your company is acquired before the co-founders are fully vested, the vesting period will accelerate in one of two ways: single trigger acceleration or double trigger acceleration.
Single trigger acceleration is when 25% to 100% of your unvested shares become vested, meaning shareholders will receive the full or partial value of their stock. This route is unpopular with investors who are trying to position the company for acquisition, as they see this as potentially losing a key founder that made the company attractive to acquirer in the first place.
Double trigger acceleration is when two events occur that cause a vesting acceleration. These events are usually the sale or merger of a company and the termination of an employee or founder without cause. This route is more popular, as it enables the acquirer to keep the team members the feel are most important while replacing them with members of their own team.
If a co-founder leaves before they are fully vested in the company, they will still receive the shares that were owed. However, the number of shares that were previously issued to cover the full 100% of the company’s equity will drop, but the value of each equity share will increase for every shareholder still with the company.
For more information on aligning the vision between you and your co-founders, check out the video below from a previous webinar:
How to Compensate Employees
Many of the points that apply to co-founders also apply to employees, as well. However, there are still numerous factors that need to be taken into account when compensating employees with equity.
In the Forbes article, “How Employee Stock Options Work In Startup Companies”, Richard Harroch outlines some of the most important considerations to take into account when compensating employees with stock. Below are some of the most essential points:
How Many Options Should be Reserved for Employees?
A startup’s stock option plan must allocate a specific number of shares for eligible employees. While this number is often determined by the company’s board of directors, the number is generally around 5% to 20%.
How Many Options Should be Given to Each Employee?
There is no standard number of stock options that should be given to each employee. However, it’s important to remember that the actual number of options doesn’t matter as much as the overall percentage of the company those options represents.
What is Right of First Refusal?
The right of first refusal means that the company reserves the right to refuse the transfers of underlying options, which allows the company to keep share ownership in the company to only a limited group of shareholders.
What Should the Exercise Price Be?
The exercise price refers to how much the employee has to pay for the stock when they exercise their option. Usually, exercise prices are the stock’s fair market value at the time the option is granted.
How Long Do Employees Have the Right to Exercise their Options?
In most cases, employees have between 30 and 90 days to exercise their options after their employment with the company has ended.
How Does a Company Determine the Value of its Stock?
To determine the fair market value of its common stock and set the exercise price of its options, the company must hire a third-party valuation expert.