The Recruiter's Guide to Equity Compensation
Equity compensation is an important part of the total compensation (TC) equation for potential employees. Equity acts as an investment in the success of the company, aligns incentives, and provides for a possible windfall at the end for potential employees. Equity compensation also happens to be one of the more confusing parts of the TC equation. Being able to explain and articulate the equity component of a job offer to a potential employee could mean the difference between recruiting the ideal candidate, and settling for a suboptimal one. We will discuss equity compensation in depth in this article.
What is Equity
Equity at its core is a piece of a company, a piece of the pie if you will. Equity is often shown or measured in the form of a percentage (of ownership) or a number of shares (which also corresponds to a percentage of ownership, more on that later). Effectively communicating the value of that equity is crucial for recruiters to be able to close hires, especially at private companies.
Check out Carta for a wealth of information on how to think about and evaluate compensation, we are summarizing some of the key points they bring up. Challenges often arise from reconciling “the known” total compensation at a public company with “the unknown” total compensation at a private company which is notoriously difficult to pinpoint. Specifically the unknown refers to the equity component, see the two formulas below:
- Total Compensation Public Company = Base + Any Bonuses + RSUs
- Total Compensation Private Comp = Base + Any Bonuses + Future “Value” of Options
*The main difference is the Equity component
Equity at a public traded company is easy to evaluate. A potential employee can look up what the company's stock is trading for and see what the “equity” component is worth at that point in time. To calculate the equity compensation at a public traded company use the formula below.
(Number of options * (current price - strike price))/vesting period (yrs) = Annual Equity Compensation at time of offer
Equity at a private company is more difficult to evaluate because it is not publicly traded, there is no way to easily look up the price of the stock to evaluate the “value” of the options. As a result when a potential employee uses the above formula to calculate the possible value of the equity compensation at the private company they do not get an encouraging figure. The value of the equity component often seems smaller compared to the equity component at the public company. This is on top of the fact that base and bonus compensation are typically lower at private companies, because of their limited budgets.
In summary, the TC at the private company seems lower than the TC at the public company. But that is not the full picture, the potential employee is taking a calculated bet on the private company's growth over the following years, and the appreciation of the equity grant. Down the line that equity could be worth 10X, 50X, or even 100X making the private company a compelling option. To help calculate possible scenarios check out this Compensation and Equity Calculator created by the rockstars at Front. We will walk through everything you need in order to explain equity so you can convert candidates into employees.
How does Equity happen?
Check out Meld Valuation for a wealth of information on the mechanics of equity, we are sharing some of the key points. The board of a company creates an “option pool”, this is the place that all employee options come from. It generally ranges from 10% - 20% of the total number of outstanding shares of the company.
Equity Pool Example:
- Private company AAA Associates has 1,000,000 outstanding shares, 20% are designated for employees. The company is hiring a founding engineer, they offer him a package that includes 1% equity. This can be presented as 1% equity in the company, or as 10,000 shares. Given the total outstanding shares these numbers amount to the same equity stake, but the different presentation may be confusing.
Why do companies use equity as compensation?
When a company is hiring early employees, equity is often a part of the compensation package. Companies do this for a number of reasons including:
- Minimize cash burn
- Team ownership mindset
- Loyal talent
How does equity work?
Risk it for the Biscuit
Not everyone receives equal equity. Equity provides the potential for great upside, but also comes with high risk e.g the company may fold and the product might never make it to market. As a company grows and matures, the risk associated with working there also decreases, as does the equity component given to later employees.
- The equity package given to the 5th employee at a startup while carrying more risk, has the potential for a life changing outcome. The equity package given to the 5,000th employee carries less risk, but also has less likelihood of a life changing outcome.
The National Center for Employee Ownership has a wealth of information on equity delivery methods, we are sharing some of the salient points. Equity is typically granted in the form of Stock Options or Restricted Stock. For this article we will focus on the three most common types of equity, Restricted Stock, NSO Options, and ISO Options.
Restricted Stock is stock granted with restrictions (vesting being one of them). Restricted stock gives employees the right to purchase shares at fair market value, at a discount, or they may receive shares at no cost. With restricted stocks you do not have shares until specified restrictions lapse. It is also important to note that restricted stocks may be taxable on delivery, lastly this compensation is pretty liquid meaning you can turn it into real cash with relative ease.
The other popular method for delivering equity is options, options give you the right to buy share(s) at a predetermined price known as the strike price at a later date. Options can be broken into two categories Incentive Stock Option (ISO) and Non-Qualified Stock Options (NSO). When you exercise an ISO option, meaning you utilize your OPTION to purchase shares you do not pay taxes, instead you pay when you sell the shares. When you exercise an NSO option, meaning you utilize your OPTION to purchase shares you pay taxes on the spread, that is the difference between your strike price and what the shares are trading for at the point of exercise. Below is a table comparing the key points of the equity vehicles we have discussed
You don’t get something for nothing. In order to get your equity an employee must earn it. This happens in the form of a vesting schedule, equity is earned over time worked at the company. A commonly used vesting schedule is a 4 year monthly vest with a 1 year cliff. In this scenario the employee will vest 25% of their equity on their one year anniversary, the remaining equity will vest 1/48 of the original grant monthly.
- Daniel receives a grant for 10,000 options when he starts his new job, the shares vest on a 4 year monthly vest with a 1 year cliff. On his 1 Year work anniversary, he has earned 2,500 of his options, every subsequent month that he stays at the company he will “earn” an additional ~208 options.
Many companies are experimenting with levers to improve and incentivize talent retention. One way to do this is to back weight equity. This means that an employee receives a larger portion of their equity grant the longer they work there.
Amazon is one company that has a back weighted vesting schedule. Their vesting schedule is 5-15-40-40
- Year 1 - 5% of your original equity grant vests
- Year 2 - 15% of your original equity grant vests
- Year 3 - 40% of your original equity grant vests
- Year 4 - 40% of your original equity grant vests
This structure incentivizes employees to stay longer because of the increasing equity payday. This is often referred to as “Golden Handcuffs”, employees are shackled to the job by the equity.
- Back Weighted equity is an important consideration when trying to recruit a candidate who is close to vesting the majority of their equity.
This is a clause in some equity agreements. Accelerated vesting, literally refers to vesting being sped up, often times due to a company sale or acquisition.
Accelerated Vesting Example:
- Let’s use the scenario of Daniel from earlier. On his 2 year anniversary the company gets acquired by a much larger company, he has only vested 5,000 of his options, but due to the accelerated vesting clause in his contract, his entire 10,000 option grant vests, and he may exercise those options.
Another lever that employers use in order to incentivize talent to stay are equity refreshers. These come in two main forms, refresher equity grants and promotion refreshes.
- Equity Refresh - A company can issue an employee an equity refresher to up their equity and keep them at the company. Some companies do this annually to help retain employees, others only do this after the initial grant expires
- Promotion - An employee is promoted to a new position, the equity grant is refreshed to align with the compensation of others in the role
Check out Meld Valuation for more information on vesting and equity refreshers, we are sharing the highlights you need in order to hire the best talent.
One of the lures with non private companies is the immense potential for growth. In normal times it is unusual to see a publicly-traded company grow more than ~15% a year, but a private company in growth mode can grow 10x, 50x, or a 100x over a few years making the equity component which was previously negligible. Check out the graph below for a scale of the possible upside.
While equity at a private company may seem complicated or opaque at first, armed with the information in this article you no longer need to fear it. The better you are able to communicate and present equity compensation, the easier it will be to close and hire the best talent!
Below are some commonly asked questions to prepare for:
- When can you sell? - Once your options or shares have vested, and there is an: Exit Event, IPO, Acquisition, or a Share buyback
- What do these terms mean? - AngelList has done a great job explaining these terms practically here
- So the equity is essentially worth nothing right? - The equity corresponds to a piece of the company, which was last valued at $XXX dollars
- Are these figures guaranteed? - These are calculations based on expectations, we cannot guarantee any outcome
- How does equity add to the total comp? - It is in addition to the Base and Bonus compensation
- When was the last funding round? - This is company specific
- What was the company’s valuation upon the last funding round? - This is company specific
- Who were the lead investors? - This is company specific and may vary by funding rounds
- What's the exit strategy? - This is company specific
- When will the company IPO? - This is company specific, and may not be something you are permitted to share
- What's the strike price? - This is company and timing specific
- What percentage of the company are these options worth? - This is company and offer specific
- What's the vesting period? - This is company specific, make sure you can explain the structure, and the cliff if applicable