Is it ethical to compensate employees with equity in a startup over cash?
My team is launching our startup on a very limited budget. I want to compensate them for their hard work. Is it ethical to offer up equity in the company? If so, is this a smart business decision to make?
Giving somebody equity instead of paying them a salary is the most expensive form of payment there is.
If your business succeeds, you'll later regret giving so much of it away.
If it fails, then you'll be stuck with the knowledge that you enticed these people to work for you with promises of a return, and then you let them down. This is beyond legalities or even ethical considerations. It's on your conscience.
The only good reasons to grant equity in a start up are:
-- Synergy among the founders who will make crucial and equal input, and should share equally in the rewards
-- To obtain an essential resource that cannot be obtained in any other way: e.g., capital, patents, market access
A minority share in a privately held company is worth virtually nothing unless there is an IPO or an acquisition.
Many men and women have been made rich by accepting equity instead of cash as part of their start-up pay package. An equity bonus or salary payment is an opportunity for employees to purchase equity at an incredibly cheap valuation. Once an employee owns equity, it's expected that they would have considerable motivation to see the company succeed. Thus the employee's interests become well-aligned with those of the owners.
It should always be explained to any employee that a payment is equity is never guaranteed any return, and may in fact be worth zero someday. That is for your protection as much as theirs. In fact, I'd put it in writing and have the employee sign it as condition for accepting the payment in-kind.
But for an employee who is willing to accept the risk, the payoff can be well worth it.
Ethical? Why not? As long as you are making a full disclosure of the risks, the (adult) person you're hiring can make a decision as to whether to accept those risks or not. There is no ethical problem.
I'd emphasize Daniel Shanklin's excellent answer. Full disclosure is absolutely critical, and may be legally mandated.
One should also consider the tax implications. Granted equity has an implicit value which may need to be declared as compensation...but which is subtracted later when calculating capital gains. There are forms to do this - contact your attorney or tax adviser.
And both employer and employee...especially of very young startups...need to consider the cap table. Future funding rounds will dilute the holdings; additional employees may also want/deserve equity. These can very much reduce the future value of the current grant of equity.
As long as you have an appropriate multiple to cash in exchange for the risk. Take your initial valuation, which is probably a guess anyway and then I would use something between 25 and 50%.
It is a risk for the owner too as you will be giving up ownership. I would try fund 75% of salary/cost with cash and treat equity as a signing bonus and then a quarterly bonus to earn. That way you can adjust compensation percentages and values as your viability comes into focus.
Yes, but in addition to explaining the risks, the employees should also be informed on the potential exit strategies. I have taken part in a few and learned from my mistakes. As an employee I would insist on contingency conditions be included that address some of the potential scenarios that could arise if the ownership group undergoes significant change such as the sale of controlling interest or a hostile takeover.
In one of the past companies I was in the BOD approved the sale of the company for $1 to a new investor and the deal included a proviso that only the Class A shares were transferred to the new ownership and all non-voting Class B shares were dissolved. So I got 7% of $1 and no shares in the newco. In fact all the people whose risk in the venture was significant to their livelihood were screwed.
It's these types of stories that bring the ethics into question. But the deal we made was ethical. It's the people we made it with that were unethical.
I kind-of laugh at the answer of 'yes' without a real check on that response.
Offering equity is a great way of getting started, but I do feel (as I have been in this situation several times), it's good to have a mixture of equity and some type of monetary compensation.
Say for a typical salary, you expect to pay out, say, a $35,000 a year...but with your limited budget you decide to do say, $25,000 a year with equity options. Depending on those options, someone probably would be more willing to push to make the company successful, vs, not pay them much at all, and continue to tell them to keep pushing forward until the company makes lots of money. I've seen a lot of start-ups flop completely, because no one was being paid to do anything, and nothing was getting done, but the 'CEO' kept pushing "You'll get lots of money when we launch".
Companies can take quite some time to get profitable, off the ground and paying their people what 'they are worth'...Sometimes more than a decade or two. So at the end of the day, be honest with your employees, be up front with what the company can afford (and be sustainable), and generous when the company reaches stages of growth.
As long as all involved understand fully the risks involved, then it is entirely ethical. Ensure employees understand Startup Risks--be clear and thorough--in communication, and show your integrity by honoring your commitment to the compensation WHEN YOUR STARTUP SUCCEEDS!
Who define ethnic? Its all bottom down to your perception!
To me, the word is fairness.
1. is such compensation is beneficial to the business as a whole?
2. is such compensation is what the employees looking for? (some employees like, some not)
3. Any decision should come from good intention, you should be in good position.
Also, why ask is it ethical to compensate employees with equity in a startup over cash? As long as your intention is a good one and accepted by the respective stakeholders at fair basis, why not?
Statistics tell us the chances are very good that the company will never be more than a small business with a few shareholder employees. If it grows rapidly and significantly, the employees will be very happy to be acquired, retire, and clip coupons. If you struggle for a long time, lose your investment and have to put the company down, the only question that matters is who owns 51% as that person will ultimately be in control.
I don't have a problem with the conscience issue. If you and the employees took the risk in good faith and the company fails, you'll have learned some very valuable lessons and will be more aware of the risks the next time.
The imputed income issue can be a problem as the IRS has been known to declare founder's stock is income, and send you and your entrepreneur partners tax bills (including penalties). Option programs are even more complicated, so talk to a securities attorney and start it up properly -- it will benefit you in the long run.
Also, if you're going to take on partners whom you will pay (even partially) in equity, do a background check - $15-20 online. Know who you're dealing with and check references. Ask around about the person before you take them on as a shareholder. You can fire a salaried employee -- it's a lot harder to fire a shareholder or board member.
About the spouse thing: most serious investors will not even consider investing in a husband-wife business -- too many issues dealing with the bedroom that carry over to the office. Don't do it if you're going to go after professional money. Let your spouse start their own company or make a salary to help support you while your company is growing.
Not to be a wet blanket but it's worth your time to think about the risks as well as the rewards before taking the plunge. There are a lot of good sources of information to help you, but in the end it's solely your decision. Good luck.
Follow the golden rule - offer them a package that you'd find fair if the roles were reversed.
As long as you are being upfront with the risks and transparent about the current and expected future state of the business there is nothing wrong with it nor are there any legal issues. You are not forcing people to accept a job with you. It would be a different situation if you had employees on payroll and then switched the comp plan up on them.
It's not really a question of "wanting to compensate them". You need to do that one way or another, or they will depart as soon as they figure out that there is nothing in it for them. If you do not want them around for the next few years as equity partners (with a voice in managing the business), then you'll have to pay them. If they seem like good long-term assets, whether in this role or another, then sure, try the equity route. It is the reason people agree to work on start-ups in the first place. See "Slicing the Pie". Explains how to deal with this problem fairly and legally. Well worth the few bucks it costs.
I agree with Dan's response. I had worked in one and sadly the startup folded. But I did learn a lot though. I entered that arrangement knowing the risks and the possibility of getting nothing out of it.
The scope of work needs to be clear and how much equity will be involved. A lawyer might help also.
Not smart. CA and MA are legally tough on it. Best to pay and keep it on the level. It reduces the highs but elevates the lows. As a serial entrepreneur our worst problem with equity was their partner or spouse, whether male or female, young or old. They accepted the concept of lower pay much more easily plus being on the ground floor gave them a title edge outside the company and the opportunity for salary growth inside the company. More honest. If a hot shot comes to you and wants equity and not pay, that can be a bonanza. Otherwise risky-you are putting them out of their comfort zone.
Of course you can offer equity instead of cash. This would not be unethical unless you knew that you will not make it, or are planning on shutting down, and did not make that clear to your employees and partners. These workers will of course need cash to live until they can sell their equity shares. The bottom line, they do not have to accept the equity payment and they do not have to work for you. Just be open about what your plans are and explain your situation and those that want to leave will leave and those who want to, and can, stick it out will.
1- A company is required by law to pay its employees at least $7.25/hour and that amount is different from state to state.
2- It is a bad business decision. People have to pay their bills. If they're not getting compensated by your company to sustain their lives, they have to work elsewhere to get their income, and your projects will become second priority with less focus and interest. That's something to consider and manage.
Read this article:
Ethical, or not, it very rarely works out for the benefit of either party:
1. Employees ALWAYS overestimate how much time they will have to spend on a project that offers no pay. So they usually perform below your expectations and take forever to deliver on their promises.
2. Employers ALWAYS underestimate how long it is going to take to develop their idea. Add that with the employees working without pay, and you have a certain recipe for doom.
3. Everyone thinks they have the greatest idea since sliced bread, so that is all they need. Sorry, you need capital.
Equity only works when the company has buzz in the local community otherwise the immediate, necessary benefits are not there. Compensation for living costs and transportation would be more effective. They want to work, and you should ease that.
Lexi - You've received a lot of great answers - a lot of good information. I think a big thing here is to consider whether there are legal limits to your offering equity to your employees, but you also really have to carefully consider the long-term picture as well. What happens if an employee wants to leave? What if you want them to leave? But with equity - they are owners. Can you remove them? Maybe they are star employees today, what if they disagree with a decision you make? Will they take the position that they are owners too and don't have to listen to you? I think these are operational questions that need to be considered alongside the equity/tax/compensation questions. Happy to help further if you'd like...Rich V.
There is nothing unethical about doing this- if it suits your business model go ahead.However a word of caution-are you capable of giving equity to employees as a start up- is the model sustainable in the medium to long term?