Startups often offer equity to valuable employees in place of a higher salary.
- Equity compensation has the potential to offer benefits to startups and new hires if the terms are acceptable to all.
- Research the type of equity being offered and assess the risks before signing any contracts.
- A part of salary negotiations is deciding on fair terms for equity compensation.
What is equity compensation?
Equity compensation is a strategy used to improve a business's cash flow. Instead of a salary, the employee is offered a partial stake in the company. Equity compensation comes with certain terms with the employee not earning a return at first.
Startups often lure in star employees with the promise of equity. Why? A lot of startups are short on cash but can issue shares at will and have equity to hand out.
I recently helped a client negotiate his full-time employment agreement with a newly funded startup doing exactly that: providing equity in lieu of higher compensation. We normally deal with freelancers, but we are increasingly being asked to lend our negotiating skills for full-time employment contracts.
The basic terms of the deal he was offered were perfectly acceptable. The salary was approximately 35% below his market rate as a chief technology officer (CTO). The low salary was being offset with a reasonable chunk of equity.
How is equity paid out?
Each company pays out equity differently as a way to make up for a low salary offer like the example provided. The two main types a company usually provides are vested equity and granted stock upfront. With vested equity, payments are made over a set number of increments pre-determined when you sign a contract. Granted stock is provided at the beginning of your contract. Although the equity offer is significant, there's always risk involved with accepting equity in place of a salary.
When I dug deeper into the structure of the deal and the kind of equity being offered, I was concerned. First, I discovered that the company was not offering equity but rather options to purchase equity.
Second, the options being offered were in a different class of equity from that of the founders.
Third, the terms on the option plan required that the employee exercise his options within 60 days of leaving the company. So my client would have to purchase equity without knowing if the company would be successful and if the equity would have any value.
We were not OK with these terms. Asking an employee to take a lower salary and offering unfavorable equity terms is not a winning strategy for any company seeking to find great talent. In response, we offered three solutions:
- The company pays for the options to be purchased, saving the employee the cost of exercising and de-risking them.
- The company lends the money for the options to be purchased until they can be liquidated.
- The company extends the option period for 10 years (instead of 60 days) so the employee doesn't have to exercise his option until there is a clear value for him.
What is the most commonly used form of equity compensation?
Equity compensation comes in different forms. The employer could offer stock options, restricted stock, or employee stock purchase plans. Within these types are sub-categories that give companies more or less control over how the equity is paid out. The solutions presented were favorable to the new hire since option periods are extended and the cost to purchase is not the responsibility of the employee.
The company rejected all three solutions. When you are dealing with a hardball negotiation and facing unfavorable terms, it is crucial that you – the would-be employee – take charge and either walk away or bring in an agent to help. It is easy to think that stock options won't matter in the long run, but then, why take a lower salary in the first place?
We eventually reached an agreeable compromise: The company agreed to a five-year exercise period. In other words, once our client eventually leaves this employer, he will have five years to decide whether to exercise the options. This makes accepting a lower salary more logical.
Regardless, the company's initial reluctance to compromise signaled poorly to our side of the negotiation. At best, it signaled a culture of rigidity; at worst, it implied employees are meant to be exploited. Who wants to work in an environment like that?
Your employees are the key to your success, and finding good ones is hard. When you finally find someone with the right skills who is also a culture fit, you should work to bring them in feeling good and committed to your mission. If you make a mistake, you have recourse.
Smart entrepreneurs know that finding good employees is not possible without fair, clear and mutually beneficial deals. They should not take advantage of would-be employees with shady deals and convoluted contracts. If you feel like you're being taken for a ride, consult an expert or seek outside help. Ask around about other such deals. You might be amazed at how much you learn. The cash components of these deals are typically easy to follow – the equity, not so much.