employees, employee-compensation, equityWhen trying to found a startup where the goal is not an early exit, but the creation of a lasting company: How essential is it for (especially first) employees to get some share of the company? Are there any substitutions for sharing equity?
There are a number of reasons why one might consider sharing the ownership of one’s business with others:
as exchange for something that you need (e.g. to obtain cash from an investor, or to obtain work from an employee whom you do not have the cash resources to pay in full);
to ensure that such people’s incentives are aligned towards the same goals as your own; and
to “lock” people into longer-term commitments than they might otherwise consider (a person is less likely to quit a business in which they own stock than one in which they do not).
Of course, as with anything, there is a trade-off: primarily, dilution of control and dilution of earnings. Dilution of control might be avoided through a different class of stock (that carries reduced or no voting weight), but dilution of earnings is the means by which the above goals are accomplished (and therefore cannot be avoided).
A further consideration lies in the additional complexity of disengaging from one another should the relationship deteriorate in the future: it’s therefore sensible to enter a clear written agreement between shareholders that sets out exactly what happens in the event of a dispute.
As to your specific questions, I assume that (rather than talking about “business partners” or “cofounders”) you’re talking about people who you have sought to recruit in the job market (and therefore about whom you know very little besides their application, resumé, references and interview):
How essential is it for (especially first) employees to get some share of the company?
It’s only essential if your desired employees refuse to work for you without having a share of equity.
I’d generally caution that it’s probably a bad idea to give a share of one’s company to such employees outright. It’s very difficult, even for mature businesses, to identify which job applicants will ultimately turn out to be the very best employees. Will they deliver on expectations? Will they work well with the rest of the team? Will they learn and grow in their role? Will they share their knowledge and skills with others? Will they add substantial value and contribute towards the company’s success? Will they still be working for the company in a year’s time? How about five years?
Moreover, what if you soon after have to recruit another employee into a similar (or even more senior) position? They might well demand a similar (or even more significant) equity share. Once the precedent has been set, it can be hard to escape.
Why is this so?
Because those prospective employees may perceive that they are capable of achieving a better deal elsewhere. Be conscious of what remuneration packages similar businesses are offering for similar roles and be ready to spell out what differentiates you from them.
For example, a high-tech startup in Palo Alto looking to recruit a CTO with 10 years high-level managerial experience in relevant technologies might find it difficult to recruit a person of that calibre without offering an immediate equity stake; whereas a retail startup in Glasgow probably wouldn’t find it too difficult to recruit a shop assistant without offering equity.
Can it be substituted?
Rather than granting equity outright, one might consider instead a share option scheme (under which the employee earns, over time, a right to buy shares from you—perhaps for some nominal, or even zero, amount). One can specify the criteria necessary for their options to “vest” (e.g. the employee must deliver on certain targets, or remain employed for a certain period of time). You will almost certainly require professional advice to set up such a scheme.
Alternatively, one could set out a clear bonus incentive, by which the employee is capable of earning substantial reward without sharing in the ownership of the company. This is simpler and less costly to implement, but beware that it may not be as tax advantageous as equity-based rewards.
As mentioned risk is the factor. The easiest substitute is a salary. If they are getting market rates for their work then they generally don’t require equity.
However, if you are hiring the right people in the beginning, you aren’t hiring employees you are hiring people with an appetite to build something great and giving them equity will certainly help them feel more accountable and part of reaching the main vision / goal.
People also join smaller companies because they believe they can contribute more and have more of an affect. They work harder and hence I believe it is important to reward them further.
Its not essential but depending on the type of employee it certainly helps bind the founding team.
I think the main concern is risk. How much risk are your first employees taking on? The first founders normally commit to the startup with no salary and no assurance that the company will survive and they take the largest shares. Once you start hiring employees they receive a salary, but the long-term success of the company may not be guaranteed and they could easily lose their jobs. Evaluate their risk and distribute accordingly. Of course the easiest substitute is salary.
The practice of sharing equity in the early stages of a company is usually provided as a method of delayed compensation. Many start ups have limited funds, so they use equity offerings as compensation for working at a lower initial salary. You are keeping your liquid assets available for more immediate early needs (materials, infrastructure, etc.). However, this is usually only done for companies that expect a rapid growth phase - where company equity is cheap to begin with, but has high potential to be very valuable in the future. If you have capital to pay proper salaries, offering equity incentives wouldn’t be necessary for general employees. A potential employee with highly specialized skills (hired CEO, etc.) may be looking for equity, but it is your decision to offer it or not.
Valuable positions are another currency you can pay with.
Of course, nobody would keep an under-performing C*O or software architect, but high positions are difficult to get in a well established company, and there are more people who would do the job well than people who get the job then applying to the place with no risk and good salary.
Various “coupons” you may be tempting to issue and pay with them pretending you can afford are not good replacement, I have seen people walking away outright from such proposals if nothing else was included.
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