One of the toughest compensation-related questions that founders and executives face is that of granting stock to key employees, board members, advisors or consultants.
How many shares should I grant?
Should I grant shares or options?
Can I give people the upside of stock ownership without actually having to give up control or take on the responsibility of managing minority shareholder rights?
This question creates confusion because it is typically improperly framed. This question is not so much a compensation question as it is a valuation question.
Consider the ramifications of making the wrong decision:
Offer too little value in the way of stock-based compensation, and you fail to create the value-creation incentives you desire, or worse, you insult the key people you were trying to reward.
Offer too much value in the way of stock-based compensation, and you set perverse expectations for future grants, and you unnecessarily take away from your own return.
Before continuing, let’s recall why you might be interested in granting some form of equity in the first place.
Equity is an expensive source of financing
Equity is the most expensive source of financing and form of currency around. Where possible, you are almost always better off compensating people with cash than with equity.
However, cash compensation may fall short because you don’t have the cash to pay market value for the resources you are getting, and/or those key resources fancy themselves as entrepreneurs and believe in you and thus prefer to forego cash in exchange for the opportunity to participate in the upside of your company.
So how do we figure this out?
We could start with “market” indicators, which are pretty much anecdotal, or some kind of rule of thumb. Googling various sources on the Internet reveals the following guideline grants (as a percentage of total company equity – Blogs by Guy Kawasaki, Fred Wilson, TechCrunch, Founder Institute):
Employee stock option pool – 10%-20%
“Normal” advisors – 0.1%-0.25% (50% more if very early stage)
“Super” advisors/board members – 1%-2% (50% more if very early stage)
Vice President/Director level employees – 1%-2%
Target founder share at exit – 20%
Non-founder CEO – 5%-10%
Non-founder C-Level (ex-CEO) – 2%-5%
Managers – 0.2%-0.3%
Engineers – 0.2%-0.7%
“Normal” advisors are those who attend board meetings and offer helpful guidance. “Super” advisors are those who spend significant time and actively leverage their rolodexes to help the company attract key resources, such as investors, talent, and customers.
In addition, a widely understood rule of thumb suggests that 10-20% of a startup company’s equity ought to be reserved for an employee stock option pool.
Considering stock grants
The above-mentioned rules of thumb may be sufficient starting points if you feel that you don’t require a great deal of precision in your stock-granting process. However, you can also create grants that are customized to your specific situation. Like stock options, stock grants are reward and motivation tools.
Conceptually, determining the right amount of a stock grant is simple: take the amount of compensation that your employee or advisor would normally command in the market, determine the amount of cash compensation you are prepared to offer (or can afford), and the difference between the two is the amount of equity value you should grant.
This simple approach is expressed by the formula below.
Market Compensation – Cash Compensation = Equity Compensation
The challenge at this point is understanding the exchange rate between your company’s equity and cash. In other words, what your equity is worth – again, a valuation question.
What is your equity worth?
For example, if you know that the cash compensation gap is $25,000 for a certain employee, you should be thinking about offering $25,000 worth of securities, whether those are shares, options or stock appreciation rights.
If your shares are worth $1/share, then you should be offering 25,000 shares. If you offer options instead and they are worth $0.50 per option, then you should be prepared to offer 50,000 options.
These grants may not be one-time grants. You should be prepared to make that offer each year until you can (or want to) meet the normal cash compensation market. As your company gains in value, the number of shares granted should be decreasing.
The question that falls to you now is how to set the value of stock or options you will be granting. Teaching you how to value your shares falls well beyond the scope of this article. However, the following framework should point you in the right direction.
If cost and speed are your highest priority, you can estimate the value yourself, using whatever techniques you deem credible, or even negotiate a value with the intended recipient(s).
If precision is more important to you, then consider retaining a professional business valuation specialist to help you. Depending on your circumstances, you may be required to obtain an independent, qualified appraisal of your stock anyway for tax compliance or financial reporting purposes anyway.
Other decisions in the equity compensation process include whether to issue stock or options. Employees tend to prefer stock because they feel the asset is somehow more tangible (albeit frequently tax-disadvantaged), while issuing options is frequently simpler (and cheaper) administratively and avoids dilution of control.
What about vesting?
Best practices in equity compensation also include vesting of equity grants – where the equity grants are effectively held in escrow and then released when the employee or advisor hits certain longevity or (more rarely) performance milestones. Vesting significantly dilutes the value of the equity grant.
The question of how much stock to grant to an employee or advisor does not have to be overly complex. Ultimately, the question of stock grants is more of a valuation question than a straight compensation question.
You may choose to rely on some of the rules of thumb presented here. Should you desire greater precision in the process, it finally boils down to the question of what your shares are worth. With the knowledge of share value, you turn the equity compensation process from a guessing game into a highly strategic decision.
This article has been edited and condensed.
Michael Blake is the founder of Arpeggio Advisors, a boutique business appraisal and corporate strategy advisory firm in Atlanta, Georgia. Michael is also an active educator. He is a Special Instructor of Business Valuation in the Georgia Tech/Emory University TI:GER (Technology Innovation: Generating Economic Results) program. In addition, he is regularly invited to provide instruction on entrepreneurship, corporate finance, and business valuation to graduate level classes at prominent universities across the South. Connect with @unblakeable on Twitter.