In previous articles, we looked at stocks, preferred stock, vesting schedule and essential parameters in stock splitting between founders. In this article, we discuss employee equity and when it should be awarded.
To determine when to allocate shares to startup employees, we need to consider each startup’s growth stage.
Pre-Seed
In the pre-development or very early stages, founders usually focus on building the initial product and attracting the first users. At this time, employee equity allocation is not possible. In addition, due to the low value of the company at that time or the uncertainty of its value, it is not possible to assign a share to employees, or the allocated share is low value.
Consider a newly established start-up that is launched in an accelerator. In this condition, offering a 5% stake to an employee (a high number for employee stocks) may not be appealing. In this case what matters is: “5% of which?”
When we talk about 5% of Microsoft shares, the figure is quite significant. But when it comes to a start-up company that faces multiple risks, the concept of a 5% stake is quite different. Therefore, in the early stages, when the current situation of the company and its value is in question, the employee equity is not so attractive.
Seed Stage
The Seed Stage, a stage after the Pre-Seed stage, is when the company is looking for a foreign investor (outside the company, family, friends, accelerators, etc.). At this stage, capital raising usually takes place outside the company.
Most of the investors of the seed stage are angels or benevolent investors. However, institutional investors may also be involved. Institutional investors are companies or organizations that have financial orders and are audited. At this stage, even public equity investors, such as over-the-counter mutual funds, can enter the startup. Thus, investment trends take a more proper shape.
The Importance of Employee Equity for the Investor
If the investor of the seed phase is an institutional investor, the startup needs to set aside shares for key employees (meaning that the grant should be in the commitment of the shareholders).
setting employee equity is important for the investor in two ways:
- Ensures that the company cares about human capital and uses employee equity as a tool to attract experts.
- The investor ensures that his stock will not dilute after transferring shares to key employees.
If the startup has not yet allocated employee equity, the shareholder agreement with the investor states that founders will set a percentage of the shares aside for the employees. In this case, the investor stocks will be diluted.
For example, suppose an investor acquires a 20% stake in a company in the initial round of fundraising. According to the plan, 10% of the company’s shares will be given to the employees after a year. This 10% share causes the shares of all previous shareholders to be diluted. It means the investor with a 20% stake will lose 2% of his stake to 18%. In fact, it means that he has bought 18% of the company’s shares. Therefore, it is important for investors that the startup has already excluded employee equity in the first round of fundraising.
Early Stage VC
Early Stage VC
At this stage, venture capitalists enter the startup. The amount of capital raised at this stage is much higher than at previous ones. This round of capital raising is considered the first round of venture capitalist investment. What matters to them is that the founders determine the employee equity before their investment.
Regarding a few successful rounds of capital raising, employee equity seems to be attractive enough in this stage. It means the startup has been so attractive to investors to invest in it a few times. So why not be attractive to the employees? Startups can attract more users daily, develop and improve their product, get a better-equipped office and finally provide a better service.
After the first round of venture capital financing, employees get assured they are working for a valuable startup and care about employee equity.
Employee Equity Plan
After fundraising, human resources recruitment will increase, and the company can expand its working scope. At the same time, people with more expertise and experience join the startup to take on heavier responsibilities. These people usually ask the startup for shares.
As the number of employees has increased dramatically, founders cannot negotiate to determine individual share. In this case, people will compare their share with others and will demand more.
To avoid such troubles, the startup should raise a reasonable and standard guideline to follow.
Allocating shares based on a share program shows that the startup cares about human capital and uses employee equity as a tool to attract professionals.
Late-Stage
In the late stage, raising capital by startups is multiplied. Now the startup is fully mature and so successful that it attracts various investors.
The startup capacity of hiring and increasing human resources continues to rise steadily at high speed. Employees may request more shares, but typically startups do not have to allocate more employee equity to retain professionals and recruit new ones. At this stage, the startup brand has become valuable enough to be attractive to employees.
The startup has high financial resources at this stage and can pay employees good salaries to avoid allocating extra shares. However, at this stage, employees are very interested in owning the company’s stock. In other words, in the early stages of growth, the startup is more willing to provide employee equity, while in the late stage, the startup’s willingness to give a share decreases.
However, it is crucial to have a completely standard program for granting shares at this stage, which we will discuss in the following articles.
Growth
At this stage, the startup makes an effort to conquer the target market. Achieving this goal requires a large workforce. Although most of the employee stock is probably allocated to individuals at this stage, the remaining stock is extremely attractive to employees due to the high value of the startup.
