I would highly recommend watching Fred Wilson’s live class on Employee Equity. I regularly read Fred’s MBA Monday posts and this class covers some very valuable subjects for any first time entrepreneurs. I have posted my notes below for any interested parties, but there is a more readable breakdown here (keep in mind these notes were taken on a first time watch and are not meant to be the basis of your thesis).
- If anyone goes to the pay window, everyone goes to the pay window (JLM)
- Dilution: A few cofounders start and own 100% of the company and as you hire and take on more money you will get diluted.
- If you are there at the beginning you get diluted the most.
- Founders have 100% (2,3,4 people)
- Founding team (engineers, designers, etc) give them 5% (so founders are now 95%)
- original seed investors (family, angel) invest and get 10%
- Everyone dilutes by 10%
- Founders now = 85.5 (95%*.9)
- Founding team now = 4.5% (95% * .9)
- Product is in the market and you are going to do a venture round and they will make you do an option round
- You now create an options round of 10% for new employees
- dilute another 10%
- seed goes to 9% (10% of 10%)
- founding team goes to 4.05 (10% of 4.5)
- founders go to 76.95% (10% of 85.5)
- Now VC’s want 20%
- Seed goes to 7.2% (9% * .8)
- Founding team goes to 3.24% (4.05% * .8)
- Fouders go to 61.56% (76.95% * .8)
While your ownership is going down, your companies value should always be going up (as well as stock price)- Vesting: you earn your ownership/equity over time
- employees/founding team/founders all should have vesting
- Employess typically vest over 4 years (an = amount each year over 4 years, 25% a year over 4 years)
- often with a 1 year cliff vest which means you get no vesting until the first full year. Then you vest 25% and after you maybe vest monthly or quarterly
- You do this to protect yourself from key hires that turn our to be bad. Find out fast and don’t let them stick around for 11 1/2 months before you let them go (if you do give them some vesting percentage)
- Founders stock is STOCK, not options. You will not have a tax issue when first getting started.
- When giving someone stock, you are giving them something of economic value and you will have to pay taxes on that.
- EX: if you give someone 1000 shares worth 10 dollars each, you will be giving them $10,000 worth of stock and they would have to pay taxes on that.
- Restricted stock: Stock with a vesting schedule and other restrictions like they can’t sell it without giving the company first right of refusal etc.
- Options: This allows you to give shares without giving the new hire a huge tax burden up front. You say here is 10,000 shares that are worth $1 a share (locked in price) so if the shares end up being $20 a share and they execute their purchase the can then make 19$/share.
- Strike Price: Board of directors would decide what the fair market value of the company is worth, say $1 a share and they would issue it at $1. (409a now determines most peoples strike prices)
- 409a: IRS said you should have a 3rd party decide your fair market value of common stock price.
- 409a: The floor value that the equity is worth
- Exercising options is a taxable event, thus RSU’s were born
- RSU’s: the promise to give employees restricted stock at some future date, usually at a liquidity moment. Going public or getting bought. Thats when the shares become actionable
- Not marketable in the second market. If you leave and you have vested 50% then you always have this until liquidity moment and they are still subject to dilution.
- After the Founders>Founding team> and Seed investors you will want to move away from giving up %’s of the company (you can end up diluted the hell out of yourself if you don’t) and you will want to move to $ value of equity.
- Dollar value of equity:
- 1) you put a $ value on your company (what you really think its worth) say $25 mil
- 2) put your company into buckets and issue multiplier
- Senior Team (except CEO, COO, President) .5x-1x
- Director/Junior level: .25x-.5x
- Key Hires (hard to hire and hard to attain): .1x-.25x
- All others: .05x-.1x
- Ex: CFO makes: $250,000 * (one of the multipliers; in this case senior team) .75% (what was good for our company) = $187,500 (dollar value of the equity that you are going to offer this CFO)
- 3) How many shares outstanding: 10mm
- 4) Divide #1/#3 and you get a stock price of $2.50 a share (CFO example has 75,000 shares: These will be struck at whatever the 409a valuation is which will hopefully be a lot lower than your estimate of #4 $2.50
- Retention Grants: Equity vests after 4 years. There stock vests and they walk out the front door and go work for someone else. You want to keep them so…
- retention grants should be implemented 2 years after hiring founding team and definitely after non-founder employees and every 2 years after.
- They should be at 1/2 of what the sign on date would be today (CFO example of 75K (@$2.50) will be 37.5K)
- Again, retention grant should be half of what the sign on grant would be if the person was hired today using above formula with todays value.
- Don’t let employees get 3/4 or totally vested before you offer retention grants.
- Retention grants are a 4 year vest also (keep your employees around)
- For LLC’s you would create a separate class of membership units in which to issue your key players (senior guys). Non-voting units with vesting attached
- you could reform as a Ccorp.
Closing remarks: “The sooner you can stop talking about equity in percentages and the sooner you can start talking about it in Dollars is the sooner you are going to own more of your company.”
In preparation for these classes Fred made a list of other suggested reading materials. I read through all of them pretty quickly and I would suggest that you do the same. The outline makes it very simple to read through and its a great (free) way to learn this stuff.
