What’s The Wrong Way To Think About Equity?

They found a good candidate for the position, and they only wanted to give him 1% equity vesting over four years. I told them the candidate wasn't going to take the risk of joining for such a small percentage ownership.

Their answer was, "Why not? We're going to be worth $1 billion in a couple of years."

I told them, “I don’t think I can help you if you’re not going to be realistic about what it takes to hire top talent.” I wished them well and moved on with my life.

 

You either get it when comes to equity or you don’t get it when it comes to equity.

 

It seems to me there are two types of founders:

 

A. The "Spread the Wealth Founders" where the founders are very generous with equity, or...

 

B. The "Stingy, We're in it Only for Ourselves Founders" where they grudgingly give out equity.

 

We’ve all watched Shark Tank where, seemingly every week, an entrepreneur fights to keep every single percent of his or her equity. Ask yourself this question:

“Does it really matter whether you have 80% or 90% ownership?”

You’re thinking, “Of course it matters. I’ve just lost 10% ownership.”

Of course, you’re right. But what if you are hurting your chances of success? What if 80% ownership is worth a lot more than 90% ownership? Would you still want to hold onto that extra 10%?

It turns out that being stingy with equity hurts your chances of success, so the "Spread the Wealth Founders" have a much better chance of success. Indeed, Noam Wasserman wrote about this phenomenon in a 2008 HBR article titled, The Founder’s Dilemma. Wasserman states:

“Choosing money: A founder who gives up more equity to attract investors builds a more valuable company than one who parts with less—and ends up with a more valuable slice, too.”

Wasserman isn’t the only one who believes spreading the wealth is the right way to go. Andy Ratchleff, former Venture Capitalist and current founder of Wealthfront, believes one of the common traits of successful startups is spreading the wealth. Ratchleff says in his article The Right Way to Grant Equity to Your Employees:

“When I was a venture capitalist, I noticed companies that seldom lost employees due to recruitment had a lot in common. Sure they offered challenging and inspiring work environments sought by top-tier talent. But you might be surprised to learn they all rewarded outstanding performance through the issuance of additional stock options (or as is now the case, RSUs) in a similar way.”

When I worked at Micrel, a public company in the semiconductor space, the CEO threw equity around like manhole covers. He owned a huge amount of the company and controlled the board of directors.

One of the issues Micrel had was significant turnover after an employee had been at the company for four years which was the length of the original stock granted to employees. The follow on grants were minuscule, so employees quit.

Many executives (myself included) proposed fixing the company’s outdate stock option plans. The CEO wouldn’t listen. He wanted control. And he was going to do things his way.

It took years, but eventually an activist investor forced him out.

 

And that’s the founder’s dilemma that Wasserman is talking about:

 

• Yes, it feels great to have all the power, and…
• Yes, it feels great to be able to do exactly what you want to do, but…
• You can develop a pretty mean case of hubris if you're not careful, and…
• Hubris will likely kill you and your company.

Being CEO can be really tricky. Everyone is kowtowing to you. Everyone is telling you that you are great. Everyone is telling you that you’re right.

It’s difficult not to be affected. I know.

On the other hand, you likely were told by just about everyone that your new company was not going to succeed, that you’d never get funding, and you were making a huge mistake. I was told all of this and more.

Consequently, your desire to keep control of the company is understandable. However, holding on to every percent of equity, tooth and nail, is likely not going to give you the result you want for you and your company.

Here’s what I’m not saying:

 

• I’m not saying you should give away equity like candy, and…
• I’m not saying you should overpay your employees, however…

 

I am saying you should be fair:

• Fairness builds loyalty, and…
• Fairness builds a great team, and most importantly…
• Fairness gives you the best return on your investment.

 

Yes, you may give up more equity than you like, but you will be better off.

 

I’ll never forget a conversation I had with one of our investors when we were closing the initial round of funding for my company. Gill said to me:

“Brett, the amount of equity you have in the company today is irrelevant. I can tell you already that the investors are going to end up with X and the company is going to end up with Y.

“The rest of it doesn’t matter.”

I always felt that what he was really saying was, “There’s a fair outcome for both of us, and that’s what I’m committed to.” Now, having said that, we had another investor, the infamous “Raul”, whose goal was to squeeze every percentage of equity he could from us like blood from a stone.

 

What is the right amount of equity to relinquish?

 

There is no one size fits all answer. However, let me give you the thought process I follow:

 

A. If winning means giving up more equity, then I am all for giving up more equity.

 

B. You know you have given the right equity to someone when you feel good about the amount and the employee feels good about the amount.

 

There are a lot of articles on the Internet about equity allocation for different positions. You can use these as a guide. You can also network with other entrepreneurs to find out what they are doing. Your investors should have research on equity allocation, so you can use this as another resource.

 

Oh, before I forget, make sure that the equity grants you give vest over time:

 

1. A typical equity grant should vest over four years, and…
2. The first 25% should vest after twelve months (a one year “cliff”), and…
3. The remaining 75% should vest monthly in 36 equal increments.

This structure protects you just in case someone doesn’t work out. Then you haven’t given away a large chunk of your company to someone who isn’t contributing.

 

One final thing that you should do: refresh the stock options of your team.

 

You and your team are going to be diluted as you raise more money. That’s a fact of life. However, you want to keep your team motivated, and the way to do this is by refreshing their stock options.

This means giving your employees an additional stock grant when a round of funding closes. This is especially important if the dilution was significant.

You will want to increase your option pool to grant your employees new options. You may be surprised to hear this, but your investors will likely support you.

You measure how much new stock to give by how much ownership a certain position should have based on the life and timing of the company. Let’s say you just raised your Series B funding.

An employee in a certain position was given 0.6% ownership initially. Now the employee has 0.35% after Series B closed, but should be at 0.5%. You should grant the employee another set of options for 0.15% ownership.

 

Always be fair: someone who took the risk of joining early should be rewarded for taking that risk.

 

I used to always tell prospective new hires that if I hire you today, you are going to own more of the company than your clone if I hire your clone a year from now. Refreshing is crucial to fairness.

Refreshing is also a key retention tool. We live in a competitive world.

You are going to lose your employees to the competition if you don’t compensate them fairly. Again, your investors know this and they should be supportive, but only if you are being fair, not greedy.

Those two founders I met years ago didn’t get it. They never got their company off the ground.

I’ve seen this same story play out over and over again. The founders that understand Wasserman’s Founder’s Dillema have a much better chance of building a successful startup than the founders that don’t understand the Founder’s Dillema.

 

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