22 April 2012

Employee Equity by Fred Wilson

Just saw this great talk by Fred Wilson, principal of Union Square Ventures, about employee equity.
It's a bit long but if you are building a company try to put an hour aside to watch this.

The video of the entire talk is embedded below, and here's a link to Fred's post about it.

There are useful tips and best practices scattered across the entire talk so it's worth listening to, but if you don't have the time/patience here are the highlights.

The high level concept of the entire talk is that "if anybody goes to the pay window, everybody goes to the pay window". Meaning that everybody in the company should be an integral part of the ride and be compensated accordingly in the case that the entrepreneur and founders get their payday by selling the company, IPO, etc...

At the beginning of the talk (minute 3:37-10:40) Fred explains the basics of dilution, giving an example of a common scenario where a founder brings on a founding team, then some seed investors who also get equity, an employee equity pool, and a VC investment. The example shows how the founder gets diluted as more people get a bite of the pie (as do everybody else along the line).

He then goes on to explain various tax implications of options vs. stock and different vesting plans for employees, founders, and the founding team.

In my opinion, the most important part of the talk starts at minute 32:50 where Fred discusses a technique that he uses for how to calculate how many shares to give a specific employee (it goes till about minute 42:00).

Here's how to determine how much stock to give a specific employee:

First of all you need to put down your own real valuation of your company. This is not an official number or something that a 409A firm comes up with (more on that in the beginning of this video, if you're interested), it's how much you really think your company is worth at that point in time. In his example it's $25M.

Next you need to bucket your employees into 4 buckets and their multipliers:
  • Senior team (CFO, CMO, CPO... executives who report to the CEO): 0.5x - 1x
  • Junior VP level/directors (people who report to the senior team): 0.25x - 0.5x
  • Key hires (engineers, designers,... people who are hard to hire and hard to retain): 0.1x - 0.25x
  • Everybody else: 0.05x - 0.1x
The multiplier ranges are so you can tune it according to your specific market and how competitive/hard to find certain people it is. Geography also affects what multiplier to use.

Now determine the market cash compensation for these people, not what you're gonna pay them, what they would get paid at a competing or big company. In his example it's a CFO who would make $250K annually (you're paying him $175K but he could make $250K on the market).
You then take that number and multiply it by that person's matching multiplier. In this case he used 0.75 which gets to $187,500 which is the dollar value of the equity that you're gonna give the CFO.

All you need now is to see how many shares you have outstanding, and divide. In his example he used 10 million outstanding shares. So you divide the valuation you came up with by the number of outstanding shares to get the price per share (in his example, $25M/10M=$2.5 per share).
Now just divide the equity dollar value that you calculated for that employee by the share price to get how many shares to grant that person. In this example, $187,500 / $2.5 = 75,000 shares (Fred has a calculation error on the board in the class).

Note that the price per share that the employee actually gets will not be the number you used for this calculation, it will be the 409A valuation which is hopefully much lower than the valuation you came up with (you want your 409A valuation to be as low as possible for tax reasons).

At minute 50:15 there is also a part about retention grants. Fred recommends giving retention stock grants 2 years after hiring so that people have unvested stock that will keep them with the company (otherwise they can just leave with their entire stock pool after the 4 year vesting is up).

The formula he recommends for retention grants is one half of what the sign on grant would be for that employee, if the employee was hired today, every 2 years.

So in the CFO example above, he originally got 75,000 shares. Two years later, the company is now worth $50M (twice as much), so his sign on grant would be 37,500. So his retention grant should be 18,750 shares (half of 37,500), vested over 4 years.

That's it, that's the gist of what you need to know about giving your employees stock so that everybody on board is motivated to make the company a success and compensated accordingly.