In the previous installments of our executive compensation series for VC-backed companies, we covered the fundamentals, common mistakes, and best practices. In this article, we’ll take a closer look at designing affordable equity awards that attract and motivate the leaders your startup needs to grow.
Why Is Executive Equity Compensation So Important?
Equity is partial ownership of a company, usually in the form of stocks or other securities. Executives are typically granted equity when they join a company and then regularly afterward to keep them motivated and committed, tying their performance directly to company success. Equity awards are often earned, or “vest,” over a set timeframe.
At early-stage companies, equity awards are commonly thought of in terms of a percentage of the company. A useful analogy is to think of company ownership as a pie. Initially, founders own 100% of the pie. Over time, they give away pieces to investors and employees to fund the business and incentivize employees to join and stay.
At a smaller company, you generally get a bigger piece of the pie because it’s riskier and has less inherent value upfront. On the other hand, when you join a large and established company like Amazon, your slice may be small, but it still holds significant value because of the company’s overall worth.
Equity Distribution Metrics to Track
The equity pool represents the total number of shares set aside by a company to award executives, employees, and others who contribute to its success. Understanding how to distribute equity from this pool is key.
As shares are awarded, the equity pool shrinks. However, it gets replenished during specific situations, such as when employees leave before their shares have vested, don’t exercise them, or after a new round of funding.
After a new round of funding, all shareholders are diluted, and the company works from a new go-forward business plan. More equity is added to the pool to recognize the dilution for current employees and to fund future hiring.
When granting equity, there are two important things to monitor and consider:
- Burn rate: How quickly a company is using its equity.
- Overhang: The amount of equity that’s been granted or reserved for future grants. It’s a critical measure of future dilution and key for investors who trade cash for ownership stakes.
Companies should track these metrics closely, benchmark them against competitive market data, and ensure they stay within market norms.
Typically, the total equity allocated to staff and reserved for future grants ranges from 10% to 25% of the company, with the annual burn rate generally under 5%, unless there’s been a large dilutive round or significant hiring push.
Common Equity Vehicles
There are different types of equity, or equity vehicles, but the ones most used by VC-backed companies are stock options and restricted stock units (RSU).
Stock options give employees the right to purchase company stock at a predetermined price, typically below market value, after a certain period. They’re usually granted by earlier stage, growth-oriented companies aiming to conserve cash. Stock options require an increase in company valuation to be valuable.
RSUs are shares of company stock given to employees outright. Employees don’t need to purchase them and can cash them in after a specified time.
RSUs are more common at later stage or public companies, where there’s a more tangible company value, so awards are more often based on target value rather than a percentage of ownership. Also, they’re less risky than stock options because they can’t go “underwater” and become worthless.
Typically, companies should start thinking about moving from stock options to RSUs when one of the following happens:
- They reach about a $1 billion valuation
- Their 409A valuation and preferred prices begin to converge
- Have share pool or dilution restrictions
- Move close to IPO
Balancing Cash and Equity
How a company implements equity compensation depends on its stage, company structure, and goals. Over time, companies may start granting different equity vehicles and adjusting the cash-to-equity mix as they mature and evolve their total rewards strategy.
While equity awards vary by company, every company needs a plan. The first things to think about when planning are benchmarking and compensation philosophy.
Benchmarking and data sources
To design competitive and attractive equity awards, benchmark against relevant market data to understand what competitors are paying.
Data can come from two different types of sources:
- Traditional vendors use a manual submission process with a lengthy QA review. They have a high participation rate among larger, established, and public companies. Jobs are defined at a very granular level, which suits more mature companies with well-defined roles.
- Live vendors offer data submitted in real time through various software integrations, typically with AI job mapping. There’s usually high participation from startups and SMBs. And jobs are defined largely by function, which is more suitable for early-stage companies where employees wear multiple hats.
Compensation philosophy
A compensation philosophy is the set of guiding principles that govern how a company pays and rewards its employees. It explains how a company will define competitive market data and how they will pay relative to that data. Lag, match, or lead? It also defines how that may differ by different elements such as level, location, function, or other factors.
For employers, a comp philosophy is a north star for all pay-related decisions. For executives, it shows that a company has a strategy for pay and informs them on what the company values and rewards.
Personalization
Executive equity also considers an individual’s experience and expectations. Equity must balance their needs and wants with company objectives, market data, philosophy, and internal equity with other executives.
Common Strategies Through Growth Stages
In this section, we’ll explore how compensation strategies often evolve through early-stage to later-stage growth, focusing on key adjustments and considerations.
Early stage: Pre-seed, Seed, Series A
Companies in this stage lean more toward equity to conserve cash. They’re selling the upside, and executive are often willing to take a pay cut on cash for more equity — and the potential for wealth in the future.
Benchmarking and equity awards are based on percentage of ownership and are compared to companies with similar valuation or invested capital. At this stage, value is volatile, unknown, and the exit is far away.
The messy middle: Series B to Series D
As your company approaches a $500 million or more valuation — but not quite $1 billion — the path is becoming clearer, but there’s still growth ahead.
You’re competing for talent with earlier-stage companies that have big dreams and rosy outlooks, as well as more mature companies that can offer more defined value in cash and equity.
At this stage, you can get more specific with market data. For example, instead of looking at tech in general, you can focus on software specifically. You’re also thinking about your valuation, invested capital, headcount, revenue, or anything unique about your company to define competitors within your benchmark data of choice.
Later stage: Series D to $1B+
As we mentioned earlier, at the $1 billion mark, consider switching from stock options to RSUs, depending on your cap table mechanics and growth plans.
Awards should focus on value delivery at current and future growth valuations, benchmarked against value delivery in the market and companies of a similar size and scale to ensure an apples-to-apples comparison.
Begin restricting eligibility below the executive level and move toward an annual review process and a more standardized approach across the executive team.
Equity Refresh Grants
Equity refresh grants are additional equity grants awarded to existing employees. They’re considered rewards for performance or tenure and are incentives to stay at a company.
At early-stage companies, refreshes often occur after a milestone, such as another round of funding, or after an employee hits a vesting percentage or threshold (such as 75% vested). Companies can review equity ownership and close market gaps or grant standardized award sizes based on the relationships between new hire and refresh equity. As companies mature, refreshes become part of an annual performance cycle, with amounts based on competitive data, philosophy, and performance.
Strategic Equity Planning
As your startup grows, the ways you structure executive equity compensation play a key part in sustaining momentum. Tailoring your equity strategy to each stage of growth ensures you attract, motivate, and keep the leaders who will drive your company’s success.
For strategies for refresh grants, stay tuned for the next article in our series. And if you want to catch up:
- Executive Compensation 101: Fundamentals for Planning
- Executive Compensation 101: Common Mistakes & Best Practices
- Executive Compensation 101: Equity Refresh Grants
How Sequoia Can Help
Whether you’re starting from scratch or need to update your plan to keep pace with growth, Sequoia advisors can help you navigate the nuances of equity and executive compensation. Connect with an experienced Sequoia advisor.
