How Much Equity Should You Give to Employees?

In the early stage of a company, cash and talent are in short supply. In order to attract talent you need cash, to get cash you need to be profitable, to get profitable you need investors, to get investors you need talent… it becomes a circular argument. Attracting talent to your growing organization is always a challenge. One strategy is to offer equity to your employees. It is a great way to both retain existing employees and bring in new talent to your team.

So how much do you give up?

Don Dodge from The Next Big Thing blog suggests the following:

A basic rule is that each level of the organization should get about one half the options as the level above. If a VP level person gets 100,000 shares, then a director level person might get 50,000, and a manager/supervisor might get 25,000 shares. Here are some “average” guidelines for equity percentages at a liquidity event. They start out higher and get diluted down to these levels after multiple rounds of financing (such as the multiple series of funding that is common with angel and venture capital investors)

• CEO – 4%
• VPs – 1% each
• Director level – .5%
• Managers – .25%
• Individuals – .05%

Now, lets do the math for a company that has 100 employees. The VCs will end up with about 60% to 75% of the company depending on how much was raised and how many rounds. Founders and VPs usually have about 10% and employees have about 15%.

The CEO will have 2% to 4% depending on when they joined or if they are a founder. Lets say you have a non-founder CEO and two founders who are VPs; they will account for 6% of the stock. There will probably be 4 other VP level people with 1% each. That is a total of 10% for founders and execs.

You might have five directors with .5% each and ten manager/supervisors with .25% each for a total of 5% equity. Then you have about 75 individual contributors at a variety of levels, but on average they hold .05% each for a total of about 4%. So, founders and execs end up with about 10%, directors and managers get 5%, and individual contributors account for another 5% collectively, for a total of 20% of the company.

Don also mentions an article by Paul Graham of the Y Combinator. Paul sums up the dilemma of equity diluton in one beautiful equation:

1/(1 – n)

He explains:

Whenever you’re trading stock in your company for anything, whether it’s money or an employee or a deal with another company, the test for whether to do it is the same. You should give up n% of your company if what you trade it for improves your average outcome enough that the (100 – n)% you have left is worth more than the whole company was before.

For example, if an investor wants to buy half your company, how much does that investment have to improve your average outcome for you to break even? Obviously it has to double: if you trade half your company for something that more than doubles the company’s average outcome, you’re net ahead. You have half as big a share of something worth more than twice as much.

In the general case, if n is the fraction of the company you’re giving up, the deal is a good one if it makes the company worth more than 1/(1 – n).

So taking Don’s figures of equity percentages we get:

So if you were to offer a Vice President 1% then he or she must add 1.01% to the total worth of the company. Use these figures as a rough rule of thumb on deciding how much equity to give to employees.

How to measure “worth”

This theory is all well and good, but how do you measure the individual contribution to the overall company’s worth. A common approach used in the corporate sector is to provide specific and measurable deliverables. These may include sales targets or technical milestones that must be achieved. Often these targets are linked to further rounds of financing. For example, a VC will only cut the next $1 million cheque in exchange for 20% if you reach a certain technical milestone in 6 months. Assuming you own 100% of the company then if you hit that milestone your share will be worth $4 million ($1 million x 80% ÷ 20%). Assuming the current company worth is $3 million, then you should be looking to give your team up to 25% of your equity (by re-arranging the 1/[1-n] formula), only if you think that team can meet the milestone.

Conclusion

The 1/(1-n) formula is a simple “rule of thumb” that you can use when deciding how much equity to give your employees. Since reading about this technique, I am now using it to guide how much I give my employees (and also how much I ask businesses that I consult with). It acts as a quantitative figure that employees can measure and track their own performance and ask themselves “have I added 1/(1-n) to the worth of the company”?