Negotiate a Better Startup Equity Package
When joining a startup lots of things go through your head. Among them, the dream of a successful exit for the company you will join. Dreaming creates questions. Questions that need to be answered before deciding to leave your cushy job and lifestyle in order to join a startup. Questions running through your mind may include:
- How do companies assign equity for founders and employees?
- How do companies decide on the mix of equity and salary?
- How do I negotiate a better equity package?
To begin answering these questions, you need to understand how companies acquire and distribute equity.
Company Equity and Option Pools
Companies can decide to get additional stock at any time. To put more stock in the companies coffers the company is required to call a board meeting for consent of the additional stock grants. Upon approval the company now has new stocks available for distribution.
Although a board meeting sounds complex it's not. For an early stage company the founders agree and sign a document their lawyer sends them. Bam! New stocks are now created.
This stock can be given to employees, advisors, or investors. The stock for employees is usually a little different and it is put into an option pool for later distribution. Option pools are, typically, established before financing and are usually set around 10% to 15% of total outstanding stocks. This means that ~15% of the company is reserved for employees.
Distribution of Stock
When the company is incorporated the founders own the company. The amount of stock the founders own is set in the incorporation documents. The founders will never own as much of the company as they do when the company is incorporated. From that point on, their equity gets diluted.
Before receiving a financial investment, the investors will require the company to establish the option pool. The investors can even force the amount the company has to set aside for future employees.
Anyone joining the company will take their equity from this established option pool. As more employees are hired, the available shares in the option pool will dwindle. Again, to replenish the pool the company has a board meeting and stock is set aside.
At this point the investors equity can be diluted. This is why investors like having board seats. Although the company could decide to create stock at any point, it is unlikely. A new option pool is typically established right before the company decides to raise additional financing. Just like earlier, the investors can and will force the company to replenish it's option pool.
A common mistake here is to think dilution means loss in value. This is not true. When stock is being diluted, the fair market value (FMV) of the stock should be going up.
Getting a Better Equity Package
Salary and equity is a very simple economic model. Cash and equity are sliding scales. * The more equity you take the less salary you have. * The more salary you require the less equity you will get.
Startups are cash poor and equity rich. Since there is a massive supply on one side, you should be able to demand more equity by taking less salary. Please don't go into debt in order to get more equity. Having financial debt is not a burden anyone should have.
Also, The earlier you join the company the better equity deal you will receive. You are being rewarded for the higher risk you are taking.
You will also need to determine if you are being given a fair share of equity. Jason Cohen wrote up an awesome post for founders on how to calculate the amount of equity to give new employees. You can use the method presented by Jason's to determine the fairness of your equity package.
Keep in mind, regardless of what you read on TechCrunch, all startup's equity is monopoly money. It is the job of the CEO to persuade you the companies stock is highly valued. Each company values equity differently. In early stage and first founder startups it is common for companies to safeguard and overvalue the FMV of their stock.
Remember when negotiating your equity package until a liquidity event the stock is worth nothing. Take enough cash to be comfortable and take enough equity that you feel you have a financial incentive for the company to do well.
Note: I've used the words usually and typically many times in this post. Keep in mind companies can do whatever they want. Although there is a general guideline how things work, companies are like people and are unique.
Thanks to Evan Peelle for the idea of this post.