Thoughts on sweat equity

Below is a summary of a question and responses I gave regarding sweat equity…

Question: I want to reward 3 grad students for their contributions made in advancing my startup company. I also would like to incentivize them to join the company and ensure they honor IP/NDA confidentiality. Do you have advice regarding offering a small, but not insignificant, equity stake that vests upon completing 1 year of employment as a reward and incentive?

Response:
First, equity in a startup is not liquid, meaning there is no market (and therefore no market value) for it. So, perception is the
key.

That said, I’m sure you’d get ten different answers to this question but here are some of my thoughts.

First, assume success. This will prevent you from overcompensating with equity. For example, if you project a $50 million exit, 1% of the company is a lot of money. Let’s assume someone does work that you think could be done for $25,000 at market rates and they do it for free. Based on the risk and time value of money, maybe their “exit” should be worth 5x by taking equity instead of cash. Therefore, their equity needs to be worth $125,000 at exit. At $50 million, that would be .25%. Based on the stage, your preferences, and the perspective of the person you’re compensating, that “5x” multiple may need to be higher or lower. The point is, try to think in terms of future value instead of percentages because to the person you’re paying, the percentages always sound low…after all, even 9% is a single digit number, while it would equate to $4.5 million in a $50 million exit.

Another thought is to determine which people are going to be core to your team long term. Those individuals should get better treatment. I would treat someone better if I want them around long term, even if the work they are doing now might not merit as much as the next guy. At the root here is motivation and commitment — and more shrewdly, golden handcuffs. Somebody with a healthy equity stake is going to stick with you through the natural ups and downs.

Another thought is to avoid compensating with equity on a “routine” basis as a substitute for cash. For example, if you hire someone on, then can’t pay them for four months, don’t try to translate the dollar value per month into equity. This can get problematic. I don’t recommend taking on a lot of deferred salary as debt either, but that’s another issue.

Another thought: As students, these folks should be flexible especially if you are “reserving a seat” for them once you have cash flow. Compensation is part of the relationship between the company and the individual and therefore the individual’s circumstances and preferences should be considered.

Another thought: your equity strategy is very dependent on whether you plan to take on outside investors. If your cap table gets out of whack before you have involved a qualified lead investor, you’re in for trouble.

Another thought: I would not offer equity to anyone other than a very trusted colleague without an attorney involved, and even then it would only be a very short term understanding. It’s just not good practice.

Another thought: many individuals have inflated expectations about payouts. This is exacerbated by media portrayals of big cash outs and often by entrepreneurs making big promises to the initial team. Depending on your approach, you don’t necessarily need to dampen “dream world” thinking, but ultimately you need to keep your key people on your side and letting them think their payout is going to be way more than realistic puts your relationships at risk.

Another thought: the way you structured your question makes me think these folks have already performed work and now you’re trying to give them some skin in the game for ongoing reasons. That’s great! The other way — where you get somebody amped up about equity up front so they will help you — is risky in my experience. Several times, I have offered substantial equity-only offers from which I got a lot of up front excitement and results, only to have both taper off very quickly when “distractions” got in the way.

Regarding your vesting schedule, a one-year cliff vest strategy is atypical for people you want as employees long term. Advisory board members or similar contributors often get this type of vesting. A 4-year vesting schedule makes more sense for an employee. If you are trying to accelerate vesting for work already completed, you can carve out a larger percentage to vest in the first year. You may also have other reasons for a shorter term. If so, think about layering in triggers that accelerate vesting as opposed to abandoning a more conventional 4-year vesting schedule.

Finally, specifically regarding IP, everyone should sign ownership agreements, including you, such that the company owns all IP. That’s regardless of any equity or confidentiality issues.

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