For startups, allocating sweat equity is a critical aspect of building a motivated and committed team. Fair and effective equity distribution not only attracts top talent but also aligns employees’ and other contributors’ interests with the company’s long-term success. In this article, we will explore best practices that startups should follow when allocating equity to ensure transparency, motivation, and loyalty among team members.
Determine equity allocation
Founders should carefully consider which type of equity distribution model they want to use, taking into account various factors such as role, seniority, contributions, and time-bound commitment to the company’s success. Common models include:
- Fixed: equity allocated based on predefined percentages or fixed number of shares for each role (care should be taken when speaking in percentages since percentages will change as the startup progresses)
- Dynamic: equity allocated using a formula that considers factors like the role, contribution and performance (The Slicing Pie Method is an example of a dynamic model)
- Milestone-based: equity allocated based on the achievement of specific milestones, such as product development, customer acquisition, or revenue targets
When discussing equity compensation, open and honest communication is key. Many founders and talent don’t understand what they’re getting into when they enter a work-for-equity arrangement and this only leads to problems further along the road when expectations are not met. Founders should be transparent about the company’s valuation, the value of equity grants, and the potential dilution which will result from future funding rounds or share sales. Transparent communication builds trust and ensures that team members understand the rationale behind their equity share.
Account for dilution
Dilution is inevitable and though media portrayal will have us believe dilution is a bad thing, it is in fact a positive sign that the startup is growing. With every funding round or share sale, the team’s shareholding becomes diluted. Understanding the potential dilution and aiming for a strategic ownership percentage post funding rounds can protect founders’ and early stakeholder interests. It is the founder’s duty therefore to manage equity distribution carefully, to ensure that meaningful value can be created for them, the team and sweat equity partners after a liquidity event.
Consider an option pool
An option pool is a reserve of shares set aside to be granted to employees, advisors, and other key stakeholders as part of their equity compensation. By establishing an option pool, startups can offer attractive equity incentives to prospective team members, aligning their interests with the company’s growth and success. The size of the option pool should be carefully determined, taking into account future hiring needs and potential dilution from future funding rounds. A typical option pool size to start with is around 10%, usually created on the first round of investment.
Agree a vesting schedule
A vesting schedule is an agreement in which sweat equity contributors gain ownership of their equity grants over time. In the past, a common vesting schedule for employees was set over four years with a 1 year cliff provision. (The cliff provision ensures that employees must remain with the company for at least one year to receive any equity.) But in more recent years, companies like Lyft and Stripe have been offering one year vesting schedules with a refresh every year. This helps protect the company’s interests while incentivizing employees to commit to the startup’s long-term success. In a sweat equity agreement with third parties who aren’t employees, it may make more sense to vest over milestones or deliverables rather than period of time.
Set up an equity compensation plan
Equity compensation can have tax implications for both the company and employees in the UK. Understanding the tax implications and what schemes are available to you according to your startup stage is best done with legal or financial advisors. The last thing anyone wants is to be hit with an unexpected tax bill, particularly during those initial stages of a startup journey. Some of the more commonly used in the UK are EMI (Enterprise Management Incentives) for employees, and unapproved option scheme which has no tax advantage but enables the company to offer sweat equity to other third parties.
You may also have come across ESOP (Employee Stock Ownership Plan) in your startup endeavours – this is more commonly used in the US. While the principles of equity compensation remain consistent across different regions, the specific terminology and legal framework can vary. Therefore, it’s essential for companies operating in the UK to seek advice from legal and financial experts with expertise in the local regulations and practices related to equity compensation.
As the startup expands and matures, it becomes essential to regularly review and adapt the equity allocation model. This practice ensures that the distribution remains equitable and motivating throughout the startup’s journey. Conducting periodic assessments enables startups to accommodate evolving roles, contributions, and the changing requirements of the business.
Allocating equity is a thrilling and transformative process for startups, igniting team motivation, loyalty, and commitment to success. By embracing best practices in sweat equity, startups can build engaged and motivated workforces and partnerships.
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