Pros and Cons of Offering Startup Equity to Employees in 2022

Last updated: October 3, 2022

Finding and hiring top talent to sign on to your new business venture can be challenging as a startup. Many of the best and brightest employees are afraid of taking a risk, especially when some of the biggest companies offer robust benefits packages. Startups aren't usually able to offer market compensation when hiring key employees, essential to growing the company. Money in the early stages isn't always readily available. Funds are more often spent and tied up on product development, research, and marketing efforts.

If you want to give yourself an edge in the increasingly competitive job market, you can consider offering startup equity. Equity can be an appealing way to attract high-performing and qualified employees to help you build your business. Founders who offer equity usually add it to a benefits package in addition to a salary or hourly wage, even if it is low. The equity can be an attractive offer that can end up paying out more depending on the success of the company.

Giving your employees equity is giving them partial ownership of your startup. Essentially your employees will own a small percentage of what your business is worth or valued at. While equity may seem like a great incentive to provide loyal employees, handing over your company equity holds a lot of disadvantages to consider. Read on to learn more about the pros and cons of offering startup equity to employees.

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    What are the Pros of Offering Equity?

    Handing out equity as a startup is usually done well before you go public, meaning what you have to offer has no monetary value. While your stock may not have monetary value just yet, it could be lucrative in the future. It's the potential that truly sells the equity as a benefit.

    You'll have to consider accurate data and predictions as to what your company may be able to achieve in the future when determining how much equity to set aside for future employees. Consider these pros when offering equity as a part of your prospective employee's benefits package.

    You Can Pay Lower Wages

    – Because most of your funding in the initial stages is tied up in growing your business, you won't have a large budget to build your team. Funding will provide a set budget, and you want to make the most of it while hiring high-performing team members. When you offer equity to employees, they are more likely to be willing to take lower pay in exchange for a larger payout if the company is a success. If you can pay lower salaries to your employees, you can hire more people to bring more value to your startup and help increase the chance of success.

    You Can Recruit Top Talent

    – It's a challenge to hire top talent when you're only able to offer salaries lower than the market rate for their qualifications. Offering equity to employees can help incentive people to join at a lower pay rate now in exchange for the potential for a higher payout when your startup becomes successful.

    Offering Equity Increases Retention Rates

    – Founders who utilize equity as a part of compensation packages are able to recruit and retain top talent. Most stock options are paid out through vesting schedules over a set period, usually about four years for the average startup. They usually pay out a certain percentage on the vesting date annually. Employees need to continue employment through their vesting date in order to receive their stock. If an employee leaves before the stock completely vests, they get to keep what has already vested and will lose what has not.

    It Can Boost Employee Engagement

    – When employees are given a small percentage of ownership in your company, they feel responsible for doing everything they can to help it succeed. When given equity benefits, employees are engaged and more on board to help the team reach their goals. They are more collaborative and committed and will work harder as a team. Studies have shown that companies with a higher level of engagement are more likely to succeed.

    What are the Cons of Offering Equity?

    While there are a lot of pros to offering equity to employees, it's important to understand the cons that can come with them.

    You'll Have Less Ownership in Your Company

    – When you set aside equity for your employees, you begin to give away ownership in your company. You only get the ownership back once the employee leaves if the employee leaves the company before the stock options vest. When you hold fewer shares, if your goal is to be acquired, you'll make less during a sale because you own less of the company.

    It's Harder to Find Investors and Buyers

    – Giving away larger portions of your shares means fewer opportunities for buyers or investors to purchase more shares if they want a larger stake. You can set aside an employee equity pool designated to offer only employees to ensure that you don't end up giving too much of your company away.

    Giving Equity to Employees Can Be Complex

    – Whether to employees or investors, giving out equity can be hard to predict in the early stages when you haven't had a long-term valuation. When you are trying to incentivize strategically to get employees to stay by offering equity, the strike price needs to be lower than the market value. If it's higher than the market value, it's a less desirable option. Your employees or people can just buy the stock at a lower price.

    How Much Equity Should You Give to Employees?

    Employees in the early stages of your startup can make the biggest impact. Determining how much equity to give isn't always clear. Choosing the amount of equity, you give employees is a big decision. When determining the amount of equity to give, there is no one size fits all approach. What's right for your startup may not be right for another.

    One common way to offer a fair amount of equity to your employees is to set aside an equity pool designated for employees called an employee stock option pool (ESOP). On average, startups set aside around 5 percent to as much as 20 percent. The pool can be updated as your startup grows and during other funding rounds.

    You have to also decide the type of equity to grant and the vesting period. There are three common options to choose from: stock options, stock warrants, or stock grants.

    • Stock Options – Stock options give employees the option to purchase stock from the founders at a set price. Many founders offer employees stock options at a better rate than investors. With stock options, you need to create a stock option plan. The plan will specify the stock price and the time when employees can exercise their options between the vesting and expiration dates. Most stock options are offered in less than a year.
    • Stock Warrants – Stock warrants are the option to purchase stock from the company at a set price instead of buying directly from you. Warrants are only good for a specific amount of time; after the expiration, they are not worth anything.
    • Stock Grants – Stock grants are given as a defined amount of stock with no vesting or expiration date. The employee can sell the shares whenever. This type of equity is commonly used as compensation used mostly as an incentive to hire new employees in the early stages of the startup. With stock grants, you would issue a number of stocks to vest over a select period of time.

    Determining how much each employee gets as you hire on your team to build your business can vary. Some startups offer equity based on the seniority of their roles, and others offer more equity to early startup employees. While others offer equal amounts regardless of any hierarchy. The equity is pulled from the ESOP and will vest over the selected vesting period.

    Providing equity to your employees can provide you with a valuable way to build a dream team you can be proud of. When you choose to offer equity, carefully consider the amount of your company you're willing to give to attract prospective employees. Consider the pros and cons and create a plan before you move forward to ensure the process goes smoothly and you don't end up giving too much of your company away.

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