One of the biggest challenges for startup founders is attracting and securing the best and brightest talent without burning through the company’s limited cash on hand. This means using forms of compensation beyond salary to entice prospective employees to leave the comfort of their existing jobs to join a startup.
Issuing stock-based compensation can be a powerful tool for founders in this position, but it must be done prudently to avoid any nasty surprises down the road.
Following are three stock-based compensation tips that will enable founders to effectively attract employees, while also aligning their self-interests with the interests of the company’s shareholders and investors:
1. Know what you’re offering. The two most common types of stock-based compensation for private companies are: stock options (both incentive and non-qualified) and restricted stock. Understanding both types is critical before setting this up.
For startups and early-stage companies, stock options provide employees with the opportunity to share directly in the company’s success. A stock option is a right to buy stock in the future at a fixed price (i.e., the fair market value of the stock on the grant date). This can be a powerful employee-retention tool (particularly if the plan is set up so the options are forfeited if an employee leaves the company) because a future liquidity event can give employees a significant upside gain on the options. Options also create incentives for executives and employees to drive the company’s growth and increase its value.
Related: Making Sense Out of Cents: Determining Employee Compensation
Restricted stock is stock that is sold (or granted) and is forfeitable and not transferable until certain conditions are met. The conditions could be time based (like an employee has to stay with the company for at least four years) or performance based, where the employee has to meet specific goals to vest in the stock. If the employee leaves the company before the vesting terms are met, the stock can be forfeited or repurchased by the company.
There are pros and cons to both forms of compensation. Founders should consult with their business advisors to determine which approach will best meet their goals for attracting and retaining top talent.
2. Make smart offers for key talent. Once founders have a good sense of what types of stock incentives they would like to offer, they must decide how much of the company they want to set aside for those stock incentives, and of that pool, how much they’ll need for key hires. They should agree on the size of this pool of stock and have a rough “budget” for how the shares will be used. Founders should exercise discipline in determining the number of shares (usually expressed as a percentage of the company) to issue to new hires, so they can strike a proper balance of achieving their employee recruitment and retention goals while preserving value for existing shareholders.
Related: Is It Ever OK for Founders to Sell Off Their Company Shares?
Determine the right terms for acquiring talent and promoting retention. During employee-incentive discussions, founders need to think about consistency across their organization, consider whether they want to have some employees treated differently and be mindful of what is typical within their market and peer-group.
Founders may encounter stock-compensation-savvy employees demanding their stock incentives on the most favorable terms. For example, employees might ask for vesting acceleration (vesting is the timetable for giving employees the right to keep their equity incentives) on their stock options in the case of a company sale or the employee’s termination.
When employees request this, founders have an opportunity to use accelerated vesting as a bargaining chip. If founders do agree to any accelerated vesting in connection with an employee’s termination, that acceleration should only be given in exchange for the departing employee agreeing to deliver a release of all legal claims against the company.
Stock-based compensation is an effective way to attract top talent and to keep employees motivated and focused. And, like stock-based compensation itself, these three tips can help founders enjoy the upside of this approach to talent acquisition, retention and performance.