Why employee equity is important to your startup
Dealing almost exclusively with first time startup founders, we at Credo tackle the following question with basically each of our CEOs: How much equity should they give to the employees?
During the first conversation with a given founder about employee equity, it is not uncommon for the CEO to fire back with the following question: Why would I give any equity to my employees? When I go on to say that we typically recommend a 15% stock options pool at seed /Series A stage, she rolls her eyes in disbelief. When I try to illustrate that this is still pretty conservative and that U.S. VCs like Fred Wilson or Sam Altman recommend at least 20%, she responds that we are not in the U.S.. When I counter that she will have to compete with those U.S. startups for the best employees and exit opportunities (some CEOs are willing to give away 96% of their company to employees and investors in order to IPO on Nasdaq, such as the rather extreme example of Aaron Levie of Box), she says that can’t happen to a Czech company. And she is right, if she wants to build a Czech company as opposed to a global startup.
Even though we only fund teams with global ambitions, they still have a hard time parting with their equity. Why is that? Some investors say that the size of the employee equity pools is a good proxy for measuring maturity of the startup ecosystem. Silicon Valley founders give out the most to their employees, while the mediocre European community tends to be pretty conservative. And the CEE founders, perhaps still scarred by the 40 years of forced collective socialist ownership, have a particularly hard time parting with their equity.
I am sure that there are plenty of other reasons for this phenomenon, so let’s just say that Noam Wasserman would call many of the European founders kings as opposed to wealth maximizers. While I don’t like Wasserman’s CEO replacement example (we at Credo strongly prefer the founder-CEO as opposed to a hired gun), the rest of the analogy explains well the trade-off between maintaining control and maximizing wealth.
Aside from that trade-off, what are some of the reasons why it might be beneficial for founders to part with their much-loved equity?
Advantages of employee equity
An important advantage of employee equity lies in its attractiveness as a hiring tool: if you are a startup with global ambitions, you have to hire the top talent, which also has global ambitions. These guys don’t get attracted by a hefty salary; they could join a corporation for that. They want to work for the promise that if your startup makes it big, they have a shot at becoming millionaires. This promise is especially important in immature startup ecosystems where employees might not fully understand why would they want to join a small, unproven company as opposed to a well-paying corporation.
Alignment of goals between founders and their employees is another strong benefit. A typical King-CEO worry I hear: it bothers me that my employees are leaving at 5pm and don’t seem to care about the fate of the company. Well, have you tried giving them a part of the equity? Owning even a very small part of the company reinforces the feeling among employees that they are equity holders, an integral part of the team that will participate in the huge gains the company can generate if it is successful. While it may seem like a rather minor change in mindset, that feeling of empowerment can serve as a tremendous boost to your company. Having the right company culture and well-motivated employees is one of the essential factors in any startup’s success.
Sometimes our CEOs tell me they feel an increase in productivity immediately after they implemented the employee equity plan: not only will your employees feel much higher opportunity cost for slacking off, they will also have the urge to work in a way that maximizes the wealth of the company, as opposed to picking problems that are easy or interesting to solve but don’t really add value to the startup.
Right communication is key
“But some of my employees don’t want equity”. Another standard reaction of the CEO. And she is most likely right in some cases. There are two reasons why your employees might not be interested in equity: (i) they prefer hard cash and don’t want to think in the long term, (ii) you haven’t communicated the benefits of the employee equity properly.
When preparing remuneration packages, we encourage our CEOs to prepare multiple alternatives to reflect for different mindsets of your employees: equity heavy with less cash versus more cash and less equity. These packages also reflect the different nature of employees in different departments: sales team might have higher risk (and therefore equity) appetite as opposed to the engineering team. Yet each employee should have a right to choose the fitting mix based on her risk/reward preferences.
I would beware of employees that refuse to take any equity at all: employees with such strong preference for the short term are typically unreliable and might cause more harm than good.
That is unless they are refusing it because you haven’t communicated the advantages of employee equity properly. You will only be able to explain effectively if you understand the concept of employee equity thoroughly and can communicate it in very simple language. Lack of clear understanding of the concept, its costs and benefits is, in my opinion, one of the major reasons why startup founders in our region are so hesitant to work with employee equity.
So I have set myself up to a very ambitious task: I will try to explain the basics of employee equity in the next blog post. Hopefully in a single blog post. It will be a busy two weeks…
Learn more about Credo Ventures or follow me on Twitter.
