How Not to Dry Up Your Equity Pool

Part 2: Priti provides advice to Founders on what to consider when giving away equity

Last year I reached out to my fellow Kellogg MBA and friend Priti Patel about her experience transitioning into the world of startups Post-MBA. In our initial conversation, I asked her about how tech startup candidates should approach the issue of compensation at an early stage company. She told me that a number of her classmates had reached out to her about this subject since it is very different than the compensation structure of your traditional marketing, consulting, or finance role out of college or B-school. So being the opportunistic guy I am, I suggested that I interview Priti on the subject from both the interview candidate and founder perspectives — since she has been on both sides in the last two years.

I originally planned for us to only to speak for about ten minutes but the advice that Priti was providing was so insightful I decided to break the blog post into two different posts. Part I was targeted to all first-time tech startup job seekers. Here on Part II, Priti and I discuss what first-time founders should consider when bringing on new employees! Below is the transcript of our conversation with slight edits for context and clarity.

Earnest Sweat (ES): Seeing it from the perspective of a founder and now as an early employee, what do you think first time founders should consider when bringing on a person and what should the compensation packages look like?

Priti Patel (PP): Oh my gosh, there is so much founders should think about! So a couple of things — this is for actually for both sides. I didn’t mention this on the employee side so I’ll mention here. All founders should just understand that you have to give up equity — you just have to. No one likes a founder who doesn’t bring early stage employees into the cap table. It’s, in my opinion, a little kind of backward in thinking if a founder wants to have all the rewards while sharing all of the risk. And so if we can all agree that you’re going to give away equity, you want to do it in a way that mitigates that risk the most. The risk I’m talking about is the exposure to the cap table. The first thing that a founder must do is get their vesting period right and also think a lot about the cliff. Because startups are this unique animal — personality is huge, culture fit is really important — there is a certain type of person that can really thrive in a startup and that is someone who can deal with ambiguity very well.

Then there are things you don’t really know in an interview and you are just going to hire the wrong people — you’re going to. Just accept that it’s going to happen! And if that’s the case, you do not want to give an employee equity that vests on day one. So usually the typical industry standard is somewhere between six to 12 months cliff. What that means is that your equity is worth nothing until you’ve been with the company at least six months or 12 months. The average cliff depends on where your startup is located. In Chicago, our cliffs are a lot more generous than in San Francisco because there’s more supply for the demand of jobs out there. So it’s an employees’ market here in Chicago. The other thing you want to think about is the vesting period itself. The vesting period means after the cliff, how long does an employee have to be with your startup for their options to fully be worth what you granted. So in the 10,000 options example (in Part I), if you have a 4-year vest after a six-month cliff, then in 54 months after you joined the company your 10,000 shares are actually worth 10,000 shares.

And that is so important. Otherwise, you’re pretty much giving away equity to people who could work for you and run. What your goal should be as a founder is to not give equity to people who are not actively contributing value. The other important issue is employee pools. So the really good way to keep a clean cap table is to figure out — of all of your fully diluted shares as a founder — how much you’re going to allocate to employees in general. This number varies depending on a lot of things. But typically I’ve heard about 15 to 20 percent of your shares can be allocated to split among all of your employees. Then from there you can start to think about what roles you might want to hire for and what is their relative value to each other. For example, the CEO that you want to bring on is going to want a bigger equity grant than an potential analyst. But make sure you have enough to go around so that when you start to hire you are hiring in a way that isn’t going to run your equity pool dry and cause any further dilution to the founders or to the early angels. This is more of a planning point, but it’s one that founders often miss and is really quite easy to do. It’s more like a 20-minute conversation to determine how much equity are we reallocating to our employee pool.

ES: Definitely great advice. It’s essential for founders to just have that conversation because a growing startup can find itself running out of options for your employees. This could cause founders’ ownership to become further diluted on top of the dilution that comes along with outside investors. Any parting advice for founders that you want to share?

PP: I think all founders should never be too proud to ask for help. In every ecosystem, there are so many resources to ask founders who have done it right or learned a lot. Many former and current founders are so willing to give back and share how their experience. One really nice aspect of being in the startup community is all stakeholders know how hard it is to make these decisions. But I often find that many successful entrepreneurs remember that aspect and they stay very involved in the community. I’ve never felt here in Chicago like there wasn’t a wealth of information and people willing to help me. The thing that I had to remember was to ask. For us, we can go back to Kellogg at any time to speak with the professors, who are so willing to help. And if you don’t have that kind of a university community, you should seek out an incubator community that might be in the area you’re living in. The incubator or innovation center will definitely be your best resource because there’re so many nuances to the startup hiring process. I tried to speak as general as possible but there’s always something that is different and you’re going to want to get someone who’s done it before to guide you through the process.

Priti Patel is the Chief Practice Officer at Life Cross Training, human performance program. Priti joined LIFE XT as an acquired hire from her first entrepreneurial endeavor. She founded and operated MindPoint, a mindfulness corporate training program based in Chicago. Priti earned her MBA in Entrepreneurship & Marketing from the Kellogg School of Management.

Earnest Sweat is an Entrepreneurial Engineer for Camelback Ventures and an Investor in Residence for Backstage Capital. If you have any questions or requests please connect with Earnest through LinkedIn, Twitter, or AngelList.

If you liked what you read tap or click “♥︎” to help to promote this piece. #readingEarnest