The Right Way to Grant Equity to Your Employees
Andy Rachleff is President and CEO of Wealthfront, a software-based financial advisor. Prior to Wealthfront, Rachleff co-founded and was general partner of Benchmark Capital. He also teaches courses on technology entrepreneurship at Stanford Graduate School of Business. Follow him on Twitter @arachleff.
“The defining difference between Silicon Valley companies and almost every other industry in the U.S. is the virtually universal practice among tech companies of distributing meaningful equity (usually in the form of stock options) to ordinary employees. Before companies like Fairchild and Hewlett-Packard began the practice fifty years ago, distributing stock options to anyone other than top management was virtually unheard of. But the engineering tradition that spawned Silicon Valley was much more egalitarian than traditional corporate culture.”
The equity culture among young technology companies is almost universal. When implemented properly, broad employee ownership within a company can:
- Align the risk and reward of employees betting on an unproven company.
- Reward long-term value creation and thinking by employees.
- Encourage employees to think about the company’s holistic success.
Unfortunately, despite decades of experience building new hire option plans, many startups still fail to put in place an equity compensation plan that adequately rewards long term employees over time.
When I was a venture capitalist, I noticed companies that seldom lost employees due to recruitment had a lot in common. Sure they offered challenging and inspiring work environments sought by top-tier talent. But you might be surprised to learn they all rewarded outstanding performance through the issuance of additional stock options (or as is now the case, RSUs) in a similar way.
The Wealthfront Equity Plan
Based on my observations, I created an equity allocation plan that I encouraged all my portfolios to adopt. It worked so well that executives and my fellow board members usually brought my plan with them when they got involved with other companies. Over the years, I am proud to say that hundreds of companies, including Equinix, Juniper Networks and Opsware, adopted this plan because it just made sense.
Not surprisingly, we’ve put this plan in place at Wealthfront.
How It Works
The Wealthfront Equity Plan is designed to specifically handle the four most important cases for granting equity to employees. Each year, you create a new option pool that addresses the following needs:
- New Hires: These grants are used to hire new employees at market levels.
- Promotion: These grants are intended to reward employees who have been promoted. Promotion grants should bring the recipient up to the level you would hire her at today for her new position.
- Outstanding Performance: These grants, made once each year, are only intended for your top 10% to 20% of employees who truly distinguished themselves on the basis of amazing accomplishments over the past year. Individual performance grants should represent 50% of what you would hire that person at for their position today. This pool should be reserved for non-executives.
- Evergreen: These grants, which are appropriate for all employees, start at an employee’s 2½-year anniversary and continue every year thereafter. The idea is you don’t want to wait until the employee’s initial grant has been fully vested to give a new grant because by that time the employee will evaluate new opportunities. Annual evergreen grants should equal 25% of what that employee would receive if she were hired for her same position today. Giving 25% of the market rate for a position each year, rather than a lump sum grant that covers the next four years, will smooth out the vesting process so the employee never reaches a cliff. As I said before, cliffs cause people to raise their heads to consider alternatives and should be avoided at all costs.
The Key: Consistent, Early Evergreen Grants
Most companies put considerable effort into the size of their equity grants for new hires. It’s rare these days to find new hires that haven’t used a tool, like the Wealthfront Start-Up Salary & Equity Compensation Tool, to determine the appropriate amount of salary & equity to expect for a given position.
Fewer companies, especially young ones, put significant effort into thinking about follow-on grants. If you tell your employees to “think like an owner,” then you need to consistently align equity with their contribution to the success of the company.
Evergreen grants are the most common area where technology startups fail to invest time until far too late in their development.
The average tenure for most technology employees is two to three years, and waiting until your first employees hit year four is just too late.
Instead of an ad-hoc process, the Wealthfront Equity Plan offers a transparent, consistent and fair program of equity grants that employees can build into their long-term expectations. As a result, not only do you avoid cliffs, but you also tie both long-term tenure and contribution to their ownership stake. The best part is that, as your company grows, you always grant stock in proportion to what is fair today rather than in proportion to their original grant.
What About Dilution?
Based on our calculations, the Wealthfront Equity Plan should result in approximately 3.5% to 5% annual dilution assuming no executives need to be hired. (Please see our Slideshare presentation for the details of how to allocate stock for a 50-person private company). As a point of reference, most public technology companies increase their option pools by 4% to 5% per year, so the proposed dilution is well within the reasonable range.
The Wealthfront Equity Plan might result in 0.5% to 1% extra annual dilution relative to less generous plans. One way to think about the trade-off is to ask yourself, if you’re a stockholder, would you rather be assured of retaining a much higher percentage of your key employees and own 97% of what you would have owned without the Wealthfront plan over your four-year vesting period (4x the mid-point of 0.5% to 1%), or deal with the risk of losing valued team members and not suffer the additional dilution? I would take the extra dilution 11 times out of 10.
That being said, there are a number of board directors who think that is too much dilution for a company to absorb. A few months ago, a fellow I recruited as CEO to two of my Benchmark portfolio companies told me he never appreciated the value of the Wealthfront Equity Plan until he joined a board where the board members were too cheap to do the right thing for their employees. Needless to say, he implemented the Wealthfront Equity Plan when he started his own company.
Investors and employees make much more money by increasing the size of the pie rather than their share of the pie. The only reason not to implement the Wealthfront Equity Plan is greed, and greed seldom leads to a good outcome.
An Equity Plan that Works for Employers & Employees
One final observation about companies that successfully retain employees: They usually create a culture that treats options as something dear that aren't offered as an alternative to a cash bonus. They encourage employees to think about increasing the value of their options through accomplishment rather than asking for more upon completion of a task. It has been my experience that companies granting options for completion of milestones seldom build a culture that values equity — and therefore suffer greater turnover.
A well-designed equity allocation plan works for both the employer and the employees. The Wealthfront Equity Plan creates a tremendous incentive for people to stay at a company without costing the employer too much. That’s the kind of win-win to which we should all aspire.
Read These Next
80% of Your Culture is Your Founder
When Molly Graham joined Facebook in 2008, the company still felt scrappy. With 400 employees serving 80 million users, people were so busy “moving fast and breaking things” that the culture still needed to be defined. Graham was hired to help make this happen — to not only tell the company’s story externally, but to build a shared vision and identity as it grew from 400 to thousands of employees. She started by asking two questions: 1) Who do we want to be when we grow up? 2) How do we talk to people outside about what it’s like to work at Facebook? Since then, these two questions have formed the foundation of Facebook’s culture discussions. Most notably, they resulted in the “hacker” identity that has distinguished the company as a technology powerhouse that is always experimenting to bring the world closer together. At First Round’s recent CEO Summit, Graham, who managed Culture and Employment Branding at the company for two years — and who now runs business operations for slick, modern word processor Quip — talked about what startup founders have to gain from defining culture early and often, and how to do this when there are dozens of competing priorities.
Here’s Why You’re Not Hiring the Best and the Brightest
What’s the most consistent piece of advice you get as a startup? Always hire the best people. Never compromise in your hiring standards, no matter how big your company gets. And it’s true. A great team can take an okay idea and transform it into an incredible, world-beating product. But something has always bugged me about this advice. There’s an elephant in the room in the form of an implied clause: Always hire the best people… who are willing to live in San Francisco. Substitute Mountain View, New York, Boston, Chicago, or any other city. The problem is the same. We pay lip service to the idea of hiring the best people in the world — but in reality, we’re only hiring the best people who happen to be close by. Call me crazy, but I think if we’re going to talk about hiring the best talent available, we should actually try to do that. This means letting go of the idea, at least in IT work, that people need to be physically present for any meaningful work to occur. There’s a better way.
About 10 years ago, after joining Netscape as its youngest employee, Angus Davis learned how to fly airplanes. Along the way, he grew the company he co-founded — voice recognition startup Tellme — into an $800 million business bought by Microsoft, and became the founder and CEO of payment company Swipely. Recently, he sent an email to his company recounting some of his most important and relevant lessons from flying to help guide them in their approach to the business and their careers. After reading it, we thought it should be shared with even more people in the startup community. Davis generously agreed to adapt and re-publish it here.