How to think about Cash vs. Equity Compensation

It’s among the most-asked questions on startup forums, and an issue we’re dealing with right now at WPEngine as we bring on new employees:

How do you decide how much equity (shares) to give a new employee or partner? Especially when the company is young and according to typical financial assessment the shares are “worth nothing?”

The question is further complicated when the new hire is getting a salary. Typically the salary is less than market with the balance given in the form of equity, but again how do you compute that when the stock is, today, of no value?

With WPEngine recently I had yet another question to answer: “What if I took $X/mo salary, then how much equity would you part with? What about $Y/mo?” Hard to know, but an important question for a bootstrap startup to answer!

Here’s a simple framework for how to come up with those numbers.

When someone works for less salary than they deserve (meaning: what they could make elsewhere), I think of that as a cash investment they’re making in your company.

Here’s why: Suppose a new hire just quit a job paying $10,000/month and agrees to take $3,000/month for a year with you, after which time (assuming the company does as well as everyone hopes) she’ll be raised back up to $10,000/month. So for $36,000 you’re getting someone who should have made $120,000. She gave up $84,000 in potential earnings, but that’s what a startup is, sacrificing cash now for a chance at a ton of cash later. Of course she needs to own P% of the company so she can share in those potential earnings, but how do you compute P?

Now consider this scenario: That same new hire quit her old job but demands the same $10,000/mo from you. You agree, but since you can spend only $36,000 this year, you raise the balance ($84,000) as an angel investment. The angel will of course demand Q% of your company for this extremely risky loan, but how do you compute Q?

Financially, these two scenarios are identical, therefore P must equal Q. In both cases you give up a percentage of your company so that you can spend a specific amount of cash to get a specific person. Whether it’s the hire herself who’s investing her loss in cash or an angel fronting the cash, you’re trading P% of the company for an amount of cash.

This is the key, because Q — what an institutional investor would accept — is a well-understood system. So if that’s the same as P, we’re done. So what kind of return does an angel investor need to make on their $84,000?

Investors in early-stage startups need large potential returns to compensate for the fact that most of those investments will never return. If you like thinking about this in terms of “annual return,” they need between 40% and 60% compounding annual return. (Remember, this isn’t like a bond or savings account paying X% every month, this is a one-time payout years from now that almost surely won’t happen at all!)

Usually this is stated as a rule of thumb: “3x return in 3 years, or 10x return in 5 years.” That formulation rings true to almost every investor I’ve met, from angels to VCs.

So let’s apply it to our example. If the company were sold in three years the investor would like to make $250,000; if sold in five years the investor needs $840,000.

Now the question is: How much money could the company be worth in three or five years? Clearly you’re about to pull a number out of your ass, but that’s OK because we’re just going for ballpark figures. In the case of WPEngine, I’ve been saying $5m in three years or $25m in five years.

To make $250,000 out of $5m the investor would need 5%; to make $840,000 from $25m the investor needs 3%. Of course the numbers don’t match because, again, I pulled those potential valuations out of nowhere.

But the exercise has proved fruitful because now you know that this new hire needs something like 3%-5% for this to be a fair trade. That’s a much tighter range than you had before you started reading this article!

Remember, though, that when you’re very small new hires should mean more to you than just financial investment! This might be a good method for computing compensation for employee #10, but hire #1 ought to also be able to substantially affect your chance of success, by changing the slope on the revenue curve, by adding expertise or skill you didn’t have before, by opening new markets, etc..

And if that’s happening, they’re contributing more than just the balance of a normal salary, they’re changing the risk profile of the company, and that deserves compensation too.

Let’s continue this discussion in the comments! What other techniques do you like? How do you deal with the intangible value that a person is bringing over and above the financial?

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  • http://twitter.com/martinbarry Martin Barry

    “Financially, these two scenarios are identical, therefore P must equal Q.”

    Are they? Just because the dollar values are equivalent, does that mean the share percentages are also the same?

    An investor can place bets on a number of startups simultaneously and hence spread their risk around.

    An employee only has 24 hours in a day and can usually only devote themselves to a single startup.

    Does the inability of the employee to spread their risk around mean they should be offered a higher potential payout if things work out for the company? i.e. P > Q because ‘risk taken by employee’ > ‘risk taken by investor’.

    • http://blog.asmartbear.com Jason Cohen

      You’re conflating the risk-logic of the “investor” with that of the founder. They’re separate questions.

      It’s up to the investor to decide whether it’s worthwhile, and it’s not just a matter of money. An investor might take higher risks in markets he’s familiar with. A person might take higher risks to be part of a company he believes in, or to learn.

      You also missed a point brought up by another commenter — that the investor puts up 100% of the cash immediately whereas the employee metes it out paycheck by paycheck and furthermore can decide to stop any time. This represents MUCH LESS risk by the employee both in time-value-of-money and the ability to “cancel.”

      In the end, with any individual case there’s always lots of factors. This is simply a framework to get a “Default” or a ballpark.

      • Zebediah

        Use Convertible Debt/Notes:
        1. Create a pool of convertible debt for employees
        2. Add new debt to the pool to compensate for salary owed each quarter
        3. Apply a different conversion premium to debt accrued on the basis of time value of money.

        For example:
        If the span of time between the creation of a new position and a liquidity event is 2 years, then cash at Q1 is valued at the maximum premium P%, At Q4 it’s .5P% and at Q8 no premium is applied because you are effectively investing in that actual round.

        To deal with the compensation for DNA influence, you can offer a smaller up-front equity stake.

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  • Matt Richards

    Martin makes a very good point, but there may be other non-monetary factors at the startup that help compensate for the $120,000 wage slave position: learning new skills, doing a startup with Jason, flexible hours (work any 23 you want!), work from home, …

  • http://twitter.com/jim_shook Jim Shook

    Definitely a good framework for beginning the discussion. Now you should do a post on how to value a very early stage startup, bc it does seem that the calc relies heavily on that assumption.

    Also, I second Martin’s comment, and though you alluded to it, it deserves repeating, that many times the cash value of an employee’s contribution can be worth far more than the cash value of just cash from an investor. (ie P > Q)

  • Ivo

    How many actual employees out there are willing to take the same risks as a VC firm? As you noted, “this is a one-time payout years from now that almost surely won’t happen at all!”. That’s almost cruel to the employee!

    • http://blog.asmartbear.com Jason Cohen

      How is it cruel? Is the founder not taking the identical risk?


      Jason Cohen
      http://blog.ASmartBear.com
      @asmartbear

      • Ross Patterson

        Yes, the founder is taking a similar risk. And how many founders do you know who expect to exit with 3-5% of their company? “But … but … but …”, the founder sputters, “it was my idea, I raised the seed capital, I found the initial key hires, …”. Still, from a purely mathematical, financial perspective, everyone’s value has the same basis.

        • http://blog.asmartbear.com Jason Cohen

          Not true. Joining a company that’s already started, had some derisking, has some revenue, perhaps some initial funding, is vastly less risky than starting it.

          Also if the employee wants to work for free, that deserves a disproportionate amount of stock.


          Jason Cohen
          http://blog.ASmartBear.com
          @asmartbear

  • http://twitter.com/atxengineer Matthew Thomas

    I appreciate the methodology you’ve taken here, but I do think there is a little more to the P = Q assertion. Martin certainly raised good points, but also there is a time based element to the risk.

    An investor is going to cut you a check today and you’ll have immediate access to that $84k. As your company progresses, the investor (and you) are hoping to see the risk of your firm decrease over time with your execution and success. The investor received a premium in the form of ownership because she is giving up a large sum of money now and assuming a good amount of risk by investing in such an early stage of the company. The employee, however, is hedging risk by only making time-based, regular “investments” in the form of forgoing compensation each month which she can stop by quitting and taking on another job. In other words, your employee is investing $7k a month for 12 months as opposed to $84k today.

    Based on this, Q should be greater than P as a result of the time based nature of the investments and when that risk is assumed over time. All that said, you could argue that the risk spread between these investments is closed somewhat when your investor has a board / management seat whereas the employee does not have that level of influence over the direction of the company.

    Though everyone’s situation is going to be unique, thinking through these considerations using a framework like this is very beneficial.

    • http://www.victusspiritus.com/ Mark Essel

      vesting nullifies this difference

  • http://trackjumper.com Damon Cali

    I’ve always thought equity was worth more to founders than to employees. Employees usually don’t have enough visibility to value it correctly, and have a giant additional risk layered on top in the form of vesting. Investor’s shares don’t vest on a 4/1 schedule – they get them all at once. Then, throw on top that the employee is not diversifying their investment by investing in several companies. So the investor comparison isn’t quite fair. Employees take much more risk with their money, and by that rationale deserve much larger stakes, which they don’t generally get in practice.

    • http://blog.asmartbear.com Jason Cohen

      Investors don’t vest because they put all their money in at once.

      An employee “invests” over time, so vesting is just the right way to compensate for that.

      An employe can leave after three months and obviously shouldn’t be compensated as if he were there for years; investors cannot remove their dollars.


      Jason Cohen
      http://blog.ASmartBear.com
      @asmartbear

      • http://trackjumper.com Damon Cali

        True. But what do you suppose is the reason that the marketplace typically delivers far less in the way of equity to employees than your (rational) analysis might show?

        You’re suggesting that the annual salary deficit equivalent in equity should be granted each year, and fully vest over the course of that year. In my experience, you’ll get a small fraction of that, once (at hiring), and it will vetst over 4 years with a 1 year cliff.

        And to add insult to injury, you’ll get hit with a tax bill (in addition to a potentially non-trivial strike price) when you exercise your options despite that there have been nothing but paper gains in the company’s value. *If* the employee sees any cash from those options, it could very well be years away. Not much help when the tax man comes calling. That’s just more risk that employees take on in order to receive equity.

        I think the way you do – employees are much like investors and their options/equity can be valued in a similar way. But I just don’t see the market working that way. If anything, employee equity is taking more risk than investor equity, and yet they receive less of it for their money.

        • http://blog.asmartbear.com Jason Cohen

          The tax comment is just untrue. There’s no IRS hit for options — that’s why you issue options and not stock.

          I don’t understand why you keep saying that employee equity is somehow “more risky” than investor equity. You put up less money up front, you have more visibility into the risks as they change over time, and you have a work environment more interesting and valuable than almost anywhere else.

          It’s true that some forms of equity are terrible for employees, especially once you get into VC-style financing with preference and other ways to screw common shareholders. That’s equally damaging to founders and I think it’s a awful thing to do, period. But that’s to do with those funding terms, not with the general concept of having a proper share in a company.

          Cheers,
          Jason

          http://blog.ASmartBear.com
          @asmartbear

          • http://ninthyard.com Damon Cali

            Exercising options is not always a tax-free event. I’m not fully qualified to lay it out here, but there are non-trivial cases where the spread between the strike price and the market value is treated as income. That can really hurt.

            There are a few main reasons employees take more risk in practice – they rarely have the information they need to evaluate equity grants, they are usually burdened by vesting cliffs, and will be very unlikely to have a position large enough to influence the governance of the entity. I’ll concede I’m probably splitting hairs here.

            And yes – the sources of funding color the discussion tremendously – a very good point to make.

            • http://blog.asmartbear.com Jason Cohen

              No, the difference between strike price and execution is always taxable, just as receiving stock is taxable immediately (which is actually worse for the investor) and when that stock is eventually worth something it’s taxable. You implied that someone employees got “screwed” there, but I don’t see how.

              The reasons you state that it’s “more risk” is not, in fact risk. And in my experience employees absolutely have more influence over the governance and direction of the company than investors because they’re present every day and because, if they’re valuable, their happiness is critical as well.

              All your objections make lots of sense with VC-funded deals but not in deals which are bootstrapped or angel. I think that’s the source of the disconnect, and that’s a very good point which probably should have been in the article as well.

              Cheers,
              Jason

              http://blog.ASmartBear.com
              @asmartbear

  • http://www.fitterhappierproductive.com Darren Beattie

    I think that compensation is only part of the equation for the employee. The investor may be interested in the process and other aspects of the business developing, but the investment is made with dollars to return dollars in the majority of investments. That is simply the goal. A goal probably not shared by the employee.

    People get bored sometimes, the idea of working on something new and exciting presents renewed sense of passion for whatever their work skill is. The opportunity to work on something that brings a sense of purpose or accomplishment can often be worth it for many people to take an earnings decrease, especially if it’s ‘only for a year.’ Some may like the challenge of a new company, perhaps a new line of work, they may enjoy the process of working their way up the corporate ladder. Others still, simply enjoy calculated risk (serial entrepreneurs anyone?) and it’s a thrill to think of a potential pay-out with a project you’ve been sold into believing strongly in.

    It could be a big opportunity to work with someone you’ve always wanted to work with. Perhaps you are there to learn from the entire team or simply learn from a mentor in the business. You could even go there because the problem the company is trying to solve is near and dear to your heart, you have vested interest in the problem.

    The majority of entrepreneurs I’ve talked with over the years all seem to have motives far beyond just money (though that certainly plays some role). It’s the thrill, or the game, or the risk involved, the experience, the challenge, the pay-off, it suits their lifestyle, some want to make a difference in society, etc… I believe that to a certain extent these factors can play a role for employees as well.

  • http://viracct.blogspot.com/ Anuja K

    In such scenarios the equity is given at once(while joining) or over the period of years say 5% divided by 3 (years) given on every anniversary of company?

    • http://blog.asmartbear.com Jason Cohen

      There’s different techniques, but yes you always have some sort of “vesting” meaning you get the equity over time. That way you don’t get 3% of the company and then immediately leave, thereby clearly not earning it. (Unlike an investor who fronts the money immediately and therefore DOES earn it.)

      Common is to split into equal pieces over 4 years. Also common is for it to be continuous but with a “1 year cliff” meaning nothing for the first year, then 25% after one year (i.e. “catching you up,”) then continuous after that.

      Also common is “all or nothing,” wherein there’s no vesting period, but if you leave the company you get nothing at all. The tradeoff there is that if the company is sold in only 2 years you get all your stock (not just 50% vested), but if you work for 4 years and leave and the company is sold after that you get nothing even though clearly you substantially helped get the company there.

  • jeteye

    Nice job Jason explaining it terms everyone can understand…great reference for those who think they should get 20% for doing little or nothing…what I like to call wedgies…

  • Greg

    While the exercise is interesting, 3%-5% stakes for lower level hires is simply unsustainble in this context, perhaps even disingenuous. Are you continuing the exercise through, showing what’s going to happen to that stake after a couple of rounds of financing? The word “poof!” comes to mind.

    While it may seem a bit unfair, there is great value in taking the risk, taking the leap and no matter how much “work” the later hires do or how much value they bring, the rewards go to the founders for taking the initiative and risk by actually doing it.

    • http://blog.asmartbear.com Jason Cohen

      Your math is wrong. If you take additional financing, the value of the company should increase by more than the dilution amount, in which case although as a *percentage* the employee’s stake decreases, the value should increase.

      Of course it doesn’t always work that way, and depending on the terms of the investment the common shares might indeed become worthless, but that’s true of any company you’re with. That’s just life in VC-land, and if you — understandably! — don’t like it, don’t do it.

      However you’re correct in that in my head I had in mind a bootstrapped or angel-only company.

      • Greg

        I guess my cynicism shines through a little too brightly. Yes it should increase more, but I just haven’t seen it play out that way too often. Color me jaded.

        I couldn’t agree more about life in VC-land, the money makes the rules and the rules always favor the house. Swim at your own peril.

        My point was really that the odds of a devloper or designer having any notion of what a cap table is and the possible variance in outcomes is close to nil, so the value proposition of a 3%-5% stake would seem concrete, when in fact, it’s rather tenuous and that expectation might prove painful down the road.

        Personally, I think it’s amazing that you’d share so much of the company and that your concern for fainess is so prominent.

  • Anonymous

    This is a great discussion and close to my heart.
    We have “hired” over 15 engineers, PM-equivalent and advisers for equity only – no salary.

    In all the cases, the individuals joined the company for different reasons, some below:
    1. To work in a startup and make a difference (compared to being a cog at 300K+ employee company)
    2. To gain real experience that wouldn’t have been gained elsewhere
    3. Flexibility of work and fun at work
    4. Make millions in year 5 ;-)

    Options vest every month. Option pricing and break up were done professionally by a lawyer (who got cash :)

    Options are based on what team members contribute to the product and team. Amount of options is not very large, about 1-2% of total equity. We never consider the salary being lost. For example, there is no way we will be able to compensate an Oracle consultant at market rate.

    If you are offering salary + equity, the equity has to be based on a substantial discount to market rate. If the market salary is $120K, then equity calculations have to assume a startup salary of $70K or lower.

    So far, no one has had problems with our formula and calculations. Team members refer their friends and family to join us – ultimate measure of satisfaction.

    There are individuals who want 5% equity for their salary lost. They don’t join our team.

    At a startup, you have to get your mind right. Don’t do it for the money. Do it for the experience, do it for fun, do it because you can make a difference.

    Abhi

    • Sammy

      do it so the CEO can make millions?
      I believe in this formula as long as the percentages are equal to the time frame they started, time invested and risk involved.

  • Al

    Jason, saw you at Webstock, thought you rocked. Thanks for making the trip out to NZ.

    I’m going through this very process at the moment so your post is timely. I’m not massively motivated by money (or so I thought) but I am interested in learning as much as I can about the mechanics of taking equity instead of salary.

    Echoing one of the posts above I think the key issue for me was how I valued the co. and got comfortable with the price I was being offered options at when earnings are zero, and when the size of the option pool is still uncertain. This feels more art than science in these early stages.

    I’ve also factored in my gut. I figure I’m actually pretty excited to be about to do something new and different again, and that should count for something. Lots of variables no doubt.

    Interesting discussion – thanks for your thoughts.

    • http://blog.asmartbear.com Jason Cohen

      I loved New Zealand and Webstock was amazing!

      It’s true in the end that to make real money you need to be a founder, but money is surely not the only concern, not necessarily the most important.


      Jason Cohen
      http://blog.ASmartBear.com
      @asmartbear

  • Ivo

    So I’ve been reading the comments for a while, and I have one beef with the premise of the whole discussion. Regardless of whether it makes sense for an employee to work for equity in lieu of salary, nobody asked the question if that employee can actually afford it.

    Let’s take the example of reducing a salary of 120k to 38k with the upside of making $600k in a few years. Even if that proposition looks advantageous, I simply do not have the funds to feed me and my family in my current standard of living off of just $38k per year, no matter the upshot.

    • http://www.victusspiritus.com/ Mark Essel

      Totally agree with the premise and thinking in Jason’s post. But I like the risk profile of founders much better than employees.

      The rewards are nice in a win for employees, but if your going to give up a steady paycheck (impinging on your family’s standard of living) for the outside chance of success, why not go all the way. Founders will often draw a salary in funded startups so their risk profile converges with early employees, the key being they brought the company to a fundable or revenue growth stage (still magic in my eyes).

      • http://blog.asmartbear.com Jason Cohen

        The answer to “why not go all the way” is because the risk is *significantly* greater for founders. Employees don’t come until much of the financial risk is eliminated, either through revenues (healthy business) or funding (guaranteed runway).

        • http://www.victusspiritus.com/ Mark Essel

          Going without a paycheck for potentially a couple of years is a serious risk, no arguments, but at the end of that period you have nothing, or influence over a living business. Early hires have their work, founder judgement and goodwill to rely on. The risk profile is different, not necessarily better.

          Angel funding and early revenue are great signals but not evidence of a sustainable, growing business. That’s where the team comes in. If the early leadership can bring a strong team to bear in a real market then you’re one risk step removed. That’s where employees are joining at a lower risk (post substantial revenue or series A).

          Risk is tough to estimate.

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  • Jim

    Of course, the key is the target numbers that you pulled out of nowhere. Simply by doubling them — $10M and $50M, you cut the stake in half. I am sure you can make a case for $10M after 3 years so it becomes a game again. I think you are best served by starting low and focusing on contribution going forward. Otherwise, your structure will be skewed by who gave up the most (which is important but not critical) as opposed to who did the most (which is critical).

    Any thoughts on how to handle for stock versus options?

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  • Kspsubbu

    very cool post, addresses a pain point that most startup have. Well written.

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