The Ins and Outs of Granting Equity to Your Tech Startup All Star Team

So, you’ve found a rockstar. You’ve networked, coffeed, shot the breeze, followed up, exchanged ideas, seen the vision, shared a beer, had the “we’re just a startup” talk, checked out his or her previous gigs, exchanged some more ideas, seen the vision again, left the bar late, pounded knuckles—it’s all coming into place. Now, with funds thin and your development needs immediate, how do you lock it down?

You’ve got to use your startup’s equity.

The allure of the home run—the fancy cars, the life changer, the kwan. But since every startup is in the same boat, what tools are at your disposal to put your equity offer in the best possible spotlight for that rockstar hire you’ve brought to the precipice?

Here are four things to keep in mind:

First, use restricted stock rather than stock options for as long as you can.

Restricted stock is different than stock options. Candidates get 100% of the stock issued up front, subject to clawback rights that disappear over time—it’s called “reverse” vesting. For Canadians, this structure is great—it starts a two year clock ticking for candidates to get a $750,000 (soon to be $800,000) tax holiday on proceeds at the time of the sale. Founders can pitch that benefit to candidates as an incentive to jump in early – once the company’s shares get valued in a financing, restricted stock is basically out.

By the way, don’t sweat the voting rights on the stock that gets issued; you can manage that to your satisfaction by contract through a voting trust or shareholder agreement.

Second, if you need to use stock options, get the strike price right and market it effectively.

You should implement a stock option plan once you’ve done a priced round of equity financing. Your stock option equity grants typically should be issued at the fair market value (FMV) of the shares proposed to be issued (usually your common or ordinary shares). Canadian Controlled Private Corporations can also issue stock options at below fair market value to employees, officers and directors, which is a tactic that is used from time to time in a company’s startup phase when cash is scarce. Get Tax advice before granting options at below FMV.

If you’ve completed a preferred share financing, consider whether to get a third party valuation to establish a common share strike price at a discount to the preferred share price (discounts can be as much as 50%). Valuations aren’t as expensive as you might think, and we have great valuation resources if you need them. Also, keep in mind that there is a “story” to every fair market value or strike price that is set by startups (shhh, don’t tell the Tax people). A “good” valuation for the candidate is one which (legitimately) relies on a previous financing round as its benchmark—it’s still valid for tax purposes, but it may very well offer advantages to the candidate if the startup goes on to complete a financing or sale at an accretive valuation within a reasonable period of time after the hire. Get it right, and tell a good story to pull great candidates onto the team.

Third, go off the farm on your vesting arrangements.

Pretty much everyone knows the “Cadillac” vesting schedule: one year cliff, following by three years’ monthly vesting. However, it’s fair to consider that standard as the right fit solely for the de-risked, fat cat startups sitting on a couple of years’ cash. If your rockstar is taking a hit on salary and giving up all of the catering gems at Facebook, Google, Twitter (or even Kik and Shopify, whose employee grub is choice), why not consider compressing that vesting schedule to three years, or layering in acceleration provisions upon the startup’s sale?

Don’t overdo it, of course, because you’ll face diligence reverb from your future investors if you’ve sprinkled those more generous terms around without getting the return. Having said that, it builds a lot of credibility with your investing public if, as a founder, you’re able to identify great people and do what you have to do to nail them down with effective compensation offers.  One thing we wouldn’t budge on is a cliff of some kind—you definitely need a period to try any candidate on for size; some rockstars just don’t show up on stage, they throw TVs and furniture out the window, and ruin everyone’s fun.

Finally, watch the optics on your strike price.

Watch the optics of the absolute value of the strike price you are setting in your equity grants. If the price is ubër high (with one startup we worked with, the option price was $83.45), consider a stock split to increase the number of outstanding shares and reduce the exercise price to something that “feels” like it has a lot of value potential (say for example, $0.8345). Not too high, not too low—simple thing, and easy to fix with your counsel.

We hope this article helps and we’d love to assist if you need any additional support as you climb up onto that great big, difficult recruiting stage, seeking to charm some of the performers to dive into the awaiting audience of your team and startup dream.

Featured in Techvibes; Written by James Smith.