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How much equity should start-ups give employees?

Start-ups flourish when there is a strong and dedicated team driving them forward, so all entrepreneurs want to make super star hires early on to increase their chances of success. But, for many start-ups, this presents a common conundrum: how do you recruit great people with only your seed money to work with?

Incentivising employees who will plug their talent and ambition back into the business can be tricky when you’re starting out. Here, we explore your options and considerations to make along the way to maintain the balance of getting the best talent on board and leaving yourself with majority ownership.

Weighing up your options when seeking talent

An experienced programmer might ask for a salary of £60, 80 or even £100,000 – even more in extreme cases. Business development managers in London might expect £40,000 plus commission on their sales.

Unless your dad is Alan Sugar, then it’s unlikely you have enough money to satisfy the salary expectations of high-flying professionals. The more people you need to get your business going, the less obtainable the salary pool becomes.

So it’s no surprise that plenty of start-ups – particularly in the tech space – offer equity to founding or early recruits in order to compensate them for a lack of ready cash.

From the point of view of new recruits, the reasoning is straightforward: they join the business because they see its potential, betting that an equity slice will grow in value and more than make up for the meagre pay.

As the business develops, their share becomes worth more and at some point, they will cash out for a windfall. Early employees of Instagram, Tesla and Monzo, for example, amassed valuable shareholdings – and many are now millionaires.

For business owners, a few questions remain, like how much equity should I set aside for star employees? Who should I offer it to and what’s the average equity for start-up employees?

How big should your equity pot be?

It’s tempting to answer this question with another: how long is a piece of string? Every founder is different, as are all companies and their staff, so it’s impossible to give a single nugget of advice that will be as useful to a city healthtech business as it is for a fledgling firm of plumbers.

That said, there are a few rules of thumb and some important calculations to consider. The first and perhaps most obvious is that whatever you give away, you can’t keep.

As the sole owner of a business you retain 100 per cent of the equity, so giving away 10 per cent in the form of shares is perhaps not terribly painful. But now imagine there are three founders; diluting a 33% share feels a lot closer to the bone.

Now consider that you have won equity investment from a business angel, for example. If they claim 25 per cent and the rest of you share 25 per cent each, that leaves a worryingly small piece of pie to divvy up.

Shareholder dilution is, perhaps, a nice problem to have as a business becomes established, grows, and takes on successive rounds of investment, but a small equity share can become tiny very quickly as new investors come on board.

Equally, if your equity offer to new staff is unappealing, say 0.5% for a prospective finance director, then it’s less likely to do the job it was intended for – i.e. enticing top talent away from corporate jobs.

Which leads to a further question:

How much should I give individual employees?

This is another tough one to answer, because (again) it depends on the existing equity breakdown of the company, the calibre of each recruit, their importance to the organisation and, of course, their own sense of how much they want.

Another relevant factor is the risk profile of your business. Are you brand new and pre-revenue? If so, you’re high risk, so expect employees to demand substantially more.

But if the business is established and growing, with clients in the bag and a burgeoning reputation, then a) your business is more valuable and b) people will compete to work for you, meaning a lower equity offer will appeal to prospective employees.

In fact, if you experience early success, you might not have to give away equity to entice people – keep that in mind.

If, for example, you’ve allocated 10 per cent equity for early recruits, create a plan for how it will be allocated. Do you need a top sales, technology, or marketing professional? You might want to allocate a bigger share to them than the less essential workers who follow.

It’s also a good idea to leave some equity in reserve for recruitment down the track. Keeping back two per cent for opportunistic hires is never a bad idea.

How do I structure my start-up compensation package?

Although it’s possible to issue shares upfront, this comes with a significant risk. Beyond reputation, CV and interviews, recruits are unknown quantities, so you have no idea whether they will honour pledged allegiance or leave after three months.

Much better, then, is to offer equity in the form of share options, which will become real shares at a specified future date (from your point of view, the later the better). It could be 12 months or three years, long enough to encourage loyalty without being so long that your recruits become disillusioned with the wait for their slice of the pie.

HM Revenue and Customs offers a few different ways to provide share options, but the overwhelming favourite is called an EMI (enterprise management incentive) option scheme.

This is great for owners and employees because the cost of implementing the scheme and its benefits are deductible from corporation tax and can’t be touched by income tax. Shareholders are still liable for capital gains tax on the increased value of the shares, but this can be softened via business asset disposal relief (formerly entrepreneurs’ relief).

The EMI scheme is aimed at start-ups and small businesses. Firms can apply if they have fewer than 250 employees and assets of under £30 million, plus the business can’t be owned by another company.

Employees can qualify to receive share options if they spend 25 hours (or 75 per cent of their working time) per week in the business. They can hold up to 30 per cent of company shares at a value of no more than £250,000 at the time they are allocated.

Offering equity to early employees is one-way start-ups can get ahead of big-name employers with their inducements of generous salaries, season ticket loans, gym memberships and medical insurance.

Allocated with due care, your equity can be the perfect incentive to win the loyalty, enthusiasm, and energy of the kind of employees who will help your business to thrive in future.      

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