Compensation: Cash or Equity?

Compensation is one of the major costs of running a business. As a start-up, cash is often limited, and equity seems attractive. Later, as you are growing your business, you have similar considerations: should I commit to an out-lay of cash, or expand the option pool?

Spartina’s guiding principle is: Equity is for long-term commitment, not services.

What do we mean by services? Imagine your company is short of cash (which may not be so hard to imagine) and a top recruiting firm comes along to help you find talent. You can’t afford their fees, but you know you have equity to offer, so you make a deal. Spartina’s opinion: Wrong Decision! As you give away valuable equity to people or groups who don’t really have a serious vested interest in your success, you are diluting the very resource that could be used for your most important allies. If your business takes seven years to develop is it fair for the short-term service provider to get the benefit of that?

As you attract and hire key people who you want to have over the long-run, vesting is a powerful tool for creating commitment. Offering people a share in the company, that matures over time, keeps them from taking the shares and then disappearing on a whim. It creates a real stake in the long-term success of the business and allows people to share in that success.

How Much Equity

How much equity do you offer? In most businesses, equity is linked to the position within the company, and is also a function of when people join the company. Those few people whom you enlist at the very beginning, and who are taking a bigger risk, will often be offered more stock than those who join later, when the company is mid-size, and posed for expansion.

Guy Kawaski offers this as a sample grid for a startup technology company “that has already raised its first round of venture capital of $1-3 million with no more than fifteen employees.” Senior engineer: .3 – .7% Mid-level engineer: .2 – .4% Product manager: .2 – .3% Architect: 1 – 1.5% Vice presidents: 1.5 – 3% CEO: 5 – 10%

Remember that as you raise more capital for the company, the percentages go down. Keep this in mind, as some of your key employees might need to get additional stock options when you increase your equity base. It is important when offering options that your employees are encouraged to focus on share price, not on the percentage. People may need to be educated that in the long run it is better to have a smaller piece of a bigger pie. 1% of a billion dollar company is worth more than 50% of a million dollar company.

Common Stock & Preferences

One last thing to consider when issuing options for compensation is the liquidation preference. Normally, employees are offered common stock, and investors, who have put up cash, have a preference for being repaid of the company has to liquidate or is acquired. It is possible when offering options that if the liquidation preference is high, the options might be worthless in a worst-case scenario. Highly paid or highly valued employees would most likely cringe at being last on the pay-out. Consider what to do for them, as a way of insuring that you get the people you need, and, you keep them.

Calculating Cash

If you asked yourself, “is equity necessary for this hire?” and the answer is “no” then you need to look at how much cash you can afford to commit. Remember, compensation is not just salary; you must include benefits, taxes, and any other payroll expenses. Most important you need to look at two factors: your burn rate, and, the cash in the bank.

“Burn rate” is commonly understood as net cash flow. If you have no revenues, the burn rate is how much you are spending each month. When you know your monthly burn rate, you simply divide your cash in the bank by the burn rate. This tells you two things: when you will run out of money, and, when you need to do another round of financing. Financing can take up to six months. So if you are about to hire someone, it is imperative to look at your future. Can you keep them on for a year? For six months? Be clear, and be honest, so that you don’t create bad feelings all around. Many people are willing to take a risk, if … they know it is a risk!