The lion is the king of the jungle and, for his kingdom to thrive, his rule must be fair. The lion must provide every animal, even the smallest, with three things: a patch of land to call home, protection from predators and fair rewards for fair effort. In self-funded company terms: meaningful work, the means to do it and, especially, a fair slice of equity as a reward.
A lion begins life as a harmless cub, king of nothing. A founder of a new self-funded software company isn't much better off. Both need to either build their domain themselves or ally themselves with others who will do work under a common banner. Within the nascent kingdom, there is much power and equity available to those who deserve it but, for the time being, even owning a large chunk of it is nearly worthless. A founder might choose to do all the work himself but he also might be better served if he grooms a team to control and work in well-defined roles while focusing his own energies on growth and improving the overall effort.
Each animal in the lion's kingdom and each person in a software company brings his own unique talents.
Jobs, skills and level of expertise are different. Some lead others; some are led. The carefree and likeable bear, the wise elephant and the hard-working leopard are important but everybody, not just those few who deal with the lion directly, needs equitable and reasonable compensation for their contribution. They also join at different times: it is reasonable that a software developer who joins a company in the beginning and forgoes salary for a year should get more equity than a software developer who is hired later at full salary on his first day. A founder should have a way to treat all fairly, including himself, and it should be fair and consistent all the time.
Whomp! But, like any of the animated Disney jungle movies, it is all too easy for the infant kingdom to become unbalanced and threatened. It is easy for a lion cub, or a new company, to do something foolish, without malice, that will become a major issue later on. A founder can fall prey to a conniving and slippery too-self-interested investor or an employee who takes equity out of his fair proportion. He may be vain or overly generous or naive. How do you grant equity fairly and stomp the snakes of unfairness?
To begin with, let's look at the end. Let's say that, after 5 years, your company employs 30 people and is sold for a $50M with virtually no debt. Who owns it? Well, if it is still your company, you'll need to own a controlling stake, say, 51%. Who else might own it? Let's say that 29% is shared by investors and owners of companies that your company acquired. And, finally, say, 20% is owned by the employees.
That's reasonable.
Allocating the portion to the employees will be the hardest: they have the smallest stake but are the most numerous. Let's now focus in on that 20% and see how to divide it fairly among those 30 employees.
If all 30 employees, like a school of 30 alligator babies, join on the same day and have the exact same skills, then you 
would divide it equally, giving each 0.6%. That's less than 1% each. That doesn't sound like much. But, when the company is sold for $50M, each employee ends up with about $300,000 pre-tax. That's a pretty good reward. Treating everybody the same isn't realistic but it shows that there is a good deal of money there.
If you divide it unequally, which is almost certain to be the case, you will base a person's equity on his skills, his responsibility and when he joins the company. In this case, each employee might get somewhere between 0.1% ($50,000) to 2% ($1,000,000). It is a safe bet that your first hire will be a hotshot software developer who you offer 2%. Simple mathematics shows that, if one person gets 2%, that leaves 18% for the other 29 people. It is also likely that you will hire two more hotshot software developers among your first 10 employees. Paying those second two 1.5% and 1.0%, respectively, seems fair. (Other early employees might only get something between a 1/10th and 1/4th of these highly skilled employees.) Those three early, prized employees would absorb 4.5%, leaving the remaining 27 employees with 15.5%. A tenth of the employees take nearly a quarter of the employee equity.
Let's back up. In that hotshot software developer's gut, 10% might seem fair but, seeing what we've covered so far, 2% is realistic. If you give him 4% or even 3%, you're in trouble: our rough calculations above indicate that that extra 1%-2% might translate into taking 5%-10% from somewhere else to keep whole compensation system equitable. Still, 2% is a hard sell: two is a pitifully small number and he's going to feel ripped off.
If you relent and allow his compensation to get out of whack with future employees, it becomes a sweetheart deal. A sweetheart deal is
an offer to an employee whose compensation is overly generous compared to other employees. Sweetheart deals, whether as a result of friendship, trickery or just a mistake, are poisonous and political. Once such unfair generosity is known, employees will quickly raise the white flag and 
convert from honest, hard-working and team-oriented teddy bears into brown-nosing, lazy and self-interested vipers who see kowtowing to the politicians as more profitable than real work. That's just nature: your weakness will beget their weakness. (This is why some companies declare discussing compensation to be a "firing offense" but that just hides and feeds their managers' weakness, rather than eliminates it.)
Anyway, even if you convince that first hotshot software developer to accept 2%, our calculations fall apart if your company ends up having 100 employees, instead of just 30. With 100 employees, that 2% might actually be a sweetheart deal. If you were to make it work, you'd have to be a savvy business forecaster, a gifted statistician and a skilled negotiator.
It's hopeless. Nobody's that good. What can you do?
You get rid of ownership percentages and replace them with company stock. Percentages don't work. Everybody loves percentages: they are reliable and easy to understand. But they don't work. We can still use percentages as a guideline to give us an idea about the value of stock at a certain point in time but the "real numbers" are now all in terms of shares of stock.
Stock is funny money; it is like buying your own printing press and issuing your own money, backed by your company. It replaces the old absolute and reliable percentages with new relative and unreliable percentages. Today, a share of stock might be worth 0.00000005% but, tomorrow, it might be a more treasured 0.0000001% or a comparatively worthless 0.00000001%. Everybody hates it because, today, 50,000 shares might be a fortune and, tomorrow, it'd be pittance. 50,000 is just a useless, unreliable number. But it's the only way. It works where percentages can't.
To begin with, if we offer that first hotshot software developer 400,000 of something or just 2 of something else, 400,000 sounds better. It's plain old dumb human nature: 400,000 is a lot while 2 is a little, even if we aren't counting the same things. You don't have to use it as a trick, though. You can still say, "400,000 represents 2% of the company right now." Even so, your offer will now sound fair, rather than miserly.
Even better, you can offer that hotshot software developer a larger percentage because, on day one, you have far less stock than on the day, 5 years in the future, that you sell the company for $50M. If you give yourself 51% of the final amount and you offer 2% of the final amount to that first employee, you have issued only 53% of the stock that you'll have issued 5 years from now. So, that 2% actually represents 3.7% of the company right now. You can even highlight this fact: "400,000 represents 3.7% of the company right now. I can't promise but, barring some terrible and unforeseen circumstance where I must issue a lot more stock, your percentage will be between 2% and 3.7%." Your offer will be more attractive. It is ethical, too, because that 3.7% is a hard number whereas that 2% is just an estimate of the equity situation in 5 years.
Now, that hotshot software developer is likely to give us serious consideration. Since you can issue as much or as little stock as you want, why let 400,000 equal 2%? Why not 800,000? Heck, why not 4,000,000?
As before, let's start at the end: let's pick the amount of stock that we want to have when the company is sold for $50M. If we pick a number too high, each share of stock won't be worth much, maybe 50 cents instead of $2.50 each, making people feel angry and cheated. If we pick a number too low, the number of shares that we offer to potential employees will seem stingy compared to other companies, in raw numbers, even though we know that we aren't counting the same things.
20,000,000 shares is a pretty good number.
| Group | Shares | Notes | ||
|---|---|---|---|---|
| Founders | 10,200,000 | issued on Day 1 | ||
| Investors, acquisitions | 5,800,000 | held in reserve until needed | ||
| Employees | 4,000,000 | held in reserve until issued to employees | ||
| First employee | 400,000 | held in reserve until issued, awarded and vested | ||
| Second crucial employee | 300,000 | held in reserve until issued, awarded and vested | ||
| Third crucial employee | 200,000 | held in reserve until issued, awarded and vested | ||
| Other early employees | 20,000-100,000 | held in reserve until issued, awarded and vested | ||
| Total | 20,000,000 |
The chart demonstrates a sample share distribution, using 20,000,000 shares as a target. (It is conceivable that founders might also need to vest their shares.)
With 20,000,000 shares, each share is worth $2.50 if the company is sold for $50M. That first employee, with 400,000 shares, will make a cool $1 million, pre-tax. Investors and acquired companies will get to share $14.5 million. You'll make a little over $25 million. If you truly are self-funded, don't have any investors and don't acquire any companies, everybody will do better: you'll make almost $36 million, the first employee will make $1.4 million and so on. These numbers make sense: $2.50 is a respectable share price and $50M is top dollar for a leading company in a niche market. Since you'll have an equitable compensation system, that $1 million for the first employee with be representative. A few employees will make $500,000 or more and a good many will make at least $100,000.
It scales up, too. If your company breaks out as a major market player, you might get $100M, $200M or even $500M for the company. As an example, during the dot com boom, Hotmail sold itself to Microsoft for $500M. Using that extreme case, the share price would be $25, giving your first employee $14M. As you can see, everybody in your company is going to have really good motivation to push your company as far as possible.
Similiarly, if the company doesn't do so well, the downside is pretty fair. Say you sell it for $10M. Numero uno will get $200,000 for his 2%; investors and acquisitions will get $2.9 million; you'll get $5 million. Yes, no doubt, the 30th employee will get close to bupkis but the company is mostly a financial loser, after all. Maybe not a technical loser but a financial one.
Numbers, numbers, numbers. Maybe, by now, you've spun that hotshot software developer around so much that he agrees to join only if you promise to stop making his head hurt. But, if not, you might sketch out an equity statement for him (or do it just to help yourself understand). An equity statement lays out all the stock and stock option information for a particular shareholder and attempts to project how various theoretical actions by himself and the company will impact his holdings.
| Equity Statement |
|
Hire Date: 1/1/2004 Note: This equity statement is for demonstration purposes only. It has not been subject to legal review. |
The example equity statement above is for an employee who has a grant of 100,000 shares, vested over 4 years, with a 1-year cliff, who has an extra 300,000 shares held in reserve by the company as awards for meeting specific milestones as determined by the company.
Whomp! But, wait, is this really what companies do?
Most don't. Like a happy-go-lucky cub, most new companies, self-funded or not, just stumble out into the world, chuck stock at people and fix problems as they crop up. Some employees make more than their fair share while others get cheated. Often, people just scramble around, never really understanding how much stock they have or what it represents. They just float along, reacting according to a blend of instinct and emotion: quitting here, joining there and just accepting whatever money comes.
With a deeper understanding of equity, you can better motivate and focus your company on financial success, not just technical success. You can avoid the trauma, the politics and the "ivory tower" mentality that more easily plagues other 
software companies where the employees don't understand or care how the financial value of the company affects them. By giving meaning to your equity, you'll get more practical developers, more marketable products, better ideas, more reliable employees and, ultimately, more financial success.
Go get 'em, tiger! Er, lion.
E-mail Dan Howard about this article
