Unleashing the Power of Equity Compensation

Deciding how much equity to share

Deciding how much of a company’s ownership to share is one of the fundamental steps in building an equity compensation plan. 

The amount of equity you decide to share should be enough to fulfill the targeted goals while at the same time keeping the investors or existing shareholders happy. Let's have a look at some methods generally used:

One method is using the ‘Market Approach’ which gives a percentage of equity based on what peer companies offer their employees. This is the most straightforward approach, nonetheless, we need to consider that the survey data is subject to multiple biases, and ultimately, employees care more about the value of the shares than the percentage of equity.

The most common way, however, is using a ‘Percentage of Equity Approach’. This approach considers existing shareholders’ tolerance for dilution and sets a fixed percentage to share. The fixed percentage will depend in part on what the alternatives are. For example, if a company is willing to share 15% of its ownership, it needs to ensure that this will be a sufficient incentive to attract, retain and motivate employees targeted by the plan. If not, that will require the use of current cash for extra pay and bonuses.  For different companies, this percentage will vary with industry norms, company performance, regulations, and distribution of ownership rights. There are some common issues with this approach:

-    Growing companies have a higher margin of error in forecasting future needs. Often, they give away most of their shares to early employees, leaving little for newcomers. This may lead to issues with pay equity and fairness.

- Even if the company workforce remains relatively stable, the philosophy of the company or the job market can change, making the initial equity allocation inadequate for new employees. While employees who leave the company might give back their shares to the company for new employees, due to market changes, these newcomers might expect more than the company has to offer.

There are 3 alternative approaches to the Percentage of Equity Approach to consider:

a) Start with a lower percentage of ownership than expected and set a higher limit for foreseen contingencies. This approach is simple and flexible, but it might need repeated requests for further dilution.

For example, let's consider a startup company that has just received its initial funding and has a total equity pool of 100,000 shares. The Board of Directors agrees that employee ownership should be at most 20% of equity value.

Accounting for this limitation, the employee ownership plan might start by providing 10% of the ownership. They award 10,000 shares to key employees and set aside the remaining 10,000 shares for future hires and unforeseen contingencies. With changes in the market and the company’s philosophy, it might be needed to increase employee ownership. You can continue confidently without needing to request additional dilution authorization until you reach the 20% limit.

b) Tie the amount of stock ownership or equity value given out on job responsibilities. This means that, as the composition of the workforce evolves over time, the allocation of equity should also change accordingly. 

For example, let's say a tech company grants its senior engineers stock options based on their level of contribution to groundbreaking projects. As the company grows and expands its services, it hires more diverse talents, including data analysts and marketing specialists. To keep the compensation fair and in line with their roles, the company revises its stock distribution plan. If existing shareholders see that this new approach is equitable and beneficial for the evolving team, they might support its continuation for future hires as well.

c) Base the total pool of available equity on the company’s performance. This approach aligns employees with company goals. Their financial reward is directly associated with the success of the company.

Let's take a look at an established company that has a performance-based equity compensation approach. The company links the total equity pool available for employees to the company's financial performance, ensuring employees are motivated to work towards the company's success.

At the end of each fiscal year, the company evaluates its financial performance, such as revenue growth, profitability, and market share, and determines the total equity employee ownership for the following year. The equity pool could be substantial if the company has had an excellent financial year and achieved all its targets.

If the company's net income exceeds $10 million for the year, the company may allocate 5% of that net income to the equity pool. This means that if the net income reaches $12 million, there would be $600,000 available in the equity pool for employee grants.

The individual equity grants would then be determined based on various factors like employee performance, seniority, and contributions to the company's success. This approach aligns employees' financial rewards with the overall performance of the company, fostering a strong sense of ownership and motivation among the workforce.

In conclusion, designing an effective equity compensation strategy requires careful consideration of several factors. As an equity compensation manager, your role involves not only understanding the financial intricacies but also staying attuned to the evolving dynamics of your company and the market. By progressively increasing employee ownership up to a reasonable limit, tailoring equity allocation to job responsibilities, and tying the total equity pool to company performance, you create a compensation structure that not only attracts and retains top talent but also drives a sense of ownership and alignment with company objectives. Just as companies evolve, so should their equity compensation approaches, adapting to changes while remaining equitable and motivating for all team members. Remember, a well-structured equity compensation plan isn't just a financial tool; it's a powerful driver of company culture and success.