In my last post on importance of employee equity, I set myself up for an ambitious task: to explain how employee equity works and how to set up a stock options plan in Europe. This topic is so complex and robust that it is almost impossible to pack all the relevant content into a single blog post. Therefore, I have decided to use a different approach: this post will summarize the basic concepts of employee equity using already existing content available on the internet (predominantly Fred Wilson’s amazing series on this topic) and provide some commentary and context for European startups. Please note that this post will most likely not make sense unless you go through the linked articles as well.
The first thing to understand is that while most people associate employee equity with “options”, this is not the only form of employee equity. There are actually four.
And here comes the first caveat for European startups: every post and legal document associated with employee equity will work with the concept of shares as the means of company ownership. We know that a lot of limited liability companies in numerous European jurisdictions don’t work with the concept of shares, but rather with % ownership interest in the company. Credo has invested in limited liability companies across various European jurisdictions over the years, and all I can say to startup founders about the fear of not having shares for the purpose of a stock options plan is don’t worry: an experienced investor and lawyer will figure it out for you. We typically set up a stock options plan in a limited liability company as a commercial agreement (backed up by contractual penalties) that mirrors the same “share-based structure” even in entities that don’t work with the concept of shares. Employees are explained the concept of stock options plan and told that they will get their money at a liquidation event or their departure even if they don’t physically own the shares.
Four steps to set up your plan
We typically go through a four-step process with our portfolio companies to setup the employee stock options plan. It essentially follows Fred’s logic outlined here:
- Establish current valuation of the company. It is very important to be able to value your company for the purposes of the stock options plan. We typically use the valuation of the last financing round. If this valuation was more than 12 months ago, we typically adjust the value based on current performance benchmarked against performance at the time of the investment.
- Prepare the vision of the company’s organizational chart (both current as well as an estimate for the next 12-24 months for future hires), with estimated salaries of each position.
- For each employee bracket (VP level, director level, etc.) assign an equity multiplier to their annual salary. If your VP takes 100k EUR annually and his equity multiplier is 0.5, the EUR value of his equity is EUR 50k. Fred provides some basic benchmarks for his multipliers. My only comment regarding those benchmarks is that, in my opinion, the most junior employees, such as secretaries, don’t need to be part of the plan, since a tiny slice of equity is not going to be a strong motivator for them.
- Take the 50k and divide it by the current valuation of the company. If it is EUR 10 MM, your VP would own 0.5% of the company. Repeat the same process for each position and add up all the percentages. The sum will be the total value of the stock options plan. It should hover between 10-20% of the company.
- It is very important to understand that by giving out options, you are not giving out company stock immediately (specifically not until the option is exercised): you are giving your employees an option to buy equity in your company at a pre-agreed price (the strike price) at some point in the future. Options and their advantages are explained here. The strike price is typically set by the startup’s board of directors. We tend to stick to valuation of the last financing round. You can read more about the intricacies of the strike price here, even though a lot of the information is relevant only for the U.S. entities. Alternate forms of employee equity are explained here; we use them occasionally, e.g. restricted stock to attract senior hires or co-founders.
- It is equally important to understand that an employee doesn’t get the option to buy his entire allocated pool straightaway. It is vested over time. Vesting is explained here. We typically use four year vesting with one year cliff.
- I have omitted the concept of shares in my four-step plan to make it easier to explain. It is not that difficult to incorporate shares in it: when you establish your valuation, just assign a number of shares to it, let’s say 100,000. So if the VP in our example owns 0.5% of the company, he owns 500 shares.
- Regardless of whether you will use shares or just percentages, it is very important to understand how dilution works
- I agree with Fred’s view to communicate equity in EUR value as opposed to % (he explains why), plus it is important to stress to employees that the value of that equity can increase more than tenfold if the startup does well. In our example, the VP can make 500k EUR on his 50k grant if the startup will do well. Let’s also not forget that the 50k is not received for free; the employee has a right to buy it at a certain strike price.
- The plan above outlines just the initial options grant. It is common practice to give employees retention grants as well. Typically they are given out after an employee has been with the company for two or more years. To set up the retention grants, go through the same four steps outlined above, but assign lower multipliers (e.g. if you do retention every two years, and initial stock grant is vested over four years, then divide the multiplier by two).
This must be the most complicated post I have written. I apologize for that, as there are entire books devoted to the topic of employee equity. If there are any questions, you can always shoot me an email at email@example.com. Nonetheless, I hope it provides at least some guidance. While there are many alternate approaches to this concept (e.g. look at the Wealthfront plan), my most important piece of advice, especially to first-time founders, is to work with an experienced investor and lawyer to set up the stock options plan. They have done it countless times before and understand all the pitfalls. After all, their knowledge of these topics should be one of the key reasons you would let an investor become part of your startup.