One of the questions I get most from startup founders is, “How do I pay people in stock?” In most of these situations the founder has met someone willing to work for all stock or part stock. The hard part is figuring out how to value the person’s contribution, how to value the stock, and how to issue the stock in a way that minimizes taxes and won’t screw up the company’s Cap Table.
Let me start with the usual disclosure: I’m not an attorney or an accountant. It’s always wise to seek advice and counsel from accredited experts. That said, allow me to relay a framework that I have used successfully in my own startups. I’ve also used this framework to get compensated for providing services to startup companies.
Step 1: Agree on the Contributor’s Market Rate
There is a wide disparity in what different people are worth in the market and to your startup situation in particular. Some people are worth $20 per hour and others are worth $200 per hour. A contributor that is worth $200 per hour should deliver 10x more value to the startup than a contributor that is worth $20 per hour. How do you figure that out in advance? Here are some tips:
- How many years of experience does the contributor have?
- What is the contributor’s area of expertise? Does he or she have certifications or specialized training?
- What is the contributor’s success rate? Can you verify his or her performance in other ventures?
- What was the contributor paid last year? Is he or she willing to share his or her pay stubs or tax returns?
With just a little bit of research and give-and-take with the contributor, you should be able to get a fix on his or her hourly rate. If the gig is going to be long term, you can agree on the contributor’s monthly or annual rate, based on the above inputs.
For the sake of this example, let’s say you and the contributor have agreed that his or her market rate is $100 per hour.
Step 2: Agree on the Minimum Time the contributor Will Commit to Your Startup
To arrive at this number, you should have a good idea of what he or she is going to do and over what period of time. Will his or her work be on a fixed project with a start and end date, or will his or her work be open ended and ongoing?
For example, a fixed project could be to write a business plan that will take approximately 100 hours, beginning on May 1 and ending on July 31. Alternatively, his or her work may be open ended and ongoing, like providing technical or marketing services that will take at least one day (8 hours) per week until terminated by either party.
For the sake of this example, let’s say the contributor is going to work at least one day per week, 32 hours per month, for your startup. The work will be ongoing. Given his or her market rate of $100 per hour in step 1, the compensation rate is $3200 per month.
Step 3: Agree on the Compensation Structure
The first thing to consider in this step is to determine whether the contributor’s compensation will be in all stock, or in part-cash and part-stock. Some startups want to preserve equity. Some people won’t work for just stock. A part-cash and part-stock structure is a good compromise. In my experience, 50/50 is typical.
If you don’t have the cash and the contributor is willing, the cash portion can be accrued until funding is raised. I’ve done this for startup clients who I believe have a good chance of raising capital, or at least becoming cash flow positive in the foreseeable future. If the cash portion can not be paid within a certain period (usually one year), it is converted to stock with a kicker (see below).
In most startups, however, the founders and the early team members are working solely for stock.
Now comes the tricky part…
People who will work for your startup for stock are taking the risk that they will never see a dime for their contribution, especially if no funding has been raised and the company is not cash flow positive. To induce them to take this risk, you can sweeten the offer by how you value the stock they will receive. There are a couple of ways of doing this.
a. For every dollar earned, the contributor gets $2 or $3 worth of company common stock. In the example in Step 2, if the contributor is being compensated at $3200 per month for his or her ongoing contribution, he or she will receive $6400 or $9600 worth of stock each month. Whether he or she gets 2x or 3x depends on the relative value of his or her contribution to the goals of the company. This is the kicker. It’s negotiable.
b. The contributor’s shares will be priced at the same rate as the founder’s shares, or slightly above the value of the founder’s shares. For example, it’s not unusual for founder shares to be valued at $0.01 per share. A contributor working for just stock should receive the lowest possible share price, as advised by company counsel.
c. A combination of a. and b. The levers are share multiple and price per share. If a contributor is getting 3x the number of shares for every dollar earned, the share price could be higher. If a contributor is getting 1x the number of shares for every dollar earned, the share price should probably be as low as possible, if not the same price as the founder’s shares.
For the sake of this example, let’s say the contributor is earning $3200 per month for his or her work and will be paid solely in stock at a 2x multiple. The contributor will be awarded $6400 worth of stock each month for the duration of his or her tenure, when it comes time to issue the stock.
Founders often debate with me the kicker multiple. If they are familiar with convertible notes, where investors get a 20% discount (kicker) upon conversion to stock, they wonder why they shouldn’t use the same formula to compensate team members in stock.
My argument is that startup team contributors are exponentially more valuable in the early stages. They are often involved before there is a product, no less revenue. Convertible note Investors usually get involved later when the company has product-market fit – the venture has MVP, proof of market and some traction. An investor’s risk has been mitigated to some extent.
In any case, use your best judgement, just don’t be piggy. If your venture is further along and perhaps the price of the shares have already been established by a lead investor, than paying a 1.2x – 1.5x multiple for people working for stock may be appropriate.
My advice to most early-stage startups: you need the talent and their work product to get in business and to raise money, so be generous with your equity with those who can help get you there.
Lastly, this should go without saying, but it’s a common trap naive founders fall into: NEVER, EVER, give any contributor equity based on a percentage of the company. It’s ill advised for a lot of reasons. The amount of stock (or options) one is given in a startup should be directly proportionate to the value of their contribution.
Step 4: Have a Written Contract and Agree on the Contributor’s Performance Milestones Each Month
The last step in the framework is to have a written contract and agree in advance on what milestones the contributor is to achieve each month for the equity he or she is receiving. This is where the framework can fall apart quickly. If the startup isn’t getting results from the contributor and not cutting him or her loose, it will be on the hook for the equity. The founder and the contributor should review what has been achieved each month and whether the stock was earned. If there is wide disagreement, terminate the contract.
Founders need to manage people paid in equity as rigorously as those paid in cash. The worst thing that can happen – and I see it all the time – is to owe a bunch of people a bunch of stock for having done practically nothing. Worse yet, it was all done on a verbal understanding. It’s going to come out of the founder’s share because investors aren’t going to pay for it. Keep your Cap Table clean!
There are a bunch of nuances in this framework regarding how many shares a startup should initially authorize and issue; the type of shares to authorize and issue; when to issue shares; how to price the shares; and how to minimize the tax consequences of paying people in stock. We’ll need to save that discussion for another post.
In the meantime, founders do NOT have to figure this all out in advance to use this framework and to engage team members using stock. Once the above parameters are contractually agreed to by contributors, the stock can be issued to them on a future date, coinciding with migration to a C-corp, the commencement of a Series A financing, or other triggers. This is also when a 409A Valuation should be done. Like a convertible note, where investors will get stock at a future date, the stock can be earned by team members now and issued later. But please don’t take my word for it. Consult a good attorney experienced in corporate formations and stock plans!
Equity is currency. Use your equity wisely, but by all means, use it to attract and keep the people you need to help build your product and grow your company.