What is equity for startup employees?
Simply put, providing equity to startup employees is a way of allocating ownership of the startup to those employees.
The equity in question is a portion of the value of the startup. A certain percentage of ownership of the startup can be allocated to an employee as a form of non-cash compensation. All companies can do this, brand new startups or established businesses, but there are compelling reasons why a startup, in particular, may adopt this type of scheme.
Equity compensation in the UK generally comes in the following form:
Share Options – Options are essentially a contract between the employee and the startup that gives them the right to buy (or sell) an equity share on (or by) a certain date. If the employee exercises their right to buy, they can hold the shares in the hope that they will further appreciate over time. Depending on where the startup is domiciled there can be different tax treatments, stock options make sense when there is a premium to pay upfront if shares are simply given to employees.
What is an EMI?
The type of scheme described above is often referred to as an “Enterprise Management Incentive” scheme, (EMI). In the UK this type of scheme makes it easier for smaller (and riskier) companies to provide equity to their employees by giving both sides of the transaction tax relief. The main tax benefits of an EMI are that it allows the employees of the startup to take part in a company’s share growth without them incurring the income tax or national insurance liabilities, whilst the capital gains tax rates are also attractive. The issuing startup may also attract substantial corporation tax deductions.
- A startup company decides to offer equity to some of its employees and so establishes an EMI.
- A qualifying employee is awarded options to buy equity in the startup. The option agreement specifies the timing of any purchase, the cost to exercise the right to buy and conditions to be satisfied before any option can be exercised.
- At the agreed future date, the employee has satisfied all conditions and purchases the equity at the agreed price.
- The employee decides to sell their shares and is subject to capital gains tax.
There are schemes in the UK where equity shares (as opposed to an option over an equity share) are granted from the start of the scheme. There is no hard and fast rule on which scheme is better and it depends largely on the individual financial conditions of each startup as to which scheme is better suited. If, however, shares are gifted or bought at less than their true value, the employee may incur a tax penalty.
Working with its professional advisers, the company should first establish whether it is EMI qualifying. If it is, it should decide in outline how its EMI scheme plan is to work.
In practice, an EMI scheme is a flexible and attractive way to distribute equity to startup employees. Key issues for companies to consider would include:
- What are the reasons to give equity to employees?
- How much equity should be available to the scheme?
- Which employees should be part of the scheme?
- When should any options be exercisable?
- Timing based, e.g., when the startup exits?
- How much will employees have to pay to exercise equity options?
- If the employee leaves the star-up, what impact does that have on the option?
Once these issues are settled then formal agreements can be agreed and HMRC can be notified. Now we know what a startup employee equity scheme looks like, we can consider why you might want to offer one.
Why should you give equity to startup employees?
There are several attractive reasons for a startup to offer an EMI. As a startup founder, the equity in your company should be treasured. It needs to be leveraged carefully, not just to raise capital, but also to obtain human capital.
1. Recruitment - An EMI can help your startup attract the best talent to your team. Early-stage startups are having to compete with much larger and more established players in the recruitment market. It's just a fact that in most instances startups cannot match the salaries offered by larger companies. An EMI scheme is a way of turning the inexperience of the startup into its strength. All of the promises and possibilities are baked into the EMI and as part of any remuneration package, this can be very appealing to talented individuals. These are people who may back themselves to be part of the startup that becomes the next Facebook or Uber!
An ambitious startup requires an ambitious team. Finding that world-class talent isn’t easy, especially when you can’t even match the benefits and salaries of competitors, never mind exceed them. Offering ownership of your startup can make the difference in securing an innovative and dynamic team for your startup.
2. Retention - Once you’ve attracted the talent to your team, you need to keep hold of it. EMI schemes are inherently flexible and the conditions, requirements and timings of the scheme are largely down to the issuer to agree. An EMI can be structured such that it becomes disadvantageous for employees to leave, particularly if the EMI makes up a material proportion of their reward package.
3. Motivation – Employees of your startup may feel more engaged and loyal if they are enrolled in an EMI scheme. Being an owner gives them a sense of being more than just an employee. This provides a powerful motivation and feeling of job security. In the early stage of a startup’s journey, having a team of equity owners involved in the key stages of development and value building decisions is a formidable motivator. Especially so if the EMI has performance conditions attached.
4. Tax Benefits – The benefits of an EMI for employers can be significant and include:
- No income tax cost.
- No National Insurance Contributions.
- Corporation tax relief on the difference between the market value of any equity shares when acquired and the final option price paid by the employee.
The tax benefits for employees can allow:
- Lower tax costs when compared to cash and other remuneration.
- No National Insurance contributions, or income tax, for taking part in the scheme or exercising options.
- A reduced Capital Gains Tax is paid on the long term value growth of the equity shares. This is done via tax credits and other methods of tax relief that these schemes attract.
Taken altogether there are compelling reasons to make your employees owners. Having your team feeling more connected to your long term business goals can be highly valuable, particularly when combined with increased loyalty and motivation. These early-stage employees will help drive your success through innovation and perseverance and aligning their interests with those of your startup can only be a positive thing.
The EMI provides two-way benefits however and the potential rewards for employees can be significant, which is why it is such a powerful motivator.
Knowing the reasons why equity share schemes can make a difference to your startup is a good place to start, but if you decide an EMI is for you, how much of your equity should you make available?
How much company equity should be available to the startup employees?
The equity in any startup, as we’ve seen above, should be treasured and protected by the founders. Equity should never be given away lightly. This begs the question; how big a share of equity should be made available to an EMI scheme?
The amount of equity to be made available is usually referred to as the option pool.
Deciding on the size of the option pool can be a complicated process. During pre-seed and seed funding stages the future of the startup has to be considered and balanced with the needs of the founders and key team members. Once funding for the startup is in place (series A onwards), investors will also need to be thought of and often it’s the founders who find themselves their share diluted.
The median amount of equity assigned to EMIs in the UK is 10%. Of those companies that offer an EMI, a sizeable proportion also opt for a pool of 5% or 15% of equity. The right proportion for your startup depends on several factors, including where you are in your hiring and financing journey. Typically between seed to series A funding an option pool of 7.5-10% would meet the needs of the average UK startup. As funding rounds progress this proportion can change and should be reviewed periodically to ensure it is cogent with the hiring and retention strategy of your startup.
An important consideration, to be discussed in more detail below is how many employees are you making the scheme available to. If the scheme is broad then the option pool will need to increase as your startup matures and the number of employees grows.
In a perfect world, the option pool should meet the needs of the current team while being sufficient for any anticipated future hiring. For example, hiring top talent early on may require more equity than at seed or series A rounds. Appointing a non-founding CEO may also require a significant EMI reward. Striking a balance is not easy and there are the conflicting interests of future and current hires to weigh against those of investors and founders, (nobody wants their share diluted).
A good place to start with an option pool is the 10% average and at each successful funding round the pool can be re-visited.
What's the average equity for startup employees?
Individual employees are rewarded in line with the benefit and value they are expected to bring to the startup. In a pre-seed funding startup, employees are taking more of a risk than if they were to take a job at a more stable and established business. This risk has to be factored into the remuneration package being offered. It has to be attractive enough to bring in the talent needed to do the early-stage foundational work, (that will make your startup a success).
Before series A funding, startups can afford to be generous to attract the right people. Up to this point, generally speaking, with teams of less than 12 people, the average granted equity for startup employees is 1%. This number can be as high as 2% for the first hires, and in some circumstances, the first hire(s) can be considered founders and their equity share could be even greater. It depends on the nature of the startup and the value that the individual brings to the startup.
Each individual is just that though, and there’s no standard equity benchmark for early hires. However, if an individual is truly pivotal and has the expertise/experience required to be transformational to your prospects, there is the freedom early on to push the boat out to bring them onboard. Imagine for example a startup that has plateaued and requires a technical expert to join them to drive a solution and move the company into growth, in this circumstance the right engineer is in a strong position to negotiate a large equity share.
There are nuances to equity awards and there are too many to consider in this blog. In broad terms you can consider average equity (at series A funding) to be:
Lead Manager/Engineer: 0.5–1%
Senior Manager/Engineer: 0.33–0.66%
Manager or Junior: 0.2–0.33%
These equity grants are based on the expected value that these people bring to the business. At the most senior levels, there is an expectation that the reward package will include a significant equity stake. The appointment of a CEO for example may require an equity award of up to 5% in some instances.
As your startup grows there will inevitably have to be a move away from individual equity grants and a decision made on whether all employees will be given access to the scheme. If so, the scheme will have to become generalised and rigid as opposed to the bespoke and flexible grants given early on. From series B funding onwards the equity awards (if offered to employees at this point) will be much smaller, in part because salaries can expect to increase as revenue grows. At this point, any awards may also be based on the seniority and performance of employees.
As your business moves through the growth cycle and into series C funding any EMI will now be an established scheme with fixed rules. Often companies will organise themselves into stratifications and make this available to employees so that the scheme is transparent.
For example, the seniority of employees may be broken up into Senior, Mid-Level and Junior. Each of these tranches will attract different levels of equity. The company may also be stratified into functions so that engineering and marketing departments also have different equity levels. For example:
As with all strategic business decisions, there are several factors to consider when awarding equity to employees. We have seen that the average granted equity to startup employees is 1% for the earliest members of the team and this number diminishes as the startup grows.
How do you calculate how much equity to give to who?
There are a number of different approaches to calculating equity awards. It’s important to state that even though there are two methods described here, your investors during funding rounds may have their own methods and experiences which supersede these approaches.
1. Employee multiples
Fred Wilson advocates for this formula and it has several steps. Firstly, you need to know the value of your startup. This is the value of the entire enterprise that you would sell for today, (this might be the value at the last funding for example). You also need to know how many outstanding shares there are for your startup.
Second, similar to the description in the section above, you organise your company into brackets. The top-level management team in the top bracket, and the lowest level, non-key function employees in the bottom bracket.
Each bracket is then assigned a multiplier, see example below. There are no fixed benchmarks for these multipliers and rely on myriad factors unique to your startup.
The next stage is to multiply the salary of individuals in these brackets to get a value for the equity grant. Once done, this is divided by the value of the company and multiplied by the number of shares outstanding, worked example below.
A company is valued at £10m and has 1m outstanding shares.
The Chief Financial Officer has a salary of £100,000 and is in the top bracket of employee equity. £100,000 x 0.6 = £60,000.
(£60,000 / £10m) x 1m = 6,000
The Chief Financial Officer is granted 6k shares in the company.
2. Market rate salary
The second method associates the equity to the market rate salary for a specific role in the start-up. Simply put, start-ups are able to recruit talent by offering a reward package that equals the market rate. The start-up can do this as the package is made up of a salary plus equity. If relying on a cash salary alone, the start-up would not be able to compete in the market and would not be able to recruit the required talent.
A senior software engineer attracts a salary of £120,000. The start-up however can only afford to offer a cash salary of £75,000. The difference is made up of equity shares. Calculated using the value of the company and the total number of outstanding shares.
These methods are a useful tool in order to explore the levels of equity different parts of your organisation might expect. There are many different ways to formulate equity offers and in all instances, the value is down to what the individual brings to your start-up, how much risk is involved and how big your option pool is.
The number of EMIs in the UK is increasing and this method of rewarding employees is becoming more and more popular. As a founder of a startup, it is no easy task to get your option pool and equity awards set at the right level.
There are important decisions to be made on the extent of the EMI scheme you adopt and the diluting effects of maintaining option pools through successive funding rounds, but by using the information in this blog as a guide you should have the information you need to navigate these issues.
There are many benefits to utilising an EMI and granting your startup employees some ownership. The positive effects created can leverage your business and allow you to compete with bigger and more established companies. The risks can be mitigated by getting your EMI set up at the right level and with the right conditions attached. Although option pools are created using founder equity early on, it doesn’t mean the effects of this dilution have to be felt until years down the line.
This conditional flexibility allows startups to maximise the positive impacts such as increased motivation, loyalty, employee alignment and engagement while helping to attract the very best talent. At the same time, these schemes can protect your startup against any potential downsides, by using performance criteria and time horizons that align with your business goals.
During the creation of any EMI scheme, it’s vital that you receive the right advice and support, guaranteeing that your employee equity grants are set up in the best interests of your startup.
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Developing an EMI scheme for your startup can be a difficult process. There are many factors to take into consideration and conflicting interests to balance. Here at Accountancy Cloud, we have professionals available with previous knowledge and experience to help you deploy a meaningful and effective EMI.
In order to maximise the equity for founders while attracting and retaining talent, we can assist you in focusing on key elements of your business, ensuring it’s ideally placed to build revenues, leverage opportunities in your marketplace and mitigate risks.
Distributing your precious equity to start-up employees is a risky endeavour. Based on your team; the potential size of the start-up opportunity; the competitive environment; and the need for further financing down the line, selecting the correct option pool size is imperative.
It’s important to remember that when deciding on the size of a start-up option pool, the process is often puzzling and rarely straightforward. This blog has looked at the key factors of granting start-up equity to employees and reviewed the important aspects of the practice. By studying these elements, you will understand the means of creating a meaningful start-up EMI scheme.
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