When it comes to distributing equity among your first set of employees, several important factors should be taken into account. Early employees should receive more equity than those who join later, as they are taking on greater risk and working in a more uncertain and hectic environment. As your startup becomes more established, the risk decreases, and the equity offered should reflect that.
Equity Allocation for Employee Incentives
Startups typically allocate between 10% and 20% of their equity for employee incentives. Venture capitalists often require this pool to be set aside before investing. While this might seem like a significant amount, it can be quickly utilized when considering the need to attract key personnel, such as a CEO, CTO, or COO, who traditionally receive 3-5% of the company.
Understanding Equity Dilution from an Employee’s Perspective
Equity dilution is a crucial concept for anyone involved in a startup, especially for early employees and founders. Here’s a scenario to illustrate how equity dilution works over successive funding rounds:
The Initial Offer
Imagine you join a startup at the pre-seed stage, and the founder offers you 10% of the company. At this point, the company is just getting started, and its future is uncertain. However, as the company raises funds and grows, your equity will be diluted due to the influx of outside investment.
The Seed Round
The company raises its first significant round of funding, known as the seed round. An investor puts in $2.5 million, and the company is valued at $10 million post-money (after the investment). This means your original 10% equity share will be diluted.
- Initial equity: 10%
- Post-money valuation:$10 million
- New equity percentage: 7.5%
Series A Round
As the company continues to grow, it raises a Series A round of funding. This time, investors put in $5 million, and the post-money valuation rises to $25 million. Your equity is diluted further.
- Initial equity: 7.5%
- Post-money valuation: $25 million
- New equity percentage: 5.25%
Series B Round
The company raises a Series B round, securing $25 million in funding with a post-money valuation of $100 million. Your equity share decreases again.
- Initial equity: 5.25%
- Post-money valuation: $100 million
- New equity percentage: 4%
Summary of Equity Dilution
Here’s a table summarizing the equity dilution over these three rounds:
| Funding Round | Investment Amount | Post-Money Valuation | Initial Equity | Equity Percentage After Dilution |
| Pre-seed | – | – | 10% | 10% |
| Seed | $2.5 million | $10 million | 10% | 7.5% |
| Series A | $5 million | $25 million | 7.5% | 5.25% |
| Series B | $25 million | $100 million | 5.25% | 4% |
The Growing Pie Analogy
While your share of the company gets smaller, the overall value of the company (the pie) is growing. If the company’s value reaches $100 million, your 4% stake will be worth $4 million.
Key Considerations
- Outside Investment: The primary cause of dilution is the injection of outside capital into the company.
- Business Model: Companies with lower capital needs may experience less dilution. For instance, an asset-light business with positive cash flow from the beginning might not need as much investment.
- Early Employee Compensation: Founders must be transparent with early employees about the potential for dilution. While they may start with a significant percentage, this will reduce over time as more funds are raised.
Understanding these dynamics is crucial for anyone joining a startup. It’s essential to balance the potential rewards of equity with the realities of dilution and the company’s growth trajectory.
By being aware of how equity dilution works, you can make informed decisions about your compensation and the long-term value of your equity in a startup.
Perspectives from Y Combinator and Carta
Y Combinator’s View
For the first employee, often an engineer in Silicon Valley, the equity distribution ranges from 1-2%. Depending on your cash reserves, you might offer more equity in exchange for a lower salary, though not all potential employees will accept this trade-off.
Additionally, the preference of the employee for salary versus equity should be considered, tailoring the compensation package to what motivates them the most.
Carta’s Insights
If the first five hires receive equity grants at the 50th percentile (based on over 8,000 equity grants from the past year), founders would part with a total of 3.62% of the company. Extending this to the first ten employees would total 4.75% of the company.
Opting for a more generous approach and granting equity at the 75th percentile results in 11.61% of the company allocated to the first ten employees. This is already higher than the typical 10% option pool for pre-seed startups.
The trend over recent years has seen the 50th percentile equity grant creeping upwards, leading to smaller teams with slightly larger equity grants per team member. This shift indicates a new default in startup building, emphasizing a more substantial equity stake for early employees to keep them motivated and aligned with the company’s success.
Equity Pool: A Powerful Leadership Tool for Startups
In the world of startups, the equity pool isn’t just a mechanism for compensation—it’s a strategic leadership tool. By carefully managing equity distribution, founders can align incentives, foster a sense of ownership, and motivate their team to work towards the company’s long-term success.
Strategic Equity Allocation: Key Insights
Attract and Retain Top Talent:
- Allocating equity at the 50th percentile for the first ten employees accounts for 4.75% of the company.
- Opting for a more generous approach at the 75th percentile increases this to 11.61%.
Align Incentives and Foster Ownership:
- – Smaller teams with slightly larger equity grants per team member have become more common.
- This trend incentivizes early employees and underscores the strategic use of equity.
Motivate for Long-Term Success:
- By leveraging equity effectively, founders ensure their team is motivated and invested in the company’s success.
- This strategic approach aligns with the shift in how startups are built, focusing on smaller, highly incentivized teams.
By understanding and strategically managing equity distribution, startups can create a motivated, invested team that drives the company towards long-term success.
