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New Ideas On Structuring Equity Incentives

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by Louis Lehot, a partner and business lawyer with Foley & Lardner LLP

Sizing an equity pool correctly is a delicate balancing act – and one that founders often get wrong without realizing it. As your startup grows, and as you onboard key contributors for the journey ahead, you will always need to be evaluating your company’s equity pool.

An important part of growing a business, an equity incentive pool is a pot of shares set aside for stock options in order to help a startup recruit and retain key talent for long term success. Oftentimes, startups use these shares in place of cash as compensation.

The reality is that equity incentive pools are a reflection of how much of your company you are able to retain. That’s why it’s essential to carefully estimate how big you need your pool to be, and how to position its value. Overall, equity pools are used to attract and incentivize talent – you’re basically offering employees an opportunity to own part of the company.

What if your startup is using the equity pool for compensation to attract early hires? In this situation, a company needs to have a big enough equity pool to make enough grants to fill out the team. It’s important to be careful that the equity pool doesn’t have a detrimental impact on the ownership interests of founders and early shareholders when deciding to raise additional funds. Ideally, you want your equity pool to be big enough to fill the equity budget of key hires through your next funding round. If the pool is too big, you’ll reduce your ownership, or if it’s too small, investors may not be on board.

Benchmarks are a helpful way to make sure your pool size is a good fit, but don’t rely on them because there’s a wide range in the standard amount founders set aside – anywhere from less than 5% to 30% or more. A reliable rule to follow is that a startup creates a 20% equity pool at the start, and that at a seed round, an investor will increase it to equal 15% or more. So, a Series A investor will see there is at least 10% of share capital set aside in an equity pool.

Some startups will need a large equity pool to fuel growth, while some will not. So, be realistic about your hiring needs. All startups should have an equity budget that equals the total size of the equity pool. So, you’ll be sure to know what positions need to be filled over the next 18-24 months and how many options you need for attracting these hires. It’s best to offer the earlier employees more equity since they take bigger risk of joining such a young company.

As a founder, it is likely that investors could pressure you into creating a larger pool than you need in relation to the stage of your financing, which is why your plan will help you create a realistic pool. As you approach each round of financing, consider what is likely to be the size of your next funding round, and what will be the likely valuation, as well as your percentage equity.

Before making any decisions, it’s best to meet with an experienced startup lawyer who is well versed in your industry and can share relevant data points about how much the market will demand, and how to demonstrate to your board and your investors why they should approve your proposals.

 

Louis Lehot is a partner and business lawyer with Foley & Lardner LLP, based in the firm’s Silicon Valley, San Francisco and Los Angeles offices, where he is a member of the Private Equity & Venture Capital, M&A and Transactions Practices and the Technology, Health Care, and Energy Industry Teams. Louis Lehot focuses his practice on advising entrepreneurs and their management teams, investors and financial advisors at all stages of growth, from garage to global.