Guestpost by Ifty Nasir, Co-Founder & CEO at Vestd.
Setting up an employee share scheme is one of the best things you can do to incentivise and reward high performing teams.
Research has shown that allowing employees to own a slice of the business is great for company culture, staff retention, and productivity.
There are a bunch of things to consider once you have decided to go down this path, as it can be a complicated area to navigate.
First and foremost, there is the question of how much equity to allocate to your employee share scheme. How big does the pot need to be? What do other companies usually do?
You’ll also want to think about how much equity to distribute to specific team members, especially those important first hires.
In this post we will explore this topic in detail, using data from the share schemes set up on the Vestd platform by UK businesses.
How Much Equity Should I Set Aside for the Team?
As with many facets of business, there is no one-size-fits-all approach. What is right for your company might not be ideal for another.
For example, early-stage business with no funding and a small team will be in a very different place to an established corporate-sized firm with hundreds of employees. No doubt their respective equity pools will be different too.
That said, there are some benchmarks to explore, to give you an idea of what other businesses tend to do when creating their share schemes.
So what does an average share scheme look like?
Typically the total equity set aside for the team will be in the range of 5-15%.
This normally comes in the form of an option pool that will be used in the share scheme. Options are granted to employees and typically vest over a number of years – employees normally need to stick around before their options can be exercised, at which point they become actual shares.
You can, of course, issue shares upfront, though an EMI Scheme is generally seen to be the most tax-efficient way to reward employees.
At any rate, before deciding on how much equity to ring-fence for your scheme, consider the following:
Founder dilution. If you are a sole founder, setting aside 15% equity for your employees means you’ll retain 85%. That’s easy enough to grasp, but what happens if you have two co-founders who also own a slice of the action? Issuing employee equity will dilute each of their stakes too.
External investors. Perhaps you have some angel or seed investors onboard? In that case, you will have already issued equity, and their shares will be diluted by your employee option pool. Future share issues – either to employees, or new investors – will further dilute everyone’s stakes.
Company valuation. An EMI Option Scheme requires a company to be valued prior to submitting the paperwork to HMRC. This, in turn, will define the total value of shares issued to your team.
Now let’s look at your employees…
How Much Equity Should I Allocate to Individual Team Members?
Employees are normally rewarded in relation to their anticipated contribution, but also in line with risk. With this in mind, the first thing to think about is the nature of your business. Are you running an early-stage business, or has it progressed to the growth phase?
People who join a business in the initial phase are taking on more risk – and often do more foundational work – than those who join later, when the business is more stable.
As such, the equity offered too early, ‘foundational’ hires may be considerably higher than to those who join in the future.
The first five people hired are often each awarded a percentage point grant of the available equity pool (normally up to the 5% mark). However, it may be that you need to push the boat out for pivotal hires.
If you’re opening up the scheme to all employees, then you may have two tiers: one for ‘foundational’ and senior roles, and another for non-foundational hires.
Remember to keep some equity aside for future hires. Avoid depleting the option pool if you plan on doubling your headcount or bringing in experienced C-level folk anytime soon.
Why do You Need a Structured Share Plan in Place?
It is wise to create an employee share ownership plan (ESOP) that facilitates the provision of equity to existing and future hires.
Moreover, it does this in a systematic way. An ESOP aligns equity distribution to roles, as opposed to valuing individuals.
The steps for setting up an ESOP are broadly as follows:
- Organise your company into groups
- Assign a set amount of equity to each group
- Establish employee levels (e.g. senior, mid-level, junior)
- Allocate equity to specific roles
- Add team members to the groups
- Add new hires to groups
The amount of equity funnelled into each group should reflect the likely contribution of each department, and that’s going to be dependent on your particular business.
This role-based model helps to standardise equity distribution. For example, a junior designer will be awarded a certain amount of equity, and if you hire another one then they’ll get the same amount. Once promoted to mid-level, they’ll move up a tier and be eligible for a bigger slice of the action.
Here’s a table from Index Ventures that illustrates how this works in practice:
Now you should probably think through some more precise calculations about how to align equity rewards to particular roles.
How Do You Calculate How Much Equity to Give to a Particular Team Member?
There are different approaches to doing this, though they share some similar thinking.
The first method comes from Fred Wilson of Union Square Ventures. You’ll need to know your company valuation and the total number of shares in your scheme.
You then create ‘brackets’ of employees, which could be based on the groups mentioned above. Each bracket is then assigned a multiplier (0.05 – 1x) and run against the employee’s salary, to determine the amount of equity – in monetary terms – to award each employee.
The second method is possibly more interesting to startups and early-stage companies, as it aligns equity to market rate. In simple terms, it allows startups to recruit talent by offering a top compensation package made up of a salary plus equity.
Let’s say a top market rate for a role is £150k, but the startup can only afford £100k. This method, from Wealthfront, would use a calculation to award the difference – £50k – in shares. To seal the deal you might offer more than that.
Both methods require you to work out the monetary value of your shares (divide your valuation by the total number of shares), in order to figure out how much to allocate to each employee.
How Does Share Dilution Work?
Let’s quickly run through an example of how equity dilution affects your employee share scheme.
In the beginning, there is one founder, Natalie Woods, who owns 100% of the company (1m shares issued).
Natalie makes two foundational hires and uses the Wealthfront ‘market rate’ compensation method. She awards 50,000 shares to Amy and George, who each own 4.5% of the business.
Natalie believes in the benefits of employee ownership and decides to allocate 100,000 shares to use for an EMI scheme. She can now incentivise new hires with options.
Natalie’s fully diluted stake has dropped to 83%, though the effect of this dilution will be deferred until the employees exercise their options, typically several years down the line.
With the company in good shape, Natalie secures a funding round from two investors: Oak Capital and Blue Foundation, who receive 200,000 and 100,000 shares respectively.
Natalie’s fully diluted stake has now been reduced to 66%. The foundational hires, Amy and George, have seen their stakes drop from 4.5% to 3.3%. And the investors own 20% of the business.
Dilution may sound like bad news, but it is often quite the opposite. The value of Natalie’s stake should be considerably higher than it was when she owned all of the business, as a single founder.
How to Launch an Employee Share Scheme
Here is a Plain English guide on how to set up an employee share scheme, which will outline the various options available to you.
Hundreds of UK businesses use the Vestd platform to create and manage their share schemes. Seedrs and Vestd are working together to reduce the costs and complexity of setting up share schemes: book in a free consultation to receive a 10% discount for the first year of your scheme.
Related content: Structuring Share Classes in Your Startup
Related content: Enterprise Management Incentives (EMI) Options
Related content: What are EMI Option Schemes and How Do They Work?
Vestd is the UK’s only end-to-end digital platform for creating and managing employee share schemes, offering a guided service, supported by an in-house team of share scheme experts. The platform has been purpose-built for UK businesses, with full digital management, signing and vesting schedules, along with a shareholder portal.