Today, a $200,000 income in San Francisco, New York City, Chicago or Miami provides, at best, a middle-class lifestyle. Don't believe me? Take a look at a few hard facts:
- The average sale price of an apartment in Manhattan is now nearly $1.7 million.
- The average monthly rent for a two-bedroom apartment in San Francisco is almost $3,900.
- The average car insurance premium in Miami is $264 per month.
Income taxes, insurance premiums, real estate costs, and the rising cost of consumer goods and services have made living well a very expensive proposition.
The most talented employees recognize this reality and acknowledge that they most likely won’t achieve their financial dreams through salary alone. For them, it’s about ownership—they want a piece of the action and are willing to do what it takes to secure your company’s financial success and, in the process, their own success as well.
As a business owner who's interested in keeping your high-performance employees around as long as possible, the question becomes how much ownership you should give your employees each year as part of their compensation.
The Wealthfront Equity Plan
Andy Rachleff, a former venture capitalist and the founder of Wealthfront, an automated investment management service with more than $1 billion in client assets, developed the Wealthfront Equity Plan (“WEP”) to help business owners more easily address this question. His plan has been adopted by hundreds of businesses in pursuit of top talent, including Equinix, Juniper Networks and Opsware. The plan’s structure is designed to align the interests of employees and founders, reward long-term thinking, and inspire employees to work toward the success of the company instead of just in their area of responsibility.
Rachleff’s WEP organizes ownership grants into four categories:
- New hires. These grants are reserved for your incoming employees and should reflect market rates.
- Promotion. These grants are given as part of the additional compensation provided to employees when they're promoted. The purpose is to bring the employee up to a market-level compensation given their skills and role within the company.
- Outstanding performance. Rachleff recommends making these grants once per year to the top 10 to 20 percent of your employees. The additional grant allocated to each employee should equal half of what they would receive if they were a new hire applying for their job.
- Evergreen. After two-and-a-half years with your company, Rachleff’s WEP calls for annual grants to all your employees. Each grant should be equal to one quarter of what a new hire would be granted for the same role and experience. The Evergreen grants are meant to keep your most talented employees around for the long term.
How much will these grants cost you? The total ranges anywhere from 3 to 5 percent annual dilution in ownership. The increase in company equity value over time given your stronger ability to attract top talent will more than offset the cost to company founders because of this dilution. (For more details, check out Rachleff’s presentation on his equity plan.)
Trading Salary for More Equity
Allowing employees to trade salary for more equity is a second option and one that's especially valuable for businesses that need more cash. Many employees are excited about the prospects of ownership and are willing to go beyond what you decide to allocate. It’s becoming more common for both existing employees and job recruits to request a reduction in salary in exchange for more equity.
Let’s take a closer look at how this would work. Say you extend an offer of $120,000 in salary to a prospective employee. If the employee wants more upside, an alternative would be to offer $100,000 in salary with $20,000 in additional equity. Even though the salary reduction is long term, the equity only needs to match the first-year reduction since it’s presumed to significantly increase in value over time. When calculating the number of shares or options, base your numbers on the current company valuation and number of fully diluted shares. This technique could also work if you're offering below-market salaries to highly qualified candidates.
Structuring this type of compensation scheme and properly executing it requires working with an experienced attorney. Make sure you consult one who has specific experience in structuring non-cash compensation and equity incentive plans for companies of your scale and within your industry.
Read more articles on small-business finances.
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