Every venture-backed business has a huge challenge - designing an equity program that supports long-term growth without breaking the cap table.

Employee equity schemes are now a popular form of compensation and for good reason! They align employee incentives with an employer’s long-term goals, driving increased engagement and motivation amongst the team. However, an effective equity scheme must evolve as a company matures through funding rounds, and it’s important to get it right at every stage.

There are a host of things to consider when rolling out an equity scheme. In future blog posts, we’ll deep dive into equity refreshers and budgeting - two critical elements of any best-in-class equity scheme. For now, let’s start with one of the most central questions:

What are the different approaches for designing initial equity grant bands? And critically, how do these approaches evolve throughout a company’s financing events (Seed → Series D)?

Pre-seed → seed: early-stage benchmarking approaches

As an early-stage business, your objective is to make your most critical early hires whilst recognising your capital limitations. There’s no one-size-fits-all approach, but understanding the history of decision-making may give you some strong fundamentals to create your own philosophy.

Here are some of the most common quantitative approaches to benchmarking to help you understand what others have done. In our experience, you’ll likely need to leverage every approach to make the right decision.

Approach 1: Equity as a way to fill the gap between the market salary and the salary you can offer

The idea of this approach is to determine the market salary for the employee, work out what you can afford to offer, and then calculate the difference.

It’s based on two variables:

1. The potential earnings of the employee.

2. What an angel investor would want for the same “investment”. Angel investors typically assume a 3x return in 3 years or a 10x return in 5 years. If you plan to be valued at $Xm in 3 years and $Ym in 5 years, you’ll need to offer angel investors an amount of equity that makes it worth their while.

The advantage of this approach is that you’re directly tackling the salary gap and providing a significant upside potential beyond that with equity. For employees, this means that not only are they getting a salary, but also the potential to earn a lot more money through equity.

The disadvantage is that calculations are based on future valuations defined by you, which may not be accurate at such an early stage in your growth. It’s also easy to adjust predicted valuations to grant less equity to employees, so there’s a significant amount of uncertainty due to the complexities of employee equity schemes. It’s important to note that it’s crucial to seek professional advice when structuring equity schemes to avoid future dilemmas.

Approach 2:  The equity equation, by Paul Graham

This calculation considers whether onboarding an employee improves your outcome more significantly than the dilution created by their equity grant. This is in line with Paul Graham’s equity equation: “The equity you give up should be less than the value of what you get.”

The advantage of this approach is that this is a very useful exercise for an early-stage company. If you’re struggling to envision how much impact a new hire will have on your outcome, perhaps it’s unnecessary to fill that role right now. This is an important consideration as it ensures that equity is allocated to the right people.

The disadvantage is that this guide was created in 2007 - a vastly different era in the startup ecosystem. Then, offering employee equity schemes wasn’t as common, but now there’s a positive trend in the number of businesses offering more employees more equity. In addition, valuations today are much higher than those that startups expected to reach in 2007, so for employees to have the same monetary upside, you’ll have to grant a smaller % than you would’ve done in 2007, making this equation a little less relevant than more modern approaches.

Approach 3: Rely on Peer or Insider Input (VCs)

This approach is based on crowdsourced insights. Rather than referring to the internal value relationship between the employer and candidate, the decision is based on the route that similar companies have taken.

Index Ventures, for example, advocate for employee equity and have created a book called Rewarding Talent. For the book, they gathered data on how much equity employees receive, which now serves as a great tool for others.

An advantage of this approach is that high-level insights can give you crucial information about what candidates have accepted at similar companies. You can therefore observe trends and anticipate the future expectations of the talent market. Input from insiders can also act as a reference point so that the employer and candidate can meet in the middle and base the conversation on objective facts.

The disadvantages are that you may have false confidence in your chosen number as benchmarking requires a deep understanding of the data source. Also, when the value is determined externally, it can create distance between the candidate and employer which could cause a discrepancy in perceived value later on.

Seed → Series C+: later-stage benchmarking approaches

During a company’s growth, there’s an inflection point at which heuristic-based approaches need to be replaced by a more robust methodology. As companies scale from Seed through Series C and beyond, they begin to take a more market-based pricing approach to derive the initial equity grant value for employees.

But, it’s not as simple as searching for a benchmark ad-hoc and including it in an offer package. Nowadays, candidates and employees increasingly demand transparency into how equity bands are derived, fairness around the interpretation of market data across teams within an organisation, and simplicity and consistency around how compensation benchmarks are created (especially if there is no single leader of Total Rewards).

Again, there’s no one-size-fits-all approach. Many companies evolve from one equity benchmarking methodology to another during their growth. Here are a few of the key models used to derive equity benchmarks from Seed to Series C and beyond.

Approach 1: Functional-specific market data points to derive the equity bands (Most relevant: Seed - Series A)

In this model, companies procure paid or free market-specific benchmarks and map role-specific benchmarks to positions in their job architecture.

The advantage is that position-specific benchmarks allow for targeted offers and at-market compensation. For example, a Software Engineer Level 3 may receive 1,000 units of equity, and a People Operations Level 3 may receive 800 units of equity.

A disadvantage is that this is a highly complex model. It requires extensive data interpretation - without this, there could be significant discrepancies across employees at similar levels in an organisation. For example, based on the market data, a Software Engineer Level 3 may receive 1,000 units, but an IT Level 3 may receive only 100 units. Is this disparity justified? What if IT is a strategic function within your organisation? In addition, this approach requires finding the correct comparables in the market, which will always be an imperfect process.

Approach 2: Use Total Cash Compensation to derive the equity grant value (Most Relevant Series B-Series C)

If companies realise that maintaining and interpreting market data for equity compensation is too difficult, they may create a more standardised approach. Typically, this involves basing an employee’s equity value on the Total Cash Compensation value of the offer. A company will define a series of percentage factors to apply to the Total Cash Compensation - typically between 10-70%.

The advantage of this approach is that it’s easy to roll out, and you can create an approach that stretches across levels (e.g. standard 30% of Total Cash Compensation for Level 5) with additional granularity for Technical vs Non-Technical roles (or other relevant segments of the organisation).

The disadvantage is that it may result in under- or over-market pricing if the factors are perfectly in-tune with the market. This can be mitigated by using market data as an input when finding the right factors.

Approach 3: Fixed values across levels (Most Relevant: Series C onwards)

This approach uses a standard grant that is given to employees across levels in an organisation, regardless of their function.

The advantages are that this is a highly consistent approach which ensures equity across roles and levels and simplifies lateral mobility within the organisation. It’s also a phased approach towards the new “normal” post-IPO in which equity compensation will be a less significant factor in an employee’s compensation package.

The disadvantages are that there is less variability across functions, which results in higher cash compensation to reflect the differences in pay across role types. Also, there’s a potentially lower incentive alignment as this is a more fixed approach.

So, there you have it - an overview of some of the most common approaches for benchmarking equity. To determine which is best for you, it’s important to review multiple approaches and remember that you’ll need to evolve as your company grows. To structure an equity program that supports long-term growth without breaking the cap table, seek professional advice to avoid mistakes and future dilemmas.