Building a startup is a team effort, so it’s only fair that the team you share your entrepreneurial journey with also shares in some of the profits.
This means giving up some of your equity and handing it over to your team.
As investors, we see far too many startups coming in without setting aside any equity for their teams. These teams are also becoming increasingly more demanding and it's quickly becoming expected that when you join a startup, you’ll be getting some equity.
So I, the investor, want you to share some equity with your team and your team is expecting you to share some equity with them. What do you do?
Well, you create a stock option pool (SOP), which is a portion of equity that founders set aside for their early employees.
Attracting the right people
The ‘why’ is pretty simple and no, it’s not altruism. It’s all about making sure your startup has access to the necessary resources it needs to succeed.
For you and your startup to succeed, you need to attract top managerial talent.
Make no mistake about it, the success of a startup cannot be more highly correlated with the strength of its management team.
140 Proof CEO Jon Elvekrog calls it the “universal first step to building a strong and sustainable company”.
The management team needs expertise across a number of verticals: they need technical, financial, operational, marketing and business development expertise, to name a few. If one of those verticals is lacking talent, that’s a problem.
The solution is to surround yourself with high calibre individuals - the kind that early stage startups can’t afford.
However, startups can offer talent the opportunity to trade a high base salary now for a potentially significant upside at exit through an SOP: when a startup makes it big, the management team ‘rakes in the money’ by selling their shares, thus compensating themselves for lower-than-average pay in the early days.
Incentivizing the right people
Secondly, you’ve got to motivate that talent and an SOP is the best way to align the interests of the company and its employees.
In 2015, Twitter CEO Jack Dorsey gave roughly 1 percent of Twitter back to its employees - a third of his own share in the company.
Why did he do that? Qstream CFO David Stack explains it succinctly as “empowering your employees with a sense of ownership provides a great incentive to go the extra mile”.
Partial owners of a company have a vested interest not only in their own performance, but in the long-term success of the whole company. This mind-set goes a long way in combating employee churn, helping you to not only attract top talent - but also to hold onto it.”
All for one and one for all
Thirdly the benefits to the ecosystem can come back and help you later.
The group of early employees who founded Paypal and exited to Ebay for $1.5 billion, AKA the Paypal Mafia, have gone on to found massively influential start-ups and have become investors in their own right. ion.
Not to mention their role in helping revitalize the tech industry in Silicon Valley, that group of 220 people for example went on to create seven distinct "unicorn" companies. Unicorns are companies with a valuation of more than $1 billion. They were able to do these things because they all owned equity in Paypal as early employees and benefited from the SOP.
Those same employees who benefit from your SOP can later come in and invest in your next startup or become professional investors who can help other startups find the financing they need. They can even become the voice of an ecosystem when it comes to lobbying the government for policy changes.
It’s a virtuous cycle that all of us in the ecosystem desperately want to see.
Show me the SOP
And finally an SOP will show investors you’re serious about your team and your business.
They show investors that the founders are invested in their employees, recognize that talent is important, and that they are making allowances for attracting the talent they need to grow.
It also shows investors a startup that has its house in order and is ready to scale. In fact, most investors, such as Y Combinator, actually require it. Redpoint Ventures partner Tomas Tunguz counts stock options among his gospel of startup best practices.
How much is enough?
At this point, you’re probably really keen on SOPs and want to know how much equity should you set aside when setting one up for your team.
Generally speaking, option pools typically range from 10 percent to 20 percent.
Y Combinator president Sam Altman argues that typically you want to give at least 10 percent in total to the first 10 employees, 5 percent to the next 20, and 5 percent to the next 50. Sam Altman’s an interesting guy who knows a lot about startups, so if you don’t want to listen to me you should probably listen to him.
There is still much to learn about SOPs. Details like vesting protect you from having your employees ditch you the minute you give them their shares: they take ownership over time, usually four years, that way you make sure they stay with you for a while.
You also need to be able to answer questions from employees like: What is dilution? When can stock options be exercised? How can you sell them? What’s a secondary market?
You can Google most of these. The important part here is to get you thinking about creating a stock option pool for your startup.