Cash vs. equity: The compensation conundrum

(Editor’s note: Jason Cohen is an angel investor and the founder of Smart Bear Software. This story originally appeared on his blog.)

As we bring on new employees at my new venture, I’ve been struggling with the question of how much equity (shares) should I give a new employee or partner.

I’m not alone. It’s one of the most frequent questions in start-up forums – and it’s doubly complicated when the company is young and according to typical financial assessment the shares are “worth nothing?”

The question gets even muddier when the new hire is getting a salary. Typically that salary is less than market with the balance given in the form of equity, but again how do you compute that when the stock is, today, of no value?

With WPEngine recently I had yet another question to answer: “What if I took $X/mo salary, then how much equity would you part with? What about $Y/mo?” Hard to know, but an important question for a bootstrap startup to answer.

Here’s a simple framework for how to come up with those numbers.

When someone works for less salary than they deserve (meaning: what they could make elsewhere), I think of that as a cash investment they’re making in your company.

Here’s why: Suppose a new hire just quit a job paying $10,000/month and agrees to take $3,000/month for a year with you, after which time (assuming the company does as well as everyone hopes) she’ll be raised back up to $10,000/month. So for $36,000 you’re getting someone who should have made $120,000.

She gave up $84,000 in potential earnings, but that’s what a startup is, sacrificing cash now for a chance at a ton of cash later. Of course she needs to own P% of the company so she can share in those potential earnings, but how do you compute P?

Now consider this scenario: That same new hire quit her old job but demands the same $10,000/mo from you. You agree, but since you can spend only $36,000 this year, you raise the balance ($84,000) as an angel investment. The angel will of course demand Q% of your company for this extremely risky loan, but how do you compute Q?

Financially, these two scenarios are identical, therefore P must equal Q. In both cases you give up a percentage of your company so that you can spend a specific amount of cash to get a specific person. Whether it’s the hire herself who’s investing her loss in cash or an angel fronting the cash, you’re trading P% of the company for an amount of cash.

This is the key, because Q — what an institutional investor would accept — is a well-understood system. So if that’s the same as P, we’re done. So what kind of return does an angel investor need to make on their $84,000?

Investors in early-stage startups need large potential returns to compensate for the fact that most of those investments will be lost. If you like thinking about this in terms of “annual return,” they need between 40 percent and 60 percent compounding annual return. (Remember, this isn’t like a bond or savings account paying X percent every month, this is a one-time payout years from now that almost surely won’t happen at all.)

Usually this is stated as a rule of thumb: “3x return in 3 years, or 10x return in 5 years.” That formulation rings true to almost every investor I’ve met, from angels to VCs.

So let’s apply it to our example. If the company were sold in three years the investor would like to make $250,000; if sold in five years the investor needs $840,000.

Now the question is: How much money could the company be worth in three or five years? Clearly you’re about to pull a number out of your ass, but that’s OK because we’re just going for ballpark figures. In the case of WPEngine, I’ve been saying $5m in three years or $25m in five years.

To make $250,000 out of $5m the investor would need 5 percent; to make $840,000 from $25m the investor needs 3 percent. Of course the numbers don’t match because, again, I pulled those potential valuations out of nowhere.

But the exercise has proved fruitful because now you know that this new hire needs something like 3-5 percent for this to be a fair trade. That’s a much tighter range than you had a few minutes ago.

Remember, though, that when you’re very small, new hires should mean more to you than just financial investment. This might be a good method for computing compensation for employee #10, but hire #1 ought to also be able to substantially affect your chance of success, by changing the slope on the revenue curve, by adding expertise or skill you didn’t have before, by opening new markets, etc.

And if that’s happening, they’re contributing more than just the balance of a normal salary, they’re changing the risk profile of the company, and that deserves compensation too.