Understanding the Evolution of Equity Compensation at Private Companies

Published: January 2020

 

Well-managed HR processes are key ingredient to successfully navigating high growth at private companies. In this article, we focus on benchmarks around equity compensation.

When startups scale and look to expand into new markets, their workforce infrastructure and rewards programs must also evolve. Our research and experience in advising private companies has found a direct link between a well-managed HR system and the success of a startup looking to scale. One of the primary factors when designing a suitable rewards program for a growth-focused startup is equity compensation, which this article will focus on.

Equity Overhang

With each round of funding, equity awards granted may increase, which contributions to dilution and higher equity overhang. Increased hiring and the buildup of unexercised awards also add to dilution. Overall, the percentage of company stock held by employees and executives will decrease with additional rounds of financing. This has major implications for a company preparing for an IPO. Following an IPO, the larger share reserve and funding only increase total overhang.

Equity Approaches by Stage

Equity grant programs evolve as companies mature from the startup to late stages. Each stage offers a different value proposition to employees as well as constraints to the equity program from investors and shareholders.

While equity has significant upside potential, it is hard to put into dollar value terms for early-stage companies that don’t have a public value. While all employees receive some level of equity to create an ownership culture and alignment across the company in a startup, new-hire participation decreases as a public company increases in size.

A majority of large public companies, particularly those relying heavily on equity compensation such as the technology sector, provide both new hire and ongoing equity awards to employees. New-hire awards are granted to employees upon hire date, often provided at a premium above annual grant values. Companies typically provide ongoing grants on an annual basis to ensure employees maintain unvested equity holdings.

Equity Design

As a startup matures and headcount rises, the equity design is bound to evolve. For startups, stock options carry significant upside, but are tricky to quantify in terms of dollar value. As a company approaches its IPO, equity shifts from being a percentage of company ownership to a dollar value of the award. In fact, some highly-valued private companies also start adding restricted stocks to their vehicle mix. Late-stage private companies usually delay refresh grants until the IPO launches. Once a company approaches IPO, equity participation decreases; while new hires may receive an initial grant, refresh grants are reserved for more senior roles.

Awarding Additional Equity

While the concept of an annual award is a public company practice, the approach has become more common at venture capital-backed private companies over the last five years as companies take longer to IPO, on average, creating a greater need to keep employees engaged. Private market liquidity also plays into refresh demand as access to secondary markets and creative liquidity solutions become more prevalent. When developing a refresh program and rationalizing additional equity for existing employees, companies need to consider a number of factors, such as equity vesting, ownership levels, recent promotions and critical roles.

Developing an Equity Strategy

Stage and size matter when developing an equity program. Equity plan participation cuts across the company at some level and the development of an approach to refresh becomes more critical. Moreover, stock options are still the predominant equity vehicle in the private pre-IPO environment.

Startups must take the following variables into account when developing an overall equity strategy:

  • Individual pay mix consisting of cash and equity
  • Overall company overhang and equity usage
  • Grant frequency
  • Participation
  • New-hire grant levels
  • Equity vehicle mix

When Is it Time to Make the Transition

There are two ways of looking at equity compensation: total potential ownership and value-based approach. The total potential ownership approach measures awards as a percentage of the fully diluted shares outstanding. If successful, it presents significant rewards and inculcates a true ownership mentality. However, competing with the public marketplace is challenging and rewards will be further diluted if ownership levels remain constant.

In the value-based approach, a company develops the award size based on equity value. This is an emerging practice across private companies. The advantages are that it communicates award value for broader market comparison and manages dilution by using fewer shares. However, it can be challenging to communicate without a necessary level of transparency and typically requires subjective valuation of company.

As a company approaches its IPO, it is likely to implement a new equity plan. This allows newly public companies to readily adapt to evolving market practices. It’s easier to implement new plans when approval is limited to a small group of founders and investors. Upon going public, the support of a broader set of shareholders must be sought, who typically impose stricter governance norms for equity compensation.

Next Steps

Startups planning to scale or go public must put the right equity compensation and governance systems in place to set the stage for business success. If you have questions about rewards design at your private company and want to speak with a member of our rewards consulting group, please write to rewards-solutions@aon.com

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