Early employees – Salary & Equity

In the beginning of a startup there are just the founders. They do all the work – making / selling / admin / HR / cleaning / finance – everything. With their enormous passion and never ending energy they start moving the wheel. They make the product / launch it / get some traction / start getting some orders and so on. Once the work load increases to a point there is need for more hands & heads. Since they have launched / been covered / have made progress – less people look down upon them and some even show interest in working with them. Through their efforts they manage to find some passionate guys ready to come on board. (Read here about What to look for in startup interviews?). So far so good. Now comes the tricky part. What should be the salary and equity for the new team members? 

 

Salary

  • You need to find folks who are ready to work for much lower than market salary. Folks who value the other things they will get much more than money, things like – learn lot of cool stuff / work on hard problems / have loads of fun / work with uber smart folks / etc 
  •  To begin with it’s great if they agree to work for “survival salary” for a year or until the company either raises money or starts earning enough to pay him / her more than survival salary
  • Look for people who lead a fairly simple / bootstrapped lifestyle and don’t have too many commitments. Specially stay away from folks with housing loans
  • I think INR 15-25K a month is a good range to think about  
  •  When you make the salary commitments you should ensure that you have enough cash to take care of overall expenses for next 10-12 months or more
  • Budget for other expenses like – Computer / Phone / Work area / misc expenses for each employee
  • If you can hire people who bring their own laptop – that is a bonus


Equity

  • Equity should be decided depending on
    • Stage of the company
    • Potential impact on the employee on the future of the company
    • How much cut is the guy taking on the cash side (this should be compensated)
    • A good thumb rule is to think 5 years in future
      • Assume that your company is acquired for a reasonable amount
      • Calculate the return which that guy will get via sale of equity
      • Now estimate the market salary of the guy 5 years from today
      • If in the 5th year he can make 5-6 times his annual salary via the equity sale – its a decent deal / anything higher is off course better for him
  • Read PG’s excellent article on how much equity is the right equity
  • Overall you should designate a certain number of unallocated shares as the ESOP pool. These shares are not yet issued but have been allocated as employee stock – to be issued overtime
  • Typically startups keep 20% as employee stock option pool
  • Vesting Schedule
    •  Equity offered to startup employees is not just for joining but for long term contribution to the company
    • Hence you pro-rate the equity over this period of time called “Vesting Period”
    • Normally this period is 4 years. But in special cases it can be brought down to 3 years
    • You also need to think about the minimum period the person should work for the company for making a decent contribution
    • This is called “Cliff” and is normally 1 year. You can be flexible on the duration but its strongly recommended that you have the cliff in the arrangement
    • If the employee leaves (or is asked to leave) before completion of the cliff period he / she will not get any equity in the company
    • So lets say you plan to hire a guy X for following terms
      • Equity – 4%
      • Vesting Period – 4 years
      • Cliff – 1 year
    • This means that you will give X  4% equity for working in the company for 4 years. But you expect him to stay for minimum 1 year
    • Let’s say 4% translates to 4800 shares
    • Total vesting duration in months is 48 months
    • Every month that X stays with the company he becomes owner of 1/ 48th of 4800 shares – which is 100 shares
    • Now the cliff kicks in, X needs to complete the cliff period of 12 months to receive any shares
    • So if he stays for 13 months, number of shares = (4800/48) *13 = 1300
    • But if he stays for 11 months, he gets ZERO shares – since he did not complete the cliff period
  • Additional equity
    • In some case companies give additional equity to employees later on as a performance bonus or as part of promotion
    • Each equity grant should have separate vesting schedule
  • Share price
    • In most cases startup employees are only expected to pay the face value of the shares and even that is reimbursed in some form
    • But at later stages companies calculate the share price with the help of their CA and offer the shares the employee for a heavy discount or subsidy
  • Paperwork / Agreements
    • Setting up a formal ESOP plan with help of a good lawyer would be too expensive for a bootstrapped startup – hence it’s a good idea to do that after you raise series A or start making decent amount of revenues
    • For a bootstrapped startup, you should mention the amount of equity and details of vesting schedule in the employment agreement
    • At the time of issuing shares you enter into share subscription agreement with the employee – where he / she only needs to pay the face value of the shares
  • Deciding later
    • In many cases people like each other and start working together without finalizing the equity %
    • Leaving it totally open could be a bad idea – since expectations could be totally mismatched and that could become a big headache
    • If you do want to defer the decision on the number, make sure that you discuss
      • Exact time after which equity will be decided
      • Range in which the equity will fall
      • Your expectations from the employee
    • Best way is to start with a firm number slightly on the lower side and if things turn out good you can always grant more equity

Ankur raised a point while reviewing the draft of this post that some times the employee will ask you back the question – Why are you guys keeping 95% and giving me only 5%? Obviously guy is not able appreciate to or realize the difference in the contribution of a Founder and an early employee. Here are some of those reasons, which quite often remain invisible to the employees:

  • Founders take the maximum risk while starting a company
  • They quit their job not to join an existing setup but they quit with nothing in hand
  • The startups are literally created in heads of the founders – its their DNA that the startup carries – they have the maximum impact on its outcome and the equity should reflect that
  • The initial days are the hardest for every startup and there is very little to show – so at that point almost no one wants to join them – during that period its the founders alone who toil and create – employees mostly come later
  • An employee has the flexibility to leave  the job whenever they want and move on to a new job. Founders don’t have that option – they need to stay with the company thru thick and thin. (In theory they can also shutdown or leave – but in practice its very difficult)
  • Founders also make the initial capital investment in the company and add more capital in most cases / they max out the credit cards / bring personal laptops / run office from there home / bring stuff from home to run the office and many such contributions
  • Founders work for zero salary for quite a long time
  • Founders normally setup ESOP of 20% out of which other employees are also given equity grants – so they are really are not keeping 95%
  • Most employees want to do specialized jobs around their core area and stick to it – so that they continue to build their job career. Founders do not have any such choice – irrespective of their backgrounds – founders need to work in every department and do what ever it takes to keep things moving and it also involves junior most jobs like – bank work / cleaning / delivering orders / making tea / pretty much every thing
  • A founder’s career and reputation is attached to the outcome of the venture / he is the one who worries the most / looses the most sleep – the buck stops at him
  • As a founder -If you find a guy who can match you to a certain extent in above listed aspects – you should surely give him more equity or even bring him on board as a founder. One of portolio founders did this very recently – brought a guy as first employee with 9% equity / found that the guy can bring a lot more value and invited him to join as a co-founder with same amount equity as the first founder
  • As a founder – its also important that you draw the line at the right place. If you find someone really good for a particular role, but they bring no additional value and this person expects a much higher equity than what seems fair – Dont worry about it – just let them go. If they can not respect your contribution – they are anyway a wrong hire
  • As a potential employee – if you don’t see founders with the kind of commitment and qualities mentioned above – don’t join the startup

What are your experiences as a founder or a startup employee? Please share in comments and help make the post better.

 

Importance of Cash over Profits

I have been invited by folks at Power of Ideas (POI) to give a talk on the above topic as part of POI start up workshop 2010 – that will take place @ IIMA Campus from 8-17 October. I looked at the agenda of the workshop & believe its is a very good initiative and should end up adding a lot of value to the shortlisted teams (big improvement over last year’s mentoring sessions).

They requested me to jot down my thoughts about the session and share with POI folks for feedback. I thought why not jot down the thoughts on my blog and get feedback of a larger community. I plan to use a lot of real life case studies (both good and bad) from the my experience @ madhouse and with all The Morpheus portfolio companies. Here is a related post I wrote previously: Should a startup be Ramen Profitable

Please  share your thoughts in comments – especially ideas on how can I make the talk better.

Basics
  • A startup should focus on only two things – Making & Selling
  • When you are making something you need to spend cash & when you sell anything you earn cash
  • Naturally making comes before selling and hence cash-wise spending comes before earning
  • If you can earn more than you spend – you are cash flow positive
  • So managing your efforts in making and selling is the key to managing cash

Making
  • Identify the minimum set of features that you need to build as V 1.0 to solve the smallest part of the “big problem” you are going after otherwise called Minimum Viable Product (MVP)
  • What you build should offer “definitive value” to the customers – so that the product is good to use
  • It should be something you can evolve (or scale) into a complete product
  • Do not invest more than 40-50% of your initial capital in making V 1.0
  • It should take between 2 – 6 months to make V 1.0
    • Closer to 2 months for a simpler product – lets say a web service
    • Closer to 6 months for a more complex product – lets say a hardware based device 
  • Since you have 50% of your capital still with you, there will be enough room to evolve your product into something that people will pay for and something that makes money
  • Important pointers:
    • In the beginning, don’t spend more than 2 weeks on discussions / analysis / customer surveys / market search and other such activities
    • For the initial version almost all of the making should be done by founders. There is no room for hiring employees for making or outsourcing it. Outsource usually makes you spend more time & money, and you will end up with a shabby product.
    • Never hold a release waiting for a perfect product
      • There is nothing called a product that cannot be improved and startups who get into the mindset of coming out with a perfect V 1.0 end up spending most of their cash building V 1.0
      • Irrespective of how much you spent making V 1.0 – it usually doesnt sell – you need to be able to take the learnings from this phase and build 2.0 / 3.0 and sometimes 4.0 before it starts selling
      • The early you release the better it is
  • Most of these points also apply to versions that come after 1.0

Selling
  • When you have a MVP ready, its time to get initial customers to use it, give constructive feedback for you to fix things and then go out and get somemore customers.
  • The most obvious tendency is for us to do Mass Media Marketing & Advertising – that’s something that we’ve been exposed to all through our growing up days and so a default choice!
  • As a start-up or even a company that’s on its growth path – its important to act by ONE Mantra – “Marketing / Sales activities that can be measured are worth investing in”.
  • There are lots of capital efficient ways of spreading awareness about your product / generating leads / closing sales and getting repeat orders
  • In good startups all money is spent on “making” and there is no budget for “Marketing or advertising” and even if a startup was to spend some amount, given the small budget – no one would notice
  • In the first year or two almost all marketing and sales should be done by founders. There is no room for hiring employees or outsourcing the work. You will end up spending more time / more money and bad results
  • Remember: Goal of Marketing is to generate Qualified Leads & of Sales is to convert that lead into a paying customer
  • Startups need to practice “Zero budget marketing” which in a nutshell is:
    • Create kick ass products which will be sold by the initial users to other users
    • Leverage upon Social Media channels to create a community – take their permission to talk to them about your product
    • Have a simple and effective website & a blog
    • Create good content that can be used to communicate with your community
    • For offline businesses – engage with your customers via cost-effective events & meetups
    • Measure imapct of each channel – learn from the data you have – quickly discontinue channels that are not effective
  • Sales
    • Take the conversation towards giving more information about the product to the qualified lead
    • Increase the chances of him converting into a customer / freebies – for initial customers to make them feel special
    • Keep in mind to increase Trust about your brand in the customer – that can be a potential concern
    • Conversion tactics include – free trial / discounts

 Back to basics
  • Make a good product while controlling the spend on making
  • Practice zero budget marketing techniques
  • Founders should take care of both making and selling
  • Improve the product fast to help sales take off
  • Then you are at
    • Low monthly expenses
    • Early Sales
    • You are now cash flow positive and that feels good

Cashflows
  • Running out of cash is the biggest reasons for startups to shutdown
  • Hence its very important that at every point you have a good understanding of
    • Cash in Bank
    • Monthly cash flow
    • Runaway available
  • monthly_cashflow =  (monthly_cash_in) – (monthly_cash_out)
  • For example if you spend 1000 Rs in month of September and got paid 600 Rs for the sale made
  • monthly_cashflow = (600 – 1000) =  – 400
  • If you keep going like that one day you will have “ZERO” cash available and that would end up killing your startup
  • On the other hand if you become cash flow positive even by a small amount  – it means at end of every month you have slight more cash than what you had the beginning of the month
  • This means few important things
    • Your startup had infinite runway (feels good)
    • You have made something people want to use and pay for
    • You have managed to keep your cost of making and selling below the cost at which customers are buying
    • And this is pretty much formula of a successful business
  • While fighting the battle of survival – cash flow and runway are the most important things a startup should pay attention to

Profits
  • They also matter but more in longer term after you have won the battle of survival 
  • There are two kind of costs
    • Monthly costs (for example – office rent / salaries etc)
    • One time costs  (for example the office printer you paid for this month but will use for next 2 years)
  • While calculating monthly profits you take the one time costs, convert them to monthly cost, add it to regular monthly costs and compare the total to your monthly earnings
  • One time Cost
    • You purchased a printer this month for 2400 Rs
    • Printer will be useful for next 24 months
    • You convert the cost into monthly cost – which is 100 Rs per month
    • You add the printer cost into monthly cost
  • Lets you monthly costs are 1000 rs without considering the one time cost
  • Now to become cash flow positive you need to earn above 1000 Rs
  • But to be profitable you need to take into account the one time cost as well and earn above 1100 Rs

Notes:

 1. I have kept the talk to Monthly Cash flows and Profits
2. I have also kept the concept a little simplified so that its easy to understand. Not gone into payables / receivables / PAT / EBITA etc
3. Once people understand basics they can build upon them