Wednesday, January 2, 2008

Being Fair - Employee Compensation (Equity)

Well, we learned something the hard way. We learned that people often have widely varying opinions of what's fair, to the point where it can cause irreparable damage to a business. Fortunately for us, it didn't get to that point.

Let's start with a little background. I am a software engineer. Or I was. Until I went back to business school. When I started this company, programming was the last thing I wanted to do. I wanted to run the business. So we brought 3 friends into the mix to help us develop the software. And so, the adventure began.

From the beginning we declared that they would be treated fairly when it came time to determine the equity split. What we didn't know was what the equity stakes would look like. This was our first time doing this, so we looked everywhere for help. We found some basic guidelines from people we spoke to: CEO's 6-8%, other executives, 4-6%, etc. The consensus was that engineers would make something close to ~1%. This baseline was confirmed when we met with our attorneys, whom have been advising us along the way - and have advised countless tech startups. It's also important to keep in mind that these 3 engineers were taking very little risk. They were all working other jobs and were spending a few hours a day working on developing the site for us. They weren't involved in building the business or any other component.

My partner and I felt that offering the 3 engineers somewhere in the range of what 1 full time engineer would get was an adequate starting point. This process is normally a negotiation, or so we thought.

The morning after I sent out the offer letters, my partner told me he had spoken with 2 of the engineers who were visibly upset. They were so insulted by the offer that they wouldn't even negotiate. They were done. They pulled up their stakes and stopped working. I was a bit surprised to say the least. I got in touch with them later that day to explain the circumstances of the offer and why we felt that it was fair - which I still, to this day feel. We made the decision based on commitment, value to the company, risk, quality of work delivered, our relationship, etc. It wasn't an easy process - but it was one that we had thought out thoroughly.

They responded that it was insulting - that we shouldn't look at the book when working with friends (in determining equity). They had the impression that their contribution should be worth many millions more than what their equity stake suggested upon an exit. It was at this point that I began to feel good about the situation. It was obvious that they hadn't done this before and didn't really have in interest in being part of a startup - all they cared about was the compensation.

Part of the explanation that I gave them was the need to be conscious of the well being of the company and the fact that investors would look unfavorably upon a company that compensated their part time engineers with 1/10th of the company. I also highlighted our need to keep enough equity to continue to hire and grow. I also tried to point out the value of the experience and the many other benefits to working with your friends - such as being able to come on board full time upon financing, getting a great position in the company, learning how to start a company, playing a role in strategy, etc.

In the end, it was all about the money. And though it was an uneasy separation, it was for the best in the long run. We can't and won't use anything they created up to this point, but we thanked them for their time and cut our ties. We still do remain friends though as we've chalked this all up to experience.

As for that 3rd engineer? Well, he's happy with the equity he was offered. He believes in the company and in the founders and is excited to be a part of something that could be very successful. That's how it should work.

What does this all mean to me now? Well, I've strapped on my development hat and started coding again. Not what I envisioned or really wanted - but I think it's best for the company. It's always good to have a developer as a co-founder. And I'm actually a bit excited to get coding again - strange as that sounds, even to me.

The big lesson: make sure that the ideas of fairness are aligned between you and whomever you're talking to. We obviously had very very different ideas of what type of compensation would be fair. But remember, as an employee, it's not all about the money. There's more involved - startups are a great experience. I'm not sure I could ever go back to the corporate world now - it's just no fun!

For the record, I was given < 1% at the last startup I worked, where I coded many 18 hour days, worked without a salary for many months, slept at the office, and was friends with the co-founders. I didn't love the deal - but it was acceptable. And now that I can see it from the other side, it was certainly fair too.

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