Deciding to implement some type of employment incentive scheme for your start-up is a sound a smart decision to enable you to compete for talent and once you find the right talent – to motivate it to stick with you.

Deciding what type of employee incentive plan is suitable for you is the first step. For early stage start-up’s in Switzerland, the decision is likely to be between an ESOP and a PSOP . This is due to the simple fact that liquidity is usually not available at the beginning, e.g. to pay out market salaries or a traditional bonus.

The devil being in the (implementation) detail – the very important question you need to answer next – how you are going to decide who gets what.

I will explain the difference between these two methods.

1.    ALL VERSUS SOME

You first need to decide if you want ALL your employees to participate or only reserve the plan for some of your employees. Typical example could be – only the first 30 employees, only senior executives, only engineers or any other selected category that you consider for incentive plan. The other option is to open the incentive plan for all your employees – this is of course more demanding on the option pool size. On the other hand, including all your employees creates a culture of inclusiveness and transparency – and perhaps will motivate you to consider your hiring / firing decisions even more carefully.

2.    HOW BIG IS THE POT

After you have decided who will be eligible to participate in the plan, the next step is to decide how much to share with the participating employees – i.e. how many shares / phantom shares you will make available for the incentive plan. Remember that all existing shareholders are diluted by the option pool.

A good indication of the typical, market standard size based on European benchmark was published in the Balderton Essentials Guide to Employee Equity 2017. For early stage start-up you get around the 10% pool size.

3.    HOW TO SHARE THE POT

Once you made a decision on who will be participating in the plan and on the sizes of the option pool, you have 2 main options for allocation key: a fixed allocation or a dynamic allocation.

1.  Fixed allocation key

Standard fixed allocation keys are either based on:

a)    ad hoc individual negotiations – typical for very early stage or strategic key employee; or

b)    on fixed % per role (i.e. senior engineers, junior engineers, other staff).

Following the logical evolution of a start-up – first you typically design what you are going to sell and then you sell it -  first to be rewarded are typical technical roles, followed by the commercial roles later on. Balderton Capital report also indicated typical ranges and stages if you decide to go this way:

Lets use Paradise Solutions as a case study.

There are 3 founders who decided to make an incentive pool of 10% as follows:

a)    to be allocated by 0.75 % for senior roles (VP and directors) over 3 years time (proportionate) with 3 months cliff

b)    they currently recruiting for the head of their product development team (VP engineering) and head of sales team (VP sales) – each will get as part of their package the defined salaries + the 0.75 equity component. If the employee leaves in the first 3 months, he or she has no right to the equity component. If the employee leaves at the end of the first year, he or she qualified for 0.25% shares. In the second year for 0.5% shares and in the third year for 0.75% shares.

c)    in the Paradise Solutions pool is remaining 8.5% to incentives, other employees, as the team grows

d)    once the pool is exhausted – they either need to create another one or the other employees cannot participate

2.  Dynamic allocation key

Dynamic allocation keys gained their popularity first for co-founder share allocation. The most widely used one is the slicing pie method, developed in the US by Mike Moyer and in the meantime used by countless start-ups’ all over the world.

There are few paradigms shifts you need to be able to make when you start thinking dynamic:

a.    The real contributions are the base for allocation – i.e. as it develops in time – compared to traditional time-based vesting – where time is the criterion that gives the right to the options – which are allocated upfront

b.    The pot is shared between all the participants and as its value grows and more participants are included – the relative shares will decrease – this needs to be really well explained and communicated

c.       The advantage is that you can keep adding the employees to the pot and not worry that you have exhausted the pool but still need to reward some more employees.

For using the dynamic allocation key you need to decide for the participating employees which contributions you expect (i.e. time or results), and input parameters for measuring it (the employee salary or in case of results - % of sales commission of finder fee for fundraisers for example.

Then – for the duration of the plan – you regularly record the contributions and track the allocation. The shares are then fixed at a defined moment – i.e. time (after 2 years) or event (exit).

If we use the example of Paradise Solutions, here is what it will look like.

There are 3 founders who decided to make an incentive pool of 10% - and to open this pool for their senior employees. The first senior employees hired by Paradise Solutions are VP product development – hired in January 2020 and VP sales – hired in September 2020.

The input parameters are:

a)    The annual fair market salary for VP product development is 120.000 and for VP sales are 150.000. Both roles’ contributions will be counted in time only and both employees are being paid an annual salary of 80.000.

The table illustrates how it works. Each employee started at 0% and over time they earn a slice of the pool pie by their real contributions – in this example time.

1: weeks of participation reflects that VP Product started in January and worked already 48 weeks. VP sales started in September and worked 12 weeks.

2: the fair market salary and average hours worked (line 2 and 4) are used to calculate the total hours worked (line 5) and what would be the compensation using the fair market salary (line 6)

3. cash payment from the company includes what both employees are being paid (proportionate part of the yearly 80.000 salaries) which is deducted from the compensation. The difference – line 8 – is adjusted non-cash contribution – which is then being multiplied by 2 to arrive at a non-cash slice. In this case, both employees contribute only time and no cash – so this is the only slice that will be used for allocating their share.

The multipliers are important for the good/bad leaver framework which defines a different outcome for an employee who is considered a bad leaver compared to an employee who is considered a good leaver.

In this example – the VP Product qualifies for 82% of the pool and VP Sales for 12% of the 10% option pool.

The dynamic allocation key is a game-changer because:

a)    Only the real contributions count – in this example – it is time contribution

b)    If anything changes (i.e. the VP product can be paid his full market salary and prefers that to equity component) – the method can quickly adjust to this by not adding more contributions since the moment he will be paid in full

c)    The full option pool is allocated to the participants – and as their numbers increase – the % of the pool goes down in relative size (%) and grows in absolute size (the value of the slice)

Let’s fast forward a year later. Paradise Solutions raised additional financing. The VP Product asked to be paid a full market salary – rather than gaining additional shares options. The VP Sales wanted to keep growing his shares option.

The VP Product shares options went down to 33% of the 10% option pool. The VP Sales shares options grew to 67% of the 10% option pool.

Closing remarks

The main attractiveness of the dynamic allocation key is its fairness and ability to reflect possible and plausible changes – based on the real contributions of the participants.

In the US the method is being widely used for the last 10 years. European founders are similarly enthusiastic to use this method for both – their cofounding team as well as their employees.  

Stay tuned for more details on the different incentive plans – ESOP and PSOP – in the next part of our series.