The art of crafting employee incentive plans

This article is from an episode of Matrix Moments by Matrix Partners India, a podcast featuring candid conversations on what it really takes to survive the startup world. This is heavily revised from the original show transcript. For the full interview, go here.

Structuring and designing an effective incentive plan is key to promote motivation and employee retention at the early stages. But is it better to offer cash or equity? How much equity is apt at each stage? How does a founder measure employee performance through a balance scorecard?

In this episode, Matrix Partners’ Avnish Bajaj outlines simple rules of thumb when structuring incentive plans.

How does one think of ESOP vs cash at the early stages?

If a person was making X amount of money in their previous job, they would ask for an increase from their last cash computation upon entering a new firm. That norm has shifted, and in my view, it will change a lot more.

When Flipkart exited, there were a lot of millionaires. Even when my company exited, we had ESOP for all staff, down to the office boy, who made close to US$3,000. You have to look at it as a multiple of your annual income.

Because people now recognize how much money they can make from ESOP, it’s less of a sell. In certain companies, they can attract talent by offering half the cash the person was previously making.

Some founders struggle with how much equity to give, but there are very simple rules of thumb they can use.

If you’re hiring a co-founder or even beyond that, you have to look at the percentage of a company they will take. For example, a chief technology officer usually gets 3% to 7%. The maximum would be a high single-digit percentage. And this does not count the original founders, who usually have 20% to 30% each.

The next rule is to think of equity as a multiple of cost to company (CTC), or the annual amount a company has to spend for an employee.

We usually look at a range of 1x to 5x the CTC. For example, if I hire someone and give them an equity amount that’s equivalent to 3x their CTC, and then the company valuation doubles or triples, that means the value of their shares would be 6x to 9x their CTC, spread over four years or how long the shares vest. The employee would then be getting 2x their CTC per year.

This range also depends on seniority. If the hire is more junior, it would be 1x of CTC. If they are very senior and are co-founder material, then you’ll need to calculate based on company percentage.

What are some key elements that should be included in an ESOP plan?

At the most basic level, it is the exercise price, or the price at which a stock is given. If a company is starting out and is worth US$15 million, does an employee get stock at the going price at US$15 million or do they get it at zero, which is called par value?

This is a tricky balance. If the company is at US$150 million when the hire comes in and you are issuing stock at par value, then they are already making a lot of money. What incentive do the employees now have to increase the company’s valuation?