The equity culture among young technology companies is almost universal. When implemented properly, broad employee ownership within a company can:

Align the risk and reward of employees betting on an unproven company.
Reward long-term value creation and thinking by employees.
Encourage employees to think about the company’s holistic success.

Unfortunately, despite decades of experience building new hire option plans, many start-ups still fail to put in place an equity compensation plan that adequately rewards long term employees over time.

When I was a venture capitalist, I noticed companies that seldom lost employees due to recruitment had a lot in common. Sure, they offered challenging and inspiring work environments sought by top-tier talent. But you might be surprised to learn they all rewarded outstanding performance through the issuance of additional stock options (or as is now the case, RSUs) in a similar way.

The Wealthfront Equity Plan

Based on my observations, I created an equity allocation plan that I encouraged all my portfolios to adopt. It worked so well that executives and my fellow board members usually brought my plan with them when they got involved with other companies. Over the years, I am proud to say that hundreds of companies, including Equinix, Juniper Networks and Opsware, adopted this plan because it just made sense. Not surprisingly, we've put this plan in place at Wealthfront

How It Works

The Wealthfront Equity Plan is designed to specifically handle the four most important cases for granting equity to employees. Each year, you create a new option pool that addresses the following needs:

New Hires: These grants are used to hire new employees at market levels.

Promotion: These grants are intended to reward employees who have been promoted. Promotion grants should bring the recipient up to the level you would hire her at today for her new position.

Outstanding Performance: These grants, made once each year, are only intended for your top 10% to 20% of employees who truly distinguished themselves on the basis of amazing accomplishments over the past year. Individual performance grants should represent 50% of what you would hire that person at for their position today. This pool should be reserved for non-executives.

Evergreen: These grants, which are appropriate for all employees, start at an employee’s 2½-year anniversary and continue every year thereafter. The idea is you don’t want to wait until the employee’s initial grant has been fully vested to give a new grant because by that time the employee will evaluate new opportunities.

Annual evergreen grants should equal 25% of what that employee would receive if she were hired for her same position today. Giving 25% of the market rate for a position each year, rather than a lump sum grant that covers the next four years, will smooth out the vesting process so the employee never reaches a cliff. As I said before, cliffs cause people to raise their heads to consider alternatives and should be avoided at all costs.

The Key: Consistent, Early Evergreen Grants

Most companies put considerable effort into the size of their equity grants for new hires. It’s rare these days to find new hires that haven’t used a tool to determine the appropriate amount of salary & equity to expect for a given position.

Fewer companies, especially young ones, put significant effort into thinking about follow-on grants. If you tell your employees to “think like an owner,” then you need to consistently align equity with their contribution to the success of the company.

Evergreen grants are the most common area where technology startups fail to invest time until far too late in their development.

“The average tenure for most technology employees is two to three years, and waiting until your first employees hit year four is just too late.”

Instead of an ad-hoc process, you should offer a transparent, consistent and fair program of equity grants that employees can build into their long-term expectations. As a result, not only do you avoid cliffs, but you also tie both long-term tenure and contribution to their ownership stake. The best part is that, as your company grows, you always grant stock in proportion to what is fair today rather than in proportion to their original grant.

This article first appeared on First Round Review's blog and has been reprinted with the Wealthfront author's and their permission. To continue reading, click here