Every founder struggles with the salary v.s. equity dilemma.
Some founders (and investors) live by the ironclad belief that it's better to pay people healthy salaries than to give them equity in the company. On the other side of the fence are the founders and investors that see tremendous value in offering people small portions of equity--but in doing so, pay them more modest salaries. Some employees prefer the former, while some hope to share in the rewards of the latter.
As an entrepreneur and as an employee, it's important you understand the pros and cons of both scenarios.
For example: when is it better to work for a startup and take a smaller salary in exchange for an equity upside? My answer would be, only when the company has a unique or highly sought-after business model, and is a likely candidate to go public (IPO) or be bought by a large strategic business.
Now, the truth is, most employees don't know what most of the above paragraph means. If you're not sure what a unique business model looks like, or what it means for a company to go public, then I would highly discourage you from taking equity in exchange for a smaller salary. You'd be making an uninformed bet.
If you feel you have found a valuable startup, then what is the right amount of equity to ask for? And as a founder, what's a fair amount of equity for you to give?
The right amount of equity to be given to a partner or new employee depends on two key factors:
1. The value this person brings to the business that can't be bought by a salary.
There are some employees that have "it."
"It" is a special skill, experience or a mindset, or an energy you can't quantify in a salary. Say you want to open a chain of specialty coffee shops, and you hire someone with management experience from Starbucks. Especially if it's the right personality fit for what you're looking for, their experience will be valuable in a way you can't put a number on--and may be worth incentivizing further for their long-term efforts.
Certain qualities in your employees or partners are hard to come by, and if you're a startup, you're going to need all the help you can get. Equity can be a great way to incentivize long-term involvement from people who add value beyond business as usual.
2. How much they're willing to be paid below market value for their position.
Equity is the most valuable part of your business.
If you're going to share in the ownership, it's worth asking what the opportunity cost is. Paying someone $1,000 less per year in exchange for a tiny piece of equity in the company is negligible. Paying someone $20,000 less per year in exchange for equity is fairly substantial.
The gap between what you would otherwise normally pay an employee and what you would pay them after giving them equity needs to be worth both the risk and the reward. The employee needs to sacrifice short-term gains for a longer-term payoff, and you need to make it worth their while without giving them the best of both worlds.
Equity can be a great lure for top talent, but remember to use it wisely. You only have a finite amount, which is what makes it such a precious resource.
Which leads us to the final question: if you have equity in a company, how do you get cash out?
In most cases, you won't be able to cash in your equity until there is an agreed upon liquidity event by management and investors, or there is an IPO, sale, or partial sale of the company. Technically, you could receive cash if there is a distribution of profits (since you, as an employee, technically "own" some of the business), but this isn't very common in startups.
I tell a few of these stories in my book, All In, but where most equity deals go wrong, unfortunately, is when the joys of "ownership" wear off, and it becomes apparent how much more work still needs to be done in order to make the company successful. Employees cut an equity deal, accept a lower-than-market salary, and then 12 to 24 months later start asking for more money.
This is a bad form. If you take equity in a company, that means you're eligible to share in the big rewards every founder hopes for in the end. What that also means, however, is you have to share in the same risks. I strongly encourage every founder to contractually clarify these terms with partners and employees from the onset. That way, if they want to be paid more money down the road, it's mutually understood that in exchange for a raise, they'll be forgoing their equity.
If you believe in the business, equity is far more valuable than cash. But just because you have equity doesn't mean you're going to become a millionaire. Everyone needs to know what the future value could be upfront, and not have wild expectations of the way things should be a year or two down the road.
Great things take time to build.