The African tech ecosystem has witnessed exponential growth over the past decade, with numerous venture-backed startups emerging across the continent. In my role as Investment Manager at Founders Factory Africa, I have witnessed firsthand the power of early-stage companies in driving innovation and economic transformation.
One of the most critical factors for a startup’s success is its ability to attract, retain, and incentivise top talent. Below, we will explore the role of equity in incentivising employees at venture-backed startups in Africa, and delve into the best practices for equity discussions and agreements.
The role of equity in incentivising early employees
Equity represents ownership in a company, and it can be a powerful tool for attracting top talent to a startup. Early employees often take on significant risks when joining a young company, and offering equity is a way for founders to reward them for their dedication and commitment. By aligning employees’ interests with those of the company, equity grants can:
a. Encourage long-term commitment
b. Align incentives and drive performance
c. Attract top talent who might otherwise opt for more established companies
Best practices in allocating equity
To ensure fair and effective equity distribution, startups should adhere to the following best practices:
- Establish an Employee Stock Ownership Plan (ESOP): an ESOP provides a legal framework for granting equity to employees. It should outline the total number of shares available for grant, the vesting schedule, and other terms and conditions.
- Determine an Equity Allocation Model (EAM): founders should determine an appropriate EAM, taking into account factors such as employee role, seniority, and contributions to the company’s success. Common models include the:
- Fixed Model: allocates equity based on predefined percentages or a fixed number of shares for each role or seniority level within the company
- Dynamic Model: allocates equity based on a formula that takes into account various factors, such as the employee’s role, seniority, and performance
- Milestone-based Model: allocates equity based on the achievement of specific milestones, such as product development, customer acquisition, or revenue targets
- Transparent Communication: open and honest communication is essential when discussing equity allocation with early employees. Founders should be transparent about the company’s valuation, the value of equity grants, and the potential dilution resulting from future funding rounds.
- Regular Reviews and Adjustments: as the company grows and evolves, it’s essential to review and adjust the equity allocation model to ensure it remains fair and motivating.
Equity vesting and cliff provisions
Equity vesting is the process by which employees gradually gain ownership of their equity grants over time. The most common vesting schedule is a 4-year period, with a 1-year cliff. The cliff provision ensures that employees must remain with the company for at least one year to receive any equity. This protects the company’s interests while also incentivising employees to commit to the long-term success of the startup.
At every funding round, the team’s stake is diluted on the cap table. This entropy is unavoidable. In our experience within the African ecosystem, a founder’s ownership stake usually dilutes by 15 to 25% per funding round with the average being around 20%. The goal is for founders and the team to be at 51% post-Series A. It is the founder’s duty therefore to carefully manage both their equity and that of the broader team to ensure that meaningful value can be created for the founders and team post a liquidity event.
Balancing equity with cash compensation
While equity can be a powerful motivator, it’s essential to strike a balance between equity grants and cash compensation. Offering competitive salaries, alongside a robust equity package, can help attract and retain top talent, particularly in the fast-growing African tech ecosystem.
As the African startup ecosystem continues to thrive, understanding the role of equity in incentivising early employees is crucial. By adopting best practices and ensuring transparent discussions around equity allocation, venture-backed startups can attract and retain the talent needed to drive their success and contribute to the growth of the African tech landscape.
Philani Mzila is an Investment Manager at Founders Factory Africa.