Startup equity is essentially ownership of a company expressed in shares of stock. Founders who incorporate their companies (likely in Delaware) without outside investors have 100% ownership on day one. You may have put in your own money along with your co-founders. You may have worked without compensation for some time, and your opportunity cost of working somewhere else can be substantial. You have made an investment, but as soon as you take an investment or issue stock options, you are starting to become diluted. Consider this a necessary evil, but also remember
Equity Allocation
Commonly, “stock” and “equity” are used interchangeably. The units of equity are shares of stock and are used to represent ownership in your company. The shares are the way your stock is divided. Your ownership percentage is equal to the number shares you own divided the total shares.
Startup Equity for Employees
Equity is the currency in the startup and tech worlds. Once founders have divided the initial ownership between themselves and investors, they can use it to attract talent. These early-stage employees, just like VCs, take on risk and must be compensated for the reduction in salary and hours. Startup equity offers can be used to retain employees and offer the possibility of a large payday when the company exits via a buyout or initial public offering (IPO).
Equity is the currency in the tech and startup industries. Though as I can tell you, I have many hundreds of thousands of shares of worthless stock from startups that never were successful. Also, I have cashed in handsomely on other investments.
How much equity should you offer? What are the terms? There are some general rules. However, the smaller and younger your company is, the more startup capital you will need.
Founders Shares
You can choose to split ownership if you have more than one founder. This depends on the number of founders and their contributions to the success or failure of your company. To build your company, you will likely need to trade equity for the company and/or attract new employees.
There is no right answer to determining the equity split between founders. They often default to a 50/50 split to avoid uncomfortable conversations. If not addressed, it can cause serious problems for a company’s future.
Sometimes, a 50/50 split is not practical. The founders bring different skills and are committed to the company. Different stages of life can lead to different outcomes, and founders have different roles. Also, if you both own 50% of the stock you can create a stalemate in the voting of the shares of stock. You may want to consider a 51/49 split to avoid this but also consider the previous point on who would ultimately have more shares.
Also, you may have great management skills as a middle manager, but be a terrible CEO. You may be a great engineer when you build things to other people’s specs but you don’t have the creativity to develop a product. You may be a great sales person when selling real estate but fail miserably trying to sell virtual goods and services like software. All these things can be combined with an even more dangerous phenomenon, known as the Dunning-Kruger effect.
The Dunning–Kruger effect is a cognitive bias whereby people with low ability, expertise, or experience regarding a certain type of task or area of knowledge tend to overestimate their ability or knowledge. Some researchers also include in their definition the opposite effect for high performers: their tendency to underestimate their skills. This is sometimes also known as imposter syndrome.
Either situation can have seriously detrimental effects on your company. And if you have a disproportionate level of ownership it’s likely to cause conflicts.
I have strong opinions here, and they are just that, my opinions. If you are a small group of relatively evenly matched founders, then you should consider an equal distribution of shares. The risk of creating a pro rata distribution is that from day one you are creating a hierarchy that can lead to resentment. Some founders with more shares may think they have a more say, which technically they do when it comes to a shareholder vote. That’s how private and public companies work. Though it’s predicated on the idea that one partner or multiple partners are more valuable than others. In companies that haven’t proven themselves and additionally partners that haven’t proven themselves, it’s speculative. The caveat is perhaps one of the founders puts in more capital to fund expenses, then there is a real assigned value to that investment. Also if you are a non-CEO founder and you have more shares than the CEO for operational decisions you don’t have any legal grounds to over reach your operational role.
It is important to have a conversation about ownership early and be fine with the outcome. If not you can be sure this can cause some serious resentment among the team.
Investor Stock
To match the risk that investors take in funding your startup, founders will need to give up a substantial amount of equity early on. As you become more successful, your startup equity will increase in value. Investors are often willing to pay less or offer more equity in return for funding.
You are creating a business relationship with VCs when they invest capital in return for equity in your company. Investors make returns proportional to their equity in your startup if your company makes a profit. Investors lose their money if the startup goes under. But VCs are willing and able to take on this risk, as owning a portion of a successful startup can prove lucrative. Also, unlike the founders, they are diversified. Most likely, as a founder you have all your eggs in one basket, while they have many investments across many companies.
Preferred Vs. Common Stock
Two types of shares are usually issued by startups: common and preferred. In venture investing–especially at the earliest stages–investors typically negotiate for preferred shares. Founders and employees often receive common shares. Preferential shares play a different role in private markets than in public markets.
Venture investing is a way for investors to receive preferred shares of companies they support, while founders and employees get common shares. Investors may convert their preferred shares into common shares during a future liquidity event, such as an IPO or acquisition. The details of what happens at a liquidity event are detailed in the accompanying documentation to closing.
Both common and preferred shares grant the holder partial ownership rights to the company. Investors also have key benefits from preferred shares. Preferential shareholders may be paid more than common shareholders in the event of a company failure, or protected against being overly diluted by future fundraising rounds.
Benefits of Preferred Stocks
Startup investors are often minority shareholders. This means that their shareholding percentage will not allow them to direct the company’s direction. They can however gain preferred shares that give them certain rights over common shareholders. This allows them to exert some control over the company and reduce their downside risk.
These are the key benefits of preferred stock:
- Anti-dilution protection. Investors are protected against future investors’ dilution through anti-dilution protection provisions. This can take the form of a “down round”–where the company’s valuation has fallen. If the value of the company increases, dilution may also occur when the shareholding percentage of an investor is decreased in a subsequent round. Mechanisms that adjust the price at the which preferred shares are converted into common shares may be implemented in this case. Pro-rata rights, which give investors the right to invest in future rounds and preserve their shareholding percentage, are common to prevent this source of dilution.
- Liquidation preferences. Preferred shareholders will have a higher liquidation preference than common stock holders in the event of a company’s liquidation, whether it be a sale, acquisition or IPO. They will receive their share of the proceeds before the common shareholders, but after the debt holders.
- Other protection provisions. Investors often seek protective provisions to allow them to veto corporate actions that could affect their investment, such as the sale of the company. For example, they may want the right to approve a board member, or the ability to block a liquidation event.
- General voting rights and representation on the board. Preferred shareholders are generally not entitled to vote in public companies. Venture investing allows preferred shareholders to negotiate similar voting rights to common shareholders. They also have the right to vote for members of the board.
Creating an Equity Distribution Plan
To recruit key employees, board members and advisors, startup equity will be required. However, first-time founders may find it difficult to share equity. The stake an employee gets depends on many factors, including their skills and seniority, as well as the original contribution they made when they were hired.
Index Ventures (which funded two of my startups) has a useful calculator for determining start-up valuation. The Index Ventures OptionPlan calculator can provide a good guideline based on the experience and exits of their portfolio.
Also remember that the pool of options for employees will probably be created after your seed funding. Those shares are likely to come from the founders’ shares in the company, not the venture investment and won’t affect the venture capitalist’s ownership.
For example, you may get funded at a pre-money valuation of $10 million dollars. The investors will want a significant stake for their investment, given the risk, lets say 25% of the company. So they might buy 25% of the company for $2.5 million USD. Then you need to create an Employee Stock Option Plan (ESOP) and likely set aside 10% of the total stock in that pool. The 10% will most likely come from the post-investment shares of the founders. So while you may be selling 25% to the VCs you are actually taking 35% dilution when you factor in the employee stock option plan.
Vesting Schedules
Equity compensation, regardless of form, is subject to vesting schedules. It is important to reward your employees for their loyalty. Startups have traditionally used a four year benchmark with a one year cliff. This means that no equity percentage can be granted until the employee has worked for at least twelve consecutive months. As startups are more difficult to exit, they are allowing for longer vesting periods.
Also consider my earlier point that you own 100% of your shares when you incorporate your company on your own. Investors are not just investing in the company but the founding team. They will want to keep you around. After taking investment, your founder’s stock may be subject to reverse vesting, where your stock is held in escrow until you put in some given amount of time. This could be four years or longer, they may be willing to not restrict all your stock for your “time served”. Also, it’s not unheard of in later rounds for investors to want to reset the clock and only agree to investing if you have
Equity is finite. So spend it wisely.
