A guide to distributing startup equity
One of the most valuable tools in your arsenal as an early-stage startup is equity. It represents ownership of your company and gives you something to offer investors in return for their financial support.
Like slicing a cake, the more people who have a share, the smaller the slice. And each time you slice the cake again - from seed funding through to Series A, B and C rounds - the more you divide it.
To keep everyone happy and retain ownership of your business, you need to plan carefully from day one and make sure binding legal agreements cover everything.
Make a business plan that includes any equity investment rounds you intend to use to raise funds in the foreseeable future.
Add up the amounts of equity you are willing to give to investors at each stage and make sure you leave enough for yourself and any other startup founders.
And consider other ways to use the equity in your company, such as offering it to talented individuals to secure them as early employees, or making use of tax breaks on equity to make investing in your business even more appealing to stakeholders.
Here's our beginner's guide to distributing startup equity, including who gets what, when, and what it's worth, as well as how to protect your interests against any associated risks.
Who gets startup equity?
In the beginning, a new startup's founders own 100% of the equity in the business. If you are the sole founder, that means you own everything.
The more people who invest time and money into the venture, the more you might have to divide the equity up and give it to the people who support you.
Some examples of how this can happen include:
- More than one co-founder
- Financial support from friends and family
- Early investment from third parties
Here we are thinking specifically about startup equity, but remember there are also later stages when you might need to give away a stake in your business.
Series A, B and C funding rounds often involve a transfer of equity to investors. As you move through the life of your business, always keep in mind how much equity you hold and how much you can afford to give away in the future.
There are also other circumstances in which you might give an equity stake to someone who is not a company founder or a financial supporter.
A typical example is when people work for you for equity compensation, instead of a salary or wage.
Singers and actors sometimes work for a share of the profits an album or movie makes, rather than a fixed fee. Working in any business for an equity stake is comparable.
How do you split startup equity between founders?
Businesses with two or more co-founders face the dilemma of how to split startup equity between founders fairly and equally.
At this early stage, you probably still have 100% of the equity in your company. It's beneficial to split this between the founders before you give a stake to investors.
In a perfect world, you might want to be equal partners; however, it's crucial to give each founder a fair stake, even if those stakes are not perfectly equal.
An analogy for this is if you buy a $3 pie using $2 of your own money and $1 from a friend. If the friend then wanted half the pie, you might not feel like you were getting fair market value for your investment.
In business - especially when starting a new company - it's not just about the money each founding partner puts into the venture.
There are also other considerations, for example:
- Past experience and expertise each founder brings to the business
- Physical assets or machinery put into the company by one partner
- The amount of time each party spends working on the startup
For all of these different factors, it's fair for founders to expect some form of recompense.
Therefore, if you are allocating equity 'fairly', this might lead to an unequal split that favors the founder who you feel has put the most into getting your new business started successfully.
How do you split startup equity between investors?
One of the most significant reasons why it's crucial to agree on the division of equity between founders is so that you have a solid base when it comes to awarding equity to third-party investors.
At each round of funding, from seed financing through to Series A, B and C equity rounds, you need to identify how much equity you are willing to sell.
Investors then put money into your business in return for an equity stake. Again, the amount of equity each investor receives should represent how much they have put in.
So, for example, if you seek $1 million and offer 20% of your company's equity in return, an investment of $500,000 would buy a 10% stake.
Well-known investors may attempt to negotiate a lower price or a higher equity stake based on their experience, unique knowledge or track record.
It's up to the majority stakeholders whether or not to accept a lower offer; however, keep in mind how your other investors might feel if they find out they have paid more for their share.
Always keep in mind your own stake and how much it is eroded each time you give some equity away to a new external investor.
For example, you might want to make sure the founders of the company always retain a stake that adds up to at least 51% of the total equity.
By doing this, you can make sure no external investor owns enough of your business to take control of the decision-making.
How and when do employees receive equity?
There are times in the life of a startup company when you might want to deal in employee equity and vesting schedules.
A typical definition for this is:
- Company founders who initially set up the business
- Early employees (the first 25 key hires by a new startup)
- Later employees (the 26th and subsequent individuals to be hired)
These first people through the door can have a disproportionate impact on your business growth. They might bring unique skills or access to markets you otherwise could not enter.
At the same time, you might not yet have a well-established income stream or cash flow to pay your early employees a salary.
Instead, you could give an equity offer to some of your first employees, giving them a long-term stake in the success of your business.
A common way to calculate this is to work out the ratio of how much your company is worth compared with how much it will theoretically be worth once a new hire joins you.
This added value is a measure of how much equity you could give to that individual and still break even on hiring them.
Give them less than the break-even figure and you can make a profit even when giving some equity away.
Equity employees are a risk to your business because, if they do not add as much value as expected, you could end up losing money compared with never hiring them at all.
However, an equity stake also gives them a vested interest in helping your company to succeed to the greatest extent possible.
Because of this, a substantial equity stake is one way to ensure a talented individual puts their all into helping your startup to become established and profitable more quickly.
Types of equity incentives
Equity itself is an incentive to invest time or money into a business, but there are also ways a startup's owners can reward employees and investors with preferential prices and other benefits relating to their equity stake.
Convertible Debt Notes
A convertible debt note is a way to use equity as security on a loan from an investor. The convertible note is a promise to pay back the loan with interest or to award equity at a discounted price during a later finance round.
Investors benefit either way - by getting back their initial investment plus interest, or by buying an equity stake at a lower price.
This is a widely used way for startup businesses to bring in much-needed finance, without having to give away any equity until much later.
A typical duration for a convertible debt note is 12-18 months, after which the company should ideally hold a Series A finance round where investors can buy equity at the discounted rate.
Incentive Stock Options (ISOs)
ISOs are a company benefit offered to employees that allows them to buy a number of shares and usually at a discounted price, with a tax break on any capital gains made.
The tax break is because any profit made on ISOs is taxed as capital gains and is not subject to ordinary income tax.
Non-Qualified Stock Options (NSOs) are similar and more commonplace but do not meet the Internal Revenue Code requirements to be treated as ISOs, so any profits are taxed as income, not as capital gains.
How do businesses protect themselves?
Giving away equity in your business is not something that should be done lightly and you should always protect your interests using legally enforceable contracts.
Savvy business owners always seek legal advice before entering into a binding agreement, especially one that has implications for the ownership of their company.
A lawyer can draw up a contract that states how much equity is transferred and what you expect to receive in return for that stake.
The recompense you receive will vary depending on the nature of the party taking the equity stake.
For example, you might expect to receive:
- Money, assets or ideas from co-founders
- Time and expertise from early employees
- Hands-off financial support from equity investors
Failing to protect your business at the outset can undermine your ability to grow, make decisions and attract professional third-party investment later.
In the worst cases, disputes can arise over who owns the company and who has the power to make decisions about the direction it takes.
When you draw up a co-founder agreement, you anticipate any such disputes.
You have a chance to clearly state each partner's role, their equity stake and any mechanism you might agree to use to resolve disagreements, especially when you hold an equal share in the business.
When can someone sell their shares?
Always know the exit options for anyone who takes an equity stake in your business. Can they sell their share at any time and to any person they choose?
It's essential to give stakeholders an exit strategy. Apart from dividends that split your profits between all the parties who hold equity, the other way for people to make money from their equity is capital gains.
People must be able to sell their shares to release the capital gains from their equity.
By putting rules in place for this from the outset, you can avoid any shocks and, in extreme cases, avoid a hostile takeover from an investor who has been able to buy a majority stake from others.
Again, this is an area where a lawyer can help. Business lawyers have experience in such matters and can make sure your contracts cover you against stakeholders who try to sell their shares in a way - or at a time - that would damage your interests or the value of the company.
Remember any deadlines on convertible debt notes, too. If you can repay the investor's money with interest before the deadline, you can avoid losing any equity in your business.
Alternatively, if the deadline expires before you have allowed the investor to buy the agreed stake at a reduced price, you risk defaulting on the convertible note.
So it's crucial to make sure you give people the chance to buy any promised equity package within the agreed timeframe, as well as giving your investors and stakeholders opportunity to sell their shares at appropriate moments.
For more on stock options, make sure to listen to this episode of Brex in The Black with our CFO Michael Tannenbaum