Your startup is gaining traction, and you’re bringing on an all-star team and board of advisors to help you build your company and want to offer them equity in exchange for their talents and services. But let’s be honest, distributing equity in a startup isn’t an intuitive process. However, the beauty of being a business owner is the constant learning you must do to grow and scale your company. You’ve learned countless new processes and skills to get your business up and running.
Today’s lesson in business ownership: startup equity.
Startup equity refers to the degree of ownership stakeholders have of a company. This typically refers to the value of shares that founders, investors, and employees are issued.
As a founder, you want to make sure sharing ownership of your business is done with intention and care. The easiest way to understand startup equity is to think of it as a pie. There is a finite about of the pie that can be divided and shared, however, the worth of each piece of pie can increase as your business becomes more successful.
If you as a founder own 100% of your business, you own the entire pie. While it can be appealing to keep the value of your company to yourself, it is important to understand that when it comes to ownership, you only earn as much as your company is worth. And 100% ownership isn’t always the best way to go if you want to see your business truly grow.
For example, if you are the sole owner of a $500,000 business but do not have the bandwidth to grow the company on your own, you will likely stay at the $500,000 mark (assuming all factors remain constant in your business). However, if you have a co-founder or team of employees who have a variety of skills that can help you grow your business valuation to the $10 million mark and you own 50% of that, your stake is then worth $5 million. Not too shabby.
How to Distribute Equity in a Startup
Who should be awarded equity in your startup will depend on how your business is structured. Typically, equity is divided among founders (and co-founders), employees, outside investors, and company advisors. Let’s break down who these parties are, and how their equity awards should be portioned.
1. Founders and co-founders
If you are the sole founder of your company, determining your own stake can be fairly straightforward. However, if you have a co-founder or co-founders, determining how equity should be distributed among all founders is an important decision that should not be taken likely.
According to The Founder’s Dilemma by Noam Wesserman, 65% of startups fail due to co-founder fallout. Furthermore, when performing research for the book Wesserman also found that while 73% of startups determine how to split equity within a month of founding, over half of teams do not include terms outlining how to adjust equity if there is a major business event such as a change in strategy, new business model, or departure of a founder. In other words — if you want your startup to succeed in the long run, having open, honest conversations with your co-founders early and often are important.
As you work with your co-founders to determine how to split equity, you’ll want to consider the following factors:
Risk — Are all co-founders facing the same amount of risk by pursuing this venture? If one founder is taking on more risk than another, such as quitting their full-time job or investing more capital initially, that should be a considered when dividing equity.
Level of commitment — In the initial stages, many co-founders work to build their companies for little to no pay. However, if one co-founder has taken on more demanding roles and responsibilities, or has demonstrated greater commitment to helping the business succeed, that could be a factor when determining equity.
Innovation — If the company revolves around a co-founder’s idea or unique research and their partners perform other duties, ownership of the original idea can be considered when sharing equity. However, if the company was founded from a joint idea, splitting equally can also be an option.
Common equity allocation among co-founders include equal splits (such as 50-50, or 33-33-33), or a senior controlling partnership, where one founder has a larger stake (such as 60-40). Here is a co-founder equity calculator that can help you through the process.
As you build your startup, you will eventually start hiring talented team members who can bring your business to the next level. Like many founders, you may encounter tight budgets in the beginning that may impact your ability to offer robust employee salaries. However, if your initial employee salaries come shy of the market rate, you can offer equity to employees as part of their compensation package.
Many professionals are incentivized by partial ownership in the companies they work for, understanding that the success of the company can result in financial gain on a personal level.
When determining how to offer equity to your employees, here are important factors to consider:
Percentage of ownership — You’ll need to determine how much ownership you plan to award to employees. This typically begins by designating an employee equity pool, or specifying how much of your equity pie will be awarded to employees. As you determine how much equity to award employees, you may want to take into account how many team members you plan to hire, your employee’s level of experience, and your company’s financing timeline.
Vesting schedule — Next you need to determine when your employees can access their earnings. The most common timeline is a four-year vesting schedule with a one-year cliff. This means an employee can begin vesting their equity after a year of being at the company. After their first year, they will own a quarter of their equity grant, with the remainder vested on a monthly or quarterly basis. Though this is common, you can implement the vesting schedule that works best for your business.
Type of shares awarded — How do you plan to distribute equity to employees? Many startups choose to grant stock options to their employees. This means employees have the option to purchase stock at a predetermined strike price. Some companies opt to give their employees restricted stock, which consists of shares granted to recipients when the value is very low. This option can have more upfront tax implications for employees, which is important to consider.
Education — Lastly, if your company offers equity to employees, you want to make sure your employees understand how it works. Providing education and space for employees to ask questions and understand their options is critical for any company that offers employee equity.
Ideally, employee equity should incentivize employees to stay with your company and contribute to business growth and success.
Those who invest in your company — whether they are angel investors, venture capitalists, or friends and family, should also receive a slice of your business’s equity pie. When an investor puts money into a startup, they are essentially taking on financial risk in hopes of receiving a financial return.
How much equity an investor receives will vary depending on the valuation of your company when they invest, and the size of their investment. If you go the fundraising route and receive money from outside investors to build your company, conversations about equity should take place when you are pitching for and negotiating investments.
In early-stage startups, there is typically an advisory board of experienced founders and experts in your industry who provide strategic direction for the company. It is common for this role to be performed in exchange for equity.
There are not specific guidelines around how to award equity to advisors who offer their time and expertise to help you grow your startup, however many companies offer 0.2% to 1% equity to their advisors.
As you form advising partnerships, you’ll want to clearly set expectations with advisors early on so they know how big of a commitment their role as an advisor will be in exchange for the amount of equity you choose to offer.
Ultimately, how much equity you award and to whom will depend on what’s best for the growth and success of your company. Looking for more advice on running your startup? Check out The Ultimate Guide to Startups.
Originally published Feb 7, 2020 8:30:00 AM, updated February 07 2020