Your startup is gaining traction, and you’re bringing on an all-star team to help you build your company. In exchange for their talents and services, you want to offer them equity — but distributing it isn’t an intuitive process.
However, a lot of the beauty of being a business owner is in the lessons you learn and the adversity you overcome. You’ve taken on plenty of challenges as you've grown your business — distributing startup equity is just another one to figure out.
So to help you with the process, we'll review what startup equity is, see how it works in a startup, go over how it's typically structured, and pin down how to value and distribute it.
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 thoughtfully and productively. And campy as it might seem, the easiest way to understand startup equity is to think of it as a pie.
There's only so much pie that can be divided and shared — and the value of each piece increases as your business becomes more successful.
If you, as a founder, own 100% of your business, you own the entire pie. And while keeping the entire value of your company to yourself might sound appealing in theory, the reality is that you can only earn as much as your business is worth — and maintaining 100% ownership isn't conducive to your company's growth.
If you want your pie to become more valuable as a whole, you have to be willing to forfeit some pieces.
For example, if you are the sole owner of a $500,000 business but lack the bandwidth to grow the company on your own, you're bound to stall at the $500,000 mark or even dip below it — 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 does equity work in a startup?
Startup equity, as a concept, rests on the idea that a company's stakeholders deserve exactly what that title entails — a stake in the company. That generally means offering early contributors like employees and investors a certain percentage of ownership.
That percentage is dictated by factors like timing, degree of contribution, level of commitment, and the company's valuation at the time of equity distribution. Founders generally — and unsurprisingly — receive the most initial equity.
The company's earliest investors also tend to receive more equity than those who get on board later, as their investments are proportionately larger relative to the company's early valuation. And employees who help get things off the ground also often see larger proportions of ownership than those who join the company further down the line.
Equity distribution is also closely linked to funding stages. As funding rounds progress, your financial circumstances naturally shift, and in virtually every case, how you distribute equity shifts with them.
Typical Startup Equity Distribution
As we touched on earlier, startup equity distribution varies based on factors — including timing, business model, industry, CEO preferences, and number of stakeholders involved. There's no definitive, "this the only way this happens" model for the process. Still, there are some trends and relatively consistent figures that characterize a typical startup's equity distribution.
Here's a look at how equity distribution often progresses as a startup scales and moves through funding stages.
As you can see, startup equity is relatively fluid and can shift pretty radically as a company scales. And for anyone involved with a growing startup — in any capacity — knowing the value of your personal equity is key. Here's a look at how you can calculate that.
How to Value Equity in a Startup
How you can value your equity at a startup leans on a few factors.
1. Last Preferred Price
The last preferred price is what investors paid for a single share during the company's most recent funding round. It's typically used as a reference point for the degree of a startup's potential success.
2. Post-Money Valuation
A startup's post-money valuation represents the broader value of a company after a round of funding. It's calculated by adding the pre-money valuation — a company's valuation before a round of investment — and the amount of new equity.
3. Hypothetical Exit Value
Hypothetical exit value is the value a company would exit at — meaning the value that a company would generate should it be sold. Startups typically don't readily offer this information. If you want to find a somewhat accurate figure, you should research similar companies to see what theirs have looked like.
4. Number of Options in Your Grant
This one is pretty self-explanatory. The number of options in your grant is literally the number of options in your grant.
5. Strike Price
A strike price is the price per share you'd incur to exercise your options.
Once you have this information — a lot of which you should be able to find in your offer letter — use this handy calculator from Carta to determine the value of your potential equity.
Who should be awarded equity in your startup will depend on how your business is structured. Equity is usually 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.
How to Distribute Equity in a Startup
Founders and Co-Founders
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 multiple co-founders), determining how equity should be distributed among the parties involved is an important decision that should not be taken lightly.
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? Those potential factors should be 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 a 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 while 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 methods 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 at 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're 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.
Early-stage startups typically have an advisory board of experienced founders and industry experts who provide strategic direction for the company — these parties are often compensated with equity.
There are no 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 you expect from them in exchange for the amount of equity you choose to offer.
Startup Equity From the Employees' Perspective
As a startup employee, the amount of equity you're offered rests on several factors. There's no definitive model that can accurately predict your equity before it's parcelled out. Your seniority, position, tenure at the company, and experience all play a role in dictating the size of your piece of the pie.
A senior engineer who has the distinction of being employee number five at a startup is bound to receive a larger stake in the business than a junior salesperson who joined the company as employee number 30.
If there's any factor that holds more weight than others when it comes to equity distribution, it's timing. If you get on board at a startup early, you'll be more likely to receive more equity than someone hired down the line — even if they're more experienced and their position is more labor-intensive or mission-critical.
Ultimately, how much equity you award and to whom will depend on what’s best for the growth and success of your company.
Originally published Sep 21, 2021 4:00:00 PM, updated June 22 2022