Startup Equity 101 | All You Need To Know

What should you know about Startup Equity?

Curious about how startup ownership distribution and compensation are calculated? Consider the following primer to get you started.

It’s essential to be open-minded when giving out equity because it can significantly impact your company.

Equity is just one of the many benefits of being an employee, and for this benefit to work, you need employees who are willing to share their insights. Click To Tweet

Without an MBA, it can be challenging to make equity decisions as a startup founder. It’s something that people typically don’t have to think about until later in the game.

But if you feel like there’s a fight about equity and who gets what, take a deep breath. There is no need to panic; we’ll go over Startup Equity 101.

Equity. Stocks. Shares. Vesting.

When you start to figure out how equity compensation works, you are bombarded with many words that people might have heard before and will know about in the future.

It’s not that you don’t know what SEO is. It’s just that when people try to explain the process in an article or blog post, your eyes get tired, and all you want to do is go on Facebook for a mindless scroll through News Feed.

We will go over what all of these new words mean in a minute, but before we do that, let’s look at the importance and benefits of equity distribution.

Startup Equity 101: Glossary

 

Psychology – the branch of science that deals with human and animal behavior

Biology – a group or system of organs performing one or more similar functions in living organisms.

The physics-the study, using mathematical laws, of how matter and energy interact

Equity: “the value of the shares issued by a company.” “one’s degree of ownership in any asset after all debts associated with that asset are paid off.”

Exercise your shares: to choose whether or not you want to buy or sell a company’s stock. A company’s stock price is the current value of that share.

Stock grant: “A stock grant occurs when an employer pays a part or all of the compensation of an employee in the form of the corporate stock.”

Stock options: “a benefit in the form of an option given by a company to an employee to buy stock in the company at a discount or at a stated fixed price.”

Shares: “a part or portion of a larger amount that is divided among several people, or to which some people contribute.”

Shares outstanding: “Shares outstanding is the total amount of shares that all its shareholders hold.”

Valuation: “an estimation of something’s worth, especially one carried out by a professional appraiser.”

Vesting: “Employees might be given equity in a firm, but they must stay with the firm for several years before they are entitled to the full equity. This is a vesting provision.”

Startup Equity 101: Who receives stock?

 

So you’re thinking about founding a startup? Here’s who typically gets equity in the company:

1. Founders and Co-Founders – Usually, 2-4 founders get between 10% and 25%.

2. Employees, advisors, employees – They may not be part of the original team, but they can earn 1 to 5% depending on their contribution.

Every startup will offer equity to some combination of those four categories. But not every startup is going to offer equity to employees; not every startup will provide equity to advisors; and not every startup will take on investors.

One thing that every startup founder will have to do is figure out how they are going to divide equity among the founders. Let’s start there.

Startup Equity 101: Management of Co-Founders

 

What is the best way to divide your company when starting with a group of co-founders?

“Easily 60% of the time founders end up in court, it boils down to equity distribution issues,” observes startup attorney Matthew Rossetti.

I know what I’m talking about. He’s in the courtroom a lot.

When I first began hiring salespeople, I assumed that pay and commission structure would be enough. It turns out people are motivated by more than just a paycheck.

It’s not surprising that startup employees feel entitled to a good amount of equity compensation. The media is filled with stories about billion-dollar exits and millions in payouts, so it makes sense why people would want more than just a paycheck.

We’re only human, after all.

But here’s the thing: it doesn’t have to be this way. “You win, or you die” is great for Game of Thrones. It has no place in a startup office.

One way to go about it is by splitting the profits equally. But, this doesn’t work for startups because each founder contributes a different amount of money and time.

Mike Moyer, Managing Director at Fair and Square Ventures LLC, has a simple explanation for the most common way to determine co-founder equity distribution.

He’s a genius. When faced with an issue, he always asks himself, “Can I fix it?” or “Do I need to fight this problem?”.

In “fix or fight,” founders determine their portion of the startup equity compensation based on “feelings about how much their contribution to the company is going to be worth… someday.” The problem with that split is that humans are generally not great at predicting the future.

“Whenever you do a fixed split based on future assumptions, you are going to be wrong,” Mike says. “And then, every time something changes, you have to renegotiate. And that’s painful.”

Instead of focusing on an unknowable future, I recommend that you figure out your split based on what each person is willing to invest right now. Most people call this “slicing pie,” It sounds like a much better idea than constantly testing different pay structures.

To make the point, he uses a metaphor of playing blackjack.

“You and I play blackjack as a team,” Mike says. “We each bet $1. Winning is unknowable, but the bets are knowable and obvious. But if you bet $3 and I bet $1, then we shouldn’t split the winnings accordingly.”

In the second scenario, one person was willing to put up three times more than the other. It stands to reason that they would get a bigger slice of their pie.

“You can’t know how much someone’s contribution will have turned out to be worth five years from now,” Mike explains. “But you can be damn sure what they’re willing to give up to make that future possible right here, right now.”

Slicing Pie is a method of dividing the pie so that everyone gets an equal slice. A more detailed breakdown can be found on this site.

If you’re looking for help with your startup, check out the KISS documents from 500 Startups. A lot of people like them!

Startup Equity 101: Advisors

 

Advisors are an essential part of the startup ecosystem. They contribute their time and expertise to startups, which is invaluable as founders often wear a million different hats and learn on the go.

One of the most challenging parts of being an entrepreneur is dividing equity among your team. Kris Kelso, who has been through it all as a successful startup advisor and executive consultant, points out that there are no strict guidelines for this.

In contrast, experts suggest a range of 0.5 to 1 percent vested over one or two years.

One of the benefits of using a financial advisor is that they’re willing to provide advice for an affordable monthly fee. You can expect about two-five hours per month from your adviser.

“Factors include the type of company (and perceived potential value of the equity),” Kris writes. “The experience and prominence of the advisors (i.e., are they just bringing knowledge/expertise, or do they also add ‘clout’ and open up a lot of doors?), and how early in the company a particular advisor gets involved.”

Dan Martell, the founder of Clarity, believes that there are two types of advisors: formal and personal.

“Formal Advisors: These are people who have strategic insights into the business and would create value for the company by having them listed on our site and have access to them in an ongoing way,” Dan writes on Startups.com. “Personal Advisors: These are people who I turn to for specific advice around tactics and strategy on an infrequent basis (maybe once or twice a year).”

Dan recommends compensating them with startup equity that’s worth between 0.1 percent and 0.5 percent of the company for formal advisors. If the legal advisor is “amazing” and “will also help with the fundraising process,” he suggests going as high as 1 percent. Personal advisors may or may not get equity but generally don’t.

Entrepreneur and corporate lawyer Yoash Dvir has another way of categorizing startup advisors: “general advisory/ business development and VC contacts.”

“For the general work, you need to estimate the amount of work that the advisor will do,” Yoash writes. “But keep in mind that most companies allocate 5 to 10 percent of their equity for ESOP (Employees and consultants Shares Options Plan) and, from what I’ve seen, advisors usually take 1 to 2 percent. However, for the VC contacts (and make sure they are not ‘brokers’ if they are not licensed as such), you can offer a percentage (usually between five and 10 percent) from the investment, or a percentage from the issued shares in such investment (again five to 10 percent) or both.”

Startup Equity 101: Investors

 

Different types of investors have different levels of investment. Family members, angels, and venture capitalists are just a few examples, but they generally get more significant equity stakes than advisors or employees.

So, the only reason people invest in startups is that they’re hoping for a high return on their investment. If it doesn’t work out, then at least there’s still some money left.

There is no hard and fast rule to calculate how much equity your investors should get. The best you can do is come up with a calculation that feels right for the situation.

“The amount you’d give an investor is directly related to 1.) How much you value the company to be worth at the investment time and 2.) How much they invest,” Ryan Rutan, Chief Innovation Officer of Startups.com, says.

When you’re negotiating an investment, it’s essential to have a rough idea of your company’s worth. You can then use that valuation as leverage when discussing equity compensation.

The art of valuation is more about finding the right price than calculating it. Entrepreneur and author Mike Belsito have some advice on how to go about that.

“When you’re pitching your startup to a professional angel investor vs. friends-and-family vs. seed-stage venture capital firm vs. angel group, they all may have a different take on what your valuation should be,” Mike writes. “One way to get a gauge on what they might expect is to take a look at the startups that they’ve invested in recently – particularly those that are located nearby and are in a somewhat similar space.”

A common mistake entrepreneurs make is valuing their company at the high end of what they could get for it. To avoid this, one thing you can do is use Angel List’s valuation calculator to find out how much your business might be worth in different markets with various investment conditions. Another good idea would be talking to other successful founders about similar companies.

“The best way to determine the right valuation for your startup is to talk to as many founders as you can – both in your area and that operate similar businesses,” Mike writes. “You’ll get a sense for what your ‘normal’ is. If there aren’t as many startups in your area, talk to founders in areas that have similar characteristics as yours. For instance, if your Cleveland-based startup is trying to set a valuation, you could try to network with founders in Pittsburgh, Columbus, or Detroit instead of more mature startup markets like Silicon Valley or New York.”

Once you’ve decided on the valuation of your company, investors will have their take, and it’s time to negotiate. The negotiation process is when things get interesting.

I’m trying to say that you should try and work out an equity agreement to benefit both of your needs.

Startup Equity 101: Employees

 

Most startups can’t offer what big companies do to get a fair market salary. Bootstrapping isn’t just about saving and scrimping.

As a business owner, I have to be sure that my company is as frugal as possible. One way of doing this is by not paying employees too much.

To get and keep great employees, you need to offer a stake in your company. Giving early-stage employees equity is an excellent way of making up for the lack of base pay; it motivates them because they’re now part owners, and it helps retain them if you choose a four-year vesting period.

“If you get a full market salary and your expenses are paid, you’re not taking a risk and, therefore, you don’t get equity,” startup attorney Mike Rosetti tells Startups.com. “You go to work. You get paid, end of the story.”

In other words, if you’re a developer and your salary is in the top 10% of all developers’ salaries – then asking for equity might not be such a good idea. However, if you are an engineer who has been with the company since its inception and, because of that experience, makes significantly less than market-rate? Then it’s fair to ask for some form of compensation.

Important consideration needs to be made when determining who gets equity in a company. If the employees are not getting paid the market rate, they should get at least some of the pie.

The article is about how to motivate employees. It turns out that you should pay them fairly for their work, even if they are not in a glamorous position or an essential role.

When you hire a salesperson, they choose to work for your company and not someone else. They’re taking the risk of doing something riskier but with higher rewards.

I know it’s risky, but you deserve the reward. Please do it.

James Seely, head of Marketing at the ownership management platform Carta, says that rather than granting startup equity to early-stage employees by offering a percentage of the company — which gets diluted quickly as you scale — it’s better to “to think of equity in terms of a dollar amount.”

“For example, ‘I own 2,000 shares in Meetly, and investors paid $50/share in the most recent round of funding, so my equity is worth roughly $100,000 today,'” James says. “This allows founders and startups to make tangible equity offers to key hires.”

As with equity, it’s a good idea to offer stock options for employees. Click To Tweet

But some startups don’t feel the need to do so.

When it comes to whether or not salary is motivating, there are both pros and cons.

“The first disadvantage of stock options is that they are complicated, and most employees require a base level of education to understand them,” James says. “Many of the companies we work with at Carta invest in educating new hires and periodically host training sessions for existing employees.”

“The second disadvantage is that stock options are subject to the tax code, which can change at any time,” James continues. “A recent proposal would make it so that stock options are taxed at the vest instead of exercise. That would mean that every year you vest new shares, you would have to pay taxes on the gain in Fair Market Value, even though your shares are illiquid, and you might not have the cash on hand to pay those taxes.”

The Bottom Line

Here’s how to figure out the equity splits for yourself, your co-founders, investors, and advisors.

The next step is to identify who you want equity with and then discuss.

If you’re worried about not making sales, I can assure you that it will get easier once the first sale is made.

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