One of the most important decisions a startup has to make during its earliest days is how to divide up (current and future) ownership of the company. This involves determining the distribution (and the different forms) of “equity”. But what, exactly, is equity? Whilst all major financial decisions involving your startup should be made in accordance with the expert advice of lawyers and accountants, it’s important that you as a founder possess a solid understanding of the basics of equity allocation. In this article I’ll discuss a handful of crucial ideas covering the essence of company ownership.
Why Care about Equity?
Let me say a few brief words about why you should care about equity before defining the central concepts that underlie it.
Startup founders must cultivate a basic understanding of equity because, whether directly or indirectly, equity decisions ultimately have an impact on:
- How, exactly, the ownership of your company is divvied up (founders vs. investors vs. employees, etc.);
- How much of your company your employees can own and how long it will take them to acquire such ownership;
- What kinds of, and how much, tax shareholders have to pay for their stocks; and
- What would occur if you were to sell your company or, alternatively, take it public.
Let’s now consider equity in more specific terms.
1. Equity (Shares & Stocks)
Rochelle Bailis offers an excellent summary of the essential thinking behind “equity” when she states:
“The basic idea of startup equity is rather simple: In their early years, young companies don’t have the capital to pay employees a competitive salary that’s made up entirely of cash, so the companies compensate [employees] in part with stock in the company, or equity.
The arrangement incentivizes employees to work extra hard and in the best interest of the business because if the value of the company grows, so does the value of their equity”.
Let’s break this down step by step.
In other words, equity has to do with a) the total amount (i.e., the percentage) of a company and b) how much value (i.e., the amount of money) a shareholder—whether founder, investor, employee, or other—possesses.
(Shares can be further categorized into “authorized”, “issued”, and “unissued”—see here for an explanation).
Not all stocks are created equal.
In fact, here are the 4 most common types of stocks:
- Founder stock: shares that founders assign to themselves when a startup is first officially formed; usually expressed as a total number (e.g., 10,000 shares spilt equally (or not) amongst two co-founders) and as a percentage (e.g., a 40-40-20% split amongst three co-founders).
- Preferred stock: shares usually sold to investors; “preferred” in the sense that they allow their holders special rights (e.g., voting on corporate governance issues and choosing board associates); first to be paid out when a major financial development occurs (e.g., the company is sold).
- Restricted stock: shares that are granted/issued without having to be purchased but come attached to specific conditions (usually having to do with length of time worked for startup—see “vesting” below).
- Common Stock: shares that are typically sold to employees; they have no special rights or privileges and are thus priced at a discount as compared to preferred stock (sources: 1, 2, 3).
As a founder, you will have to decide which kinds of stock, and how much of each, to allocate to yourself, your co-founder(s), your employees, and your investors.
To be clear: the main function of providing people with shares—especially when it comes to your employees—is to incentivize people to work hard at building something valuable that’s not worth much in the early stages but could worth lots over time.
Ji Eun (Jamie) Lee provides a fantastic overview of the most common form of employee equity compensation, i.e., “options”:
“If you receive stock options…[then] you get the right to buy stocks at a predetermined price, or strike price. You ‘exercise your options’ when you purchase the underlying stocks at strike price. The company is legally bound to set your strike price at what is deemed fair market value of the company stock when the options are granted to you. …
So, if you were granted…stock options with [a] strike price of $1, and you were to exercise your options on th[at] same day, you would pay $1 for each stock, and own that stock valued at exactly $1. You would have a net gain of $0. As company grows over time, [however,] the value of stock would rise”.
Options, thus, are a kind of enticement-based approach to equity.
Typically used as part of a compensation package, options reward shareholders for buying stocks at price x but then being able to potentially sell or cash them in at a later date for price x + 10 (for example).
One last note about options: an “option pool” is the allocation of shares specifically reserved to be granted as options.
Founders, thus, must set aside (i.e., determine a percentage of) stock that will be dedicated to options for current and future employees.
Understanding vesting is key to properly allocating startup equity because it’s one of the main methods through which, on the one hand, employees are incentivized to buy (or keep) stocks over the long haul and, on the other, the company protects itself from giving away ownership to individuals who quit or get fired.
Rochelle Bailis summarizes vesting as:
“[A] technique that allows employees to earn their equity over time. At startups, equity typically vests over four years, meaning employees must stick around for four years in order to own all their equity. If employees leave the company before the four-year period is up, they only receive a percentage of their stock based on the terms of the vesting schedule”.
The vesting schedule sets the timetable according to which an employee gains the rights to options (or stocks).
Linear vesting, i.e., whereby the same amount of stock is vested periodically (such as monthly, quarterly, or annually), is standard practice.
The “cliff” is the point in time after which an employee is then entitled to the option or stock.
If an employee quits or gets fired before reaching the cliff then he/she earns none of the option or stock.
Most vesting periods are 4 years in length, coupled with 1-year cliffs.
Finally, stocks that have been earned through vesting typically cannot be re-purchased by the company.
4. Equity Dilution
Simply stated, “equity dilution” refers to the adjustments made to a founder’s (or a set of co-founders’) equity once an option pool has been created and one or more new employees is given shares.
This concept is best explained via use of an example.
Let’s say you and your 50-50% spilt co-founder have 1,000,000 authorized shares (i.e., the total shares representing the full ownership of the company).
Half of those shares—i.e., 500,000—are issued and the other half remain unissued.
Thus, you and your co-founder each have 250,000 shares.
You then create an option pool with 100,000 shares and you decide to give 10,000 shares to a new employee.
You and your co-founder now have 250,000 shares each not of 500,000 shares but of 510,000 shares (because you just gave 10,000 shares to your employee).
The result is that both you and your co-founder’s total share of the company has decreased slightly, i.e., it’s been diluted:
250,000 / 500,000 = 50% [prior to giving shares to employee]
250,000 / 510,000 = 49% [after giving shares to employee]
The key point, then, is to always remember that each time you “give away” more of your company to others, you (and your co-founder(s)) effectively lose a percentage (or a point of a percentage) of the ownership of your startup.
5. Capitalization (“Cap”) Tables
The final important aspect of equity distribution of which you should be aware is known as “capitalization (cap) tables”.
According to Investopedia:
“A capitalization table is a spreadsheet or table, typically for a startup or early stage venture, that shows…ownership stakes…in a company, including equity shares, preferred shares and options, and the various prices paid by stakeholders for these securities.
The table uses these details to show ownership stakes on a fully diluted basis, thereby enabling the company’s overall capital structure to be ascertained at a glance”.
A cap table, therefore, is a visual breakdown of who owns what in your company.
Why do startups need cap tables?
Because founders constantly make decisions that impact, or are influenced by, the capitalization (i.e., the ownership stakes) of their ventures.
Noah Pittard provides an example:
“[I]f you are recruiting a new COO and the candidate asks for options covering a certain percentage of the company, you need to be able to quickly determine [not only] whether you have sufficient shares available in your option pool…[but also] how dilutive the new grant will be to other holders”.
It bears repeating that all major financial decisions involving your startup ought to be made in accordance with expert lawyers and accountants.
Having said that, here a few “industry standard” practices when it comes to equity:
- Rather than automatically defaulting to a 50-50% split with your co-founder, consider allocating equity according to the amount and type of value that each of you brings to your company. There’s nothing inherently problematic about using an even split but it’s usually smart to at least consider approaching equity distribution by paying specific attention to value creation.
- Avoid utilizing an option pool bigger than 15% when you first launch your startup. Going beyond 15% of your total shares can hamper your financial flexibility in the future.
- In most cases, vesting should be structured in accordance with a total period of 4 years and a cliff of 1 year.