Your startup is gaining momentum, and you’re bringing in an all-star team to help you build your company. In exchange for their talents and services, you want to offer them stock – but distributing it is not an intuitive process.
However, much of the beauty of being a business owner lies in the lessons you learn and the adversities you overcome. You have faced a lot of challenges while growing your business – distributing shares of startup companies is just another challenge to explore.
So, to help you with the process, we’ll review what startup equity is, see how it works in a startup, learn how it’s typically structured, and outline how it’s valued and distributed.
Ownership Rights of Startups
Startup equity refers to the degree of stakeholder ownership of the company. This usually refers to the value of the shares issued by founders, investors, and employees.
As a founder, you want to make sure that sharing ownership of your business takes place thoughtfully and productively. As it may sound, the easiest way to understand startup ownership is to think of it as a pie.
There are plenty of pies to split and share – 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 full value of your company to yourself may sound attractive in theory, the truth is that you can only earn as much as your business is worth — and maintaining 100% ownership does not lead to your company’s growth.
If you want your pie to become more valuable as a whole, you should be willing to compromise a few pieces.
For example, if you are the sole owner of a $500,000 business but lack the bandwidth to grow the business on your own, you are bound to stop at the $500,000 mark or even slide below it — assuming all factors remain constant in your business.
However, if you have a co-founder or a team of employees with 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 $5 million. Not very shabby.
How do stocks work in a startup company?
Startup equity, as a concept, is based on the idea that the company’s stakeholders deserve exactly what this title entails – a stake in the company. This generally means offering a certain percentage of ownership to early shareholders such as employees and investors.
This percentage is dictated by factors such as timing, degree of contribution, level of commitment, and valuation of the company at the time of the stock distribution. The founders generally – and unsurprisingly – get the most initial shares.
The company’s early investors also tend to receive more shares than those who joined later, as their investment is relatively larger compared to the early valuation of the company. Employees who help get things done often see greater ownership percentages than those who join the company in the future.
The distribution of equity is closely related to the stages of financing. As funding rounds progress, your financial circumstances naturally change, and in almost every case, how you distribute stock turnovers with them.
Typical distribution of shares of start-up companies
As we touched on earlier, the distribution of startup stock varies based on factors – including timing, business model, industry, CEO preferences, and the number of stakeholders involved. There is nothing final, “This is the only way this can happen.” process model. However, there are some relatively consistent trends and numbers that characterize a typical stock dividend for a startup.
Here’s a look at how dividend payouts often progress as a startup progresses and transitions through the funding stages.
Image source: Gust
As you can see, the ownership of startups is relatively flexible and can shift drastically as the company expands. For anyone involved in a growing startup – in any capacity – knowing the value of your personal credit is essential. Here’s a look at how this is calculated.
How to evaluate the equity in a startup company
How you can evaluate your equity in a startup company depends on several factors.
1. Last preferred price
The last preferred price is what investors paid for one share during the company’s last funding round. It is usually used as a reference point for the degree of potential success of any startup.
2. Post-money valuation
The valuation of the startup after the money represents the broader value of the company after a round of funding. It is calculated by adding the pre-money valuation – the company’s valuation before the investment round – and the amount of new equity.
3. Default exit value
The default exit value is the value the company will exit at – which means the value the company will generate if sold. Usually startups do not provide this information easily. If you want to find a fairly accurate number, you should search for similar companies to see what their companies look like.
4. The number of options in your scholarship
This one is pretty self-explanatory. The number of options in your scholarship literally The number of options in your grant.
5. Strike price
The strike price is the stock price you would be willing to exercise your options.
Once you have this information – much of which you should find in your offer letter – use this handy Carta calculator to determine the value of your potential capital.
Who should acquire equity in your startup will depend on how you organize your business. Equity is usually divided between the founders (and co-founders), employees, outside investors, and the company’s advisors. Let’s break down who these parties are, and how their stock awards should be divided.
How to distribute the equity in a startup company
- Founders and Founding Partners
1. Founders and Founders
If you are the sole founder of your company, defining your own stake can be fairly simple. However, if you have a co-founder (or multiple co-founders), deciding how to distribute equity among the parties involved is an important decision that should not be taken lightly.
If you want your startup to be successful in the long term, having open and honest conversations with your founding partners early and often is important. As you work with your co-founders to determine how equity will be divided, you’ll want to consider the following factors:
- risk Do all founders face the same amount of risk by pursuing this project? If one founder takes more risks than others, such as quitting his full-time job or investing more capital in the beginning? These potential factors must be considered when apportioning equity.
- commitment level In the early stages, many founders build their companies for little or no pay. However, if one of the co-founders takes on more demanding roles and responsibilities — or shows a greater commitment to helping the company succeed — that can be a factor when determining equity.
- cooperation 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 equity is shared. However, if the company is established from a common idea, splitting equally can also be an option.
Common stock allocation methods among co-founders include an equal split (such as 50-50, or 33-33-33), or a large control partnership, in which one of the founders owns a larger stake (such as 60-40). Here’s the Founder’s Equity Calculator that can help you through the process.
As you build your startup, you will eventually begin to hire talented team members who can take your business to the next level. Like many founders, you may encounter limited budgets at first that may affect your ability to deliver solid salaries to employees. However, if your employees’ starting salaries are shy of the market rate, you can offer employees equity as part of their compensation package.
Many professionals are motivated by partial ownership in the companies they work for, and the understanding that a company’s success can lead to financial gain on a personal level.
When deciding how to present equity to your employees, here are important factors to consider:
- ownership percentage You will need to decide how much ownership you plan to give to employees. This typically begins by assigning a stock pool to employees, or deciding how much of your stock pie will be given to employees. When determining how much stock to give to employees, you may want to take into account the number of team members you plan to hire, the employee’s level of experience, and your company’s funding schedule.
- vesting schedule Next, you have to determine when your employees can access their earnings. The most common schedule is a four-year vesting schedule with a one-year cliff. This means that an employee can start granting equity after a year of working for the company. After their first year, they will own a quarter of their equity grant, with the remainder awarded on a monthly or quarterly basis. Although this is common, you can implement the vesting schedule that works best for your business.
- The type of shares granted How do you plan to distribute equity to employees? Many startup companies choose to grant stock options to their employees. This means that employees have the option to buy the stock at a predetermined strike price. Some companies choose to give their employees restricted stock, which consists of shares granted to beneficiaries when the value is too low. This option can have more upfront tax implications for employees, which is an important thing to consider.
- education Finally, if your company offers employee equity, you want to make sure that your employees understand how it works. Providing education and the space for employees to ask questions and understand their options is critical to any company that advances employee equality.
Ideally, equity should motivate employees to stay with your company and contribute to the growth and success of the business.
Those who invest in your company—whether they’re angel investors, venture capitalists, or friends and family—should also get a slice of your company’s stock pie. When an investor puts money into a startup, he is basically taking financial risks in the hope of getting a financial return.
The amount of shares an investor receives varies 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, the conversations about stocks should happen when you seek and negotiate investments.
This simple calculator can help you determine how much capital to give in return for financing.
Early-stage startups usually have an advisory board of experienced founders and industry experts who provide strategic direction for the company – these parties are often compensated with shares.
There are no specific guidelines on how to award stock to advisors who give 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 advisory partnerships, you’ll want to set expectations clearly with advisors ahead of time so they know how much commitment you expect from them in their role versus how much equity you choose to offer.
Equity of startup companies from the employee’s point of view
As an emerging employee, the amount of stock you offer depends on several factors. There is no specific model that can accurately predict your balance before you split it. Your seniority, position, tenure at the company, and experience all play a role in determining the size of your piece of the pie.
A senior engineer who has the distinction of being the fifth employee at a startup is bound to take a bigger stake in the business than a junior salesperson who joined the company as employee number 30.
If there is any factor that carries more weight than others when it comes to stock distribution, it is the timing. If you join a startup early on, you are more likely to receive more shares than anyone hired later — even if they are more experienced and their position is more labor-intensive or important.
Ultimately, how much stock you give and to whom depends on what is best for your company’s growth and success.