January 11th, 2023 | By: Ryan Rutan | Tags: Management, Equity & Stocks
Startup equity is one of those things that it's fair to say every startup founder without an MBA struggles with, and even those with a high degree of financial modeling education won't have been through this before. Most people don't have to think about this stuff until it's really important. But if you're starting to freak out about who gets what slice of your startup pie, take a deep breath, calm down, and get ready for Startup Equity 101 (your official startup equity guide).
Equity. Stocks. Shares. Vesting. Fair market value. The minute you dive into figuring out startup equity compensation, you're slammed from every side with a bunch of words that you might have heard in the past and you might be able to fake knowledge of at a dinner party.
But let's be real: You definitely don't have an active, working knowledge of them. One paragraph into any explanatory blog post and your eyes are already crossing, your fingers itching for the Facebook tab on your browser because all you want is to clear your brain with a mindless scroll through your News Feed.
So before we dive into different ways to split up the startup equity distribution, let's take a look at what all of these new words actually mean. Feel free to come back to this list as we go if you're feeling lost.
(All definitions are from Google's dictionary unless otherwise linked.)
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 shares: to choose to buy or sell your shares in a company. You don't have to exercise your options, but if you don't, you won't actually "own" your equity awards.
Fair market value: the current value of the share.
Equity grant: “An equity grant occurs when an employer pays a part or all of the compensation of an employee in the form of the corporate stock.” This is how most startup companies distribute equity compensation.
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 a number of people, or to which a number of people contribute.”
Shares outstanding: The number of "Shares outstanding is the total amount of shares that are held by all its shareholders.”
Valuation: “an estimation of something's worth, especially one carried out by a professional appraiser.” A company's valuation tends to move up as funding rounds progress in the case of a funded company, but also with natural business growth.
Vesting Schedule: Startup "Employees might be given equity in a firm but they must stay with the firm for a number of years before they are entitled to the full equity. This is a vesting schedule.” Most startup employees' equity packages come with a vesting schedule to protect the company from "ghosts in the cap table".
Let's start with the most basic of basics: Who actually gets startup equity? There are four groups that typically get a portion of the startup pie:
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 is going to offer equity to advisors; and not every startup is going to take on investors.
But it's a fair bet to say that all early-stage startups are going to have to figure out how to structure and portion out equity to the founders of the company. So let's start there.
How do you determine what portion of the company you and your co-founders each get?
“Easily 60% of the time founders end up in court, it boils down to equity distribution issues,” observes startup attorney Matthew Rossetti.
And he would know. He's in those courtrooms a lot of the time.
The driving force behind these co-founder disputes, Matt says "interpersonal conflicts arising out of questions about fairness. And when people in the startup world talk about “fairness,” what they're usually talking about is how their startup equity is split."
Can you blame them? The startup ecosystem is saturated in stories of spectacular billion-dollar exits that leave everyone with a stake in the company set for life. It's not that hard to understand why people have feelings about how much startup equity compensation they get. 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 method is simple: Split it evenly and be done with it. But this isn't the method most startups go with, mainly because each founder contributes a different amount of money and/or time.
So, instead, the traditional way of determining the co-founder equity distribution split is something that Mike Moyer, Managing Director at Fair and Square Ventures, LLC, explained to Startups.com. He calls it “fix or fight.”
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… some day.” The problem with that kind of 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, Mike recommends following a method he calls the “dynamic split” which most people call “slicing the pie.” Instead of focusing on an unknowable future, determine your split based on what you're each willing to invest right now. He uses playing blackjack as a metaphor to illustrate how this works.
“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 should split the winnings accordingly.”
In that second scenario, one person was willing to bet three times more upfront than the other person. It stands to reason — and fairness — that they would get a bigger portion of the startup “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.”
Check out this site for a more detailed breakdown of the Slicing Pie methodology.
And if you'd like some help getting started with a convertible debt or equity financing generator, a lot of people like the KISS documents from 500 Startups.
Advisors are an amazing part of the startup ecosystem. They're the people who contribute their time and expertise to startups — time and expertise that's absolutely invaluable to a company's growth as founders often wear a million different hats and learn on the go.
Entrepreneur and executive advisor Kris Kelso points out that, like so many things in the startup world, there are no strict guidelines for assigning startup equity compensation to advisors.
However, he says 0.5 percent and 1 percent is a good range to consider, vested over one to two years. For that amount, he suggests you can expect about two to five hours per month of involvement from your advisor.
“Factors include the type of company (and perceived potential value of the equity),” Kris writes. “The experience and/or 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, puts advisors into two categories: 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).”
For formal advisors, Dan recommends compensating them with startup equity that's worth between a 0.1 and 0.5 ownership percentage. If the formal 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 start-up equity, but generally don't, often receiving cash compensation \ ordinary income instead.
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 will be done by the advisor,” 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.”
While there are different categories of investors — family members, angels, and venture capitalists being just three that spring immediately to mind — it's fair to say that generally, investors are going to get a bigger piece of startup equity than advisors and employees, if not bigger than the founders.
That's because their main role with a startup is investing money into it. In exchange for the risk of contributing that money, investors are hoping for a large reward.
So how do you determine how much equity your investors get? Unfortunately, there's no tried and true percentage or calculation you can do
The amount you'd give an investor is directly related to 1.) How much you value the company to be worth at the time of investment and 2.) How much they invest.
More likely than not, the amount of equity compensation an investor gets will be determined by conversations you have with them as you're negotiating their investment. But in order to get the most out of that conversation as possible, you have to go in with an idea about the valuation of your company.
While valuation is more art than science, entrepreneur and author Mike Belsito writes that there are some general things you should keep in mind.
“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.”
Mike recommends talking to your peers as a means of determining your valuation or check out this
“The best way to really 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 of 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, you're ready to go into talks with investors. They'll most likely have a different valuation that they've worked out as well and that's when the negotiation starts. Ultimately, the goal is to work out an agreement about startup equity that works well (enough) for you both.
While startups can offer a lot to employees, one thing most can't offer is a salary at a fair market rate. Bootstrapping isn't, after all, just about founders saving and scrimping. It's about making sure the company is being frugal all around, including when it comes to employee compensation.
But how do you get and retain great employees if you can't pay them? By offering a stake in your company aka — incentive stock options. Offering startup equity from an employee equity pool to early-stage employees makes up for that gap; helps incentivize employees to work harder, because they're now part-owners of your company; and retains them if you choose to vest their stock over a four-year period, which is common.
“If you get a full market salary and your expenses are paid, you're not taking the risk and, therefore, you don't get equity,” startup attorney Mike Rosetti tells Startups.com. “You go to work, you get paid, end of story.”
In other words: if you're a Senior Engineer, or an experienced business development employee, you don't get to demand a hefty equity package on top of your market-rate, six-figure salary. More salary, less equity. Less salary, more equity. It's that simple. The employee equity offer is a function of the value of the contribution and the gap between the typical salary for a given role and their actual cash compensation.
If you're the company's founding engineer and you're getting paid in gimlets and a free dinner here and there, on the other hand? Then you have a pretty compelling case that you are doing equity work, and deserve some upside in the event of a successful exit.
This brings us to the flip side of this “who gets equity” coin. Because if anyone who's getting paid the market rate doesn't get equity compensation, then it stands to reason that everyone who's not getting their market rate should.
We'll put this in bold because it should come through loud and clear: if you are paying your employees less than their market rate, they should have a stake in your company. It doesn't matter who they are, or how “unsexy” their role is. If they're working for you, when they could be working for someone else for higher pay, they're taking a risk. They're passing up more secure jobs with potential employers that might pay more in order to bet on building something awesome with you.
That risk deserves a reward. So do it. Getting the right employees means being the right company.
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 certain 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 advisor startup equity, it's generally a good idea to vest individual employees' stock options over a few years, with many startups choosing a four-year period (just one of many ways to share employee stock purchase plans that's great compensation and benefits for startup companies). Many have an additional provision of a one-year cliff, meaning that nothing vests for the first year, with all equity vesting equally across the remaining years. So a 4-year vesting schedule with a one-year cliff would mean you'd vest no equity in year one, and 1/3 of your equity each year for the remaining 3 years.
But, some startups choose not to offer stocks to employees at all or have restricted stock and restricted stock units. That's because while there are advantages, there are disadvantages, too.
“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 private 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.” So, while they might only become valuable in an exit event (rarely does anybody "buy equity" in the way public stocks are traded) - they can be a liability at any time.
So there you have it: a starting point for figuring out how to award precious equity to yourself, your co-founders, your investors, advisors, and employees.
The next step? Decide who exactly you'd like to award equity to and go from there.
It gets easier once you take that first step — I promise. Now, get back out there and jack up that strike price and create some startup exits! I'll see you on the field.
Founding Partner @ Startups.com platform | Clarity.fm, Launchrock, Fundable, Zirtual, and Co-Host of The Startup Therapy Podcast. Ryan has 15 years of experience as a Founder, Advisor, Mentor, and Investor — the quintessential startup guerrilla. He works with 100's of the best startups every year on everything from ideation, idea validation, early marketing traction, customer acquisition to fundraising, scaling, and operations.
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