How Does Equity Work in Startups?

Equity, in business terms, refers to the value of shares issued by a company, and when it comes to startups in particular, equity is what founders exchange for investor funding. That is, a slice of company ownership in exchange for startup funding.

This means that anybody with equity in a startup – from founders to investors – is entitled to a corresponding percentage of company assets if the company makes an exit by means of a buyout or initial public offering (IPO).

Startup equity is more complicated than a mere slice of the pie, so to speak. Indeed, the concept of equity in a startup as opposed to a more established business is fairly different for a number of reasons, including considerations such as high risk and the urgent need for capital.

 

What is Business Equity in a Startup?

 

Startup business equity is the allocation of company ownership between founders, investors and employees.

Indeed, the general concept of equity is no different between startups and more established businesses, but there are differences in how and why equity is allocated and exchanged.

When a business is established, founders have 100% equity. Whether it’s a sole founder or multiple founders, business equity is automatically divided between founders. For instance, if there’s one founder, they’ll start off with 100% ownership and if there are four founders, they’ll have 25% each.

From there, founders are able to use equity as a type of asset. That is, they can exchange portions of the total equity of the business for the contributions of stakeholders which normally come in the form of capital, but may also be reflected as time or expertise, depending on the specific situation.

Startup equity represents the future value of the business and how much it’ll be worth when founders and investors exit, so it correlates directly to financial gain.

Now, with that in mind, there are two fundamental components of startup equity that need to be understood – namely, incentive and risk.

Equity is offered to investors and even employees as an incentive to make contributions, in the case of the former, or accept job offers, in the case of the latter. However, this incentive is all based on potential value rather than real value.

Mature, successful businesses, for instance, have real monetary value, such that if investors and founders were to exit the company by means of a buyout or IPO, for instance, they’d be compensated according to the business’s equity structure by means of payouts, depending on the financial standing of the business.

In the case of startups, however, the incentive is based on potential value. Indeed, when startups are founded and they’re in their early days, investors contribute to supporting an idea and the potential that the idea has. The ultimate hope is that the potential of the startup will be realised and eventually, the business will have real financial value.

However, in the early days, there’s no saying whether or not a startup will be successful, so becoming an investor, whether you’re contributing time, money or expertise, is a risk, as there’s no guarantee that you’ll ever see a return on your investment (ROI).

That’s why the offer of equity in exchange for investment isn’t a slam dunk – it’s a risky move. It’s all about evaluating the startup and its potential for success, and then making an informed decision, hoping for the best and trusting that the founders and executives will make the startup a success.

Acquiring startup equity is a high-risk, high-reward situation.

 

The Difference Between Stock, Shares and Equity

 

While stock, shares and equity all pertain to company ownership in one way or another, the specifics vary.

“Stock” and “equity” refer to portions of ownership of a business. Equity is a portion of the total ownership of the company while a stock is a single unit of ownership.

Now, shares refer specifically to how stocks are divided.

Put simply, a shareholder’s percentage of ownership is equal to the number of shares they own divided by the total number of shares that make up the business.

 

Who Gets Startup Equity?

 

There are four different parties who tend to have equity in startups:

• Founders
• Investors
• Employees
• Advisors

At the outset, equity is split equally between founders, and as soon as investors get involved and employees and advisors come on board, equity distribution becomes a little more complicated.

Proportions of equity correlate to control within the company, and generally speaking, as founders tend to maintain the majority of equity amongst themselves, it can serve as a useful way to attract new investors.

However, holding onto equity and distributing it wisely is one of the most important considerations for startup founders.

 

How is Startup Equity Distributed? 

 

There are different ways in which equity can be distributed depending on the preferences of the founders, investors and type of business in question, but often, the safest way to manage equity distribution is to manage it in terms of the maturity of the company.

Essentially, the idea is that percentages of equity work on a sliding scale, starting with the startup being young and gaining maturity over time.

In the early stages, it’s common for founders to hold the majority shares of the business, with investors coming in next at about half of what the founders have and employees at about 10% of founders’ equity.

As the company matures, the founders’ equity will decrease while investors’ equity increases, until eventually, the company is sitting at about 80%, 19% and 1% for investors, founders and employees respectively.

Those figures are, of course, just ballpark numbers, but normally, that’s the direction in which equity moves.

There are, however, a few other ways to distribute equity. For instance, some startups will split equity equally while others may operate according to a more complex dynamic equity model. It all depends on the desires of the founders, the structure of the business, the needs of investors and the success of the company.

Here are some of the main considerations that tend to be taken into account when allocating equity to different parties.

 

Equity for Co-Founders

 

The issue of equity should be discussed among co-founders at the very outset of business discussions, taking into account issues like investments of time and capital, as well as intellectual property and risk, both personal and professional.

Normally, values are assigned to these variables and they remain proportionate to the relative investments made by each co-founder. From there, equity is split.

Different splits can range from totally equal shares to 70/30 splits, depending on varying investments ad the agreements that co-founders come to.

 

 

Offering Equity to Investors

 

There are plenty of different types of investors that may get involved in startups, beginning with friends and family in the early days and eventually, hopefully, moving on to big-time adventure capitalists.

Essentially, investors offer startups money and/or time in exchange for shares of your company, and is usually decided during a negotiation process. In order to come to a conclusion on fair equity distribution to investors, founders (nd potentially board members) need to be fully aware of the company’s value as well as the value of the investment in question.

It goes without saying that founders would be well advised to be very careful of offering too much equity, especially in the early stages of investments, specifically in seeding rounds. Generally speaking, it’s unwise to offer more than 25%.

Of course, as the company matures and the startup moves through different rounds of investment, the proportion of equity offered will decrease as there will simply be less available.

 

Equity for Advisors

 

Advisors can play a really important role in establishing startups, helping founders make strategic decisions that may help them avoid costly mistakes. Thus, they certainly provide a lot of value to new businesses.

However, working out exactly how much value they add in financial and equity terms can be complicated.

It all depends on the expertise of the advisor, their experience and what they’ve contributed, and evaluating this is no simple task. But, normally, as a rule of thumb, advisory shares don’t tend to exceed 1% equity.

 

Issuing Equity to Startup Employees

 

Joining a startup is (literally) risky business for potential employees. Even if they fully believe in the idea and potential of the startup, there’s always the possibility that the company will fail and they, subsequently, will go down with the ship, having lost valuable time and potentially income (never mind the opportunity cost of working for a startup rather than an established organisation).

Thus, employees are often attracted to positions in startups due to offers of equity. Another reason equity is offered to employees is because startups may struggle to offer competitive salaries at the outset, and by dangling the carrot of equity in front of potential employees, startups are providing with the potential to receive way more in the future. But, of course, it’s a gamble.

So, with that in mind, employee equity pools tend to fall somewhere between 10-20% of the total shares of the startup.

At the early stages, for instance, a business may attract an experienced senior employee by offering them as much as 1% equity just to take the job, bearing in mind, however, that the salary on offer may not be as high as what established competitors may be offering.

This may be a straightforward acquisition of equity as the employee takes the job, or, in some cases, employees are required to achieve and reach certain milestones before the stock is officially earned. This can be a great way to incentivise employees.

Ultimately, the way in which employee equity is determined and structured depends on the preferences of founders, advisors, the board and the type and size of the business itself.

 

Different Types of Startup Equity

 

As is most likely pretty clear by now, startup equity is a complicated issue and there are plenty of different ways that equity can be distributed.

However, it’s not only about distribution. Indeed, there are also different types of startup equity:

 

Common Stocks

 

Common stocks are stocks that provide holders with voting rights within the business. Holders are eligible for dividends and stocks can be converted into cash or other forms of equity.

 

Preferred Stocks

 

Preferred stocks refer to shares that do not allow holders to have voting rights. They are, however, eligible for dividends, but this is based on the discretion of the company’s board members. Preferred stock holders have the right to convert stocks into cash or alternative forms of equity.

 

Restricted Stock Units (RSU)

 

RSU owners are holders of a number of common or preferred stock once vested. If it’s a share of common stock, an RSU holder does have voting rights and is eligible for dividends, but not if the stocks are preferred. Eligibility for conversion is dependent on a series of other factors and is not necessarily fixed.

 

Stock Options and Option Pools

 

These types of shares give stockholders the potential to become holders of a number of common or preferred stocks at a fixed price once vested.

 

Understanding Equity in Startups

 

The distribution of equity is complicated in any business, but it’s significantly more complicated in startups that are constantly growing and changing.

Deciding who gets shares, how much they are eligible for and what kind of equity they will receive is of the utmost importance, as it has the potential to completely change the structure and future of a business.

Ultimately, making wise decisions pertaining to startup equity is all about maintaining a solid understanding of the value of both the startup itself as well as what potential shareholders have to offer, whether it’s capital, time, advice or anything else.