Everything You Wanted to Know About Startup Equity and How It Works
When starting a new business, many aspects need more straightforward and unambiguous answers. Fluid elements, such as startup equity, are something founders must grapple with as they propel their startup to the next stages. Otherwise, they will distribute equity excessively, wonder how to divide the ownership pie, and make hasty promises of shares in the pursuit of gaining recognition.
Founders, who often have limited resources, need efficient strategies to attract top talent, secure investment capital, and garner support from the community. However, understanding the question of "how does equity work in a startup?" is essential not only for the founders but also for co-founders, employees, advisors, and investors.
In this comprehensive startup equity guide, we will delve into the intricacies of startup equity, covering everything from what it is to how to manage it when scaling your business.
What Is Startup Equity?
Startup equity is a popular financial startup term that refers to the ownership stake that individuals or entities possess in a newly established company. It represents a share of the company's value and typically comprises units known as "equity shares". Equity serves as a means of attracting talented employees, raising private and VC capital, and aligning the interests of different stakeholders toward shared objectives.
One way to imagine startup equity is to think of it as a pie. In the beginning, it would impersonate the complete ownership of the company. Next, this "equity pie" gets divided and distributed among different individuals and entities engaged with the startup. Each of them receives a slice of a size that corresponds to their contributions, roles, and affiliations with the newborn company.
It's vital to be open to allocating a portion of your assets rather than holding 100% ownership. This flexibility is crucial for achieving business growth. Here's why.
For instance, imagine you're the sole owner of a business with a valuation of $300,000. However, being a jack-of-all-trades, you're likely to be deprived of the necessary resources or expertise to expand the company independently. In such a scenario, your business's value is likely to stand still at $300,000 or even decrease over time. This assumption holds true as long as all other variables comprising your business remain unchanged.
By issuing startup equity to partners or employees with diverse skills and experience, you can supercharge your business's growth potential. Having a team with a versatile startup team structure, you can use their abilities and competencies can take your company to new heights, potentially helping arrive at a valuation of $3 million.
Even though you may have a reduced ownership share, say only 60%, you emerge as a winner. This is because the projected overall value of your business will soar. In this scenario, well-thought equity allocation becomes the key to success, enabling you to reach your goals and secure a more substantial slice of the pie, even if it's a smaller percentage.
Who Gets Startup Equity?
Ensuring a consistent approach to managing and distributing startup equity is critical. This means balancing commitments and resisting the allure of oversharing assets. For example, novice founders can mistakenly offer excessive equity to attract partners, investors, or when hiring startup developers or other top talent only to realize later that the returns fall short of initial expectations.
One efficient solution is to divide all equity shares equally among stakeholders. But this isn't the only possible path.
Alternatively, you can implement a dynamic equity model that calculates specific startup equity percentages based on factors like employee competencies or founder investments. Startups uniting individuals in a collaborative workplace need to acknowledge the contributions of those offering more expertise, time, or financial resources. This practice guarantees an accountable and transparent distribution of equity in startups, fostering trust and alignment among all interested parties.
The key stakeholders who typically receive startup equity include:
- co-founders;
- specific employees (such as your hired CTO);
- advisors;
- investors.
This comprehensive startup equity guide acknowledges that not every startup will distribute equity across all four categories. The distribution of startup equity varies from one business to another. Therefore, we can conclude there is no "one-fits-all" when distributing equity to employees, advisors, or other external players.
No matter what stage of startup development you are at right now, knowing how to create an equitable structure for allocating shares to different parties is pivotal. Here's what it looks like.
Co-Founders
If your startup features co-founders, initiating a transparent discussion and documentation regarding equity distribution at the earliest opportunity is advisable. Co-founders are the individuals who create and launch the new venture. They form the basis of the startup culture, invest their time, previous expertise, and personal finances to set the company in motion. Co-founders are usually issued a significant portion of the initial equity, which reflects their early involvement and commitment to shared goals.
The equity distribution among co-founders can vary based on factors such as individual roles, responsibilities, and contributions. What can the equity split look like?
In this example, the startup equity distribution adds up to 100%, reflecting each co-founder's unique role in a new venture. Once again, equity allocation should result from discussions and align with the co-founders' expectations and the startup's long-term goals.
Employees
Startup employees is an invaluable asset to any young company. They invest their skills and knowledge to help the business grow. To attract and retain top minds, startups have to provide competitive compensation packages to employees. Nevertheless, if your initial compensation falls below the median market rate, you have the option to issue startup equity as an additional incentive.
The allocation of equity to employees is typically based on their role, seniority level, and salary. These equity flows can come in different forms, including stock options, restricted stock units (RSUs), or direct ownership of equity shares. Nonetheless, they have to be carefully considered as there might be implications when the time for startup team scaling comes.
Advisors
Founders often turn to startup communities to find support and to fill knowledge gaps. Advisors play a critical role in guiding teams, helping them avert common startup mistakes, offering expertise, industry insights, and valuable connections. In exchange for their contributions, advisors may expect to get equity in a startup at a pre-negotiated percentage. The equity allocated to advisors can be project-based or incorporated in a long-term advisory collaboration.
One crucial aspect of equity distribution to advisors is the alignment of expectations. Startup founders should ensure clear terms for equity arrangements and specify the scope of advisory services in exchange for equity compensations.
Investors
The startup ecosystem has various types of investors, including angel investors, venture capitalists, and crowdfunding supporters. Moreover, many of the top startup accelerators offer funding to program participants, generally, in return for equity. Also, it's not unusual for investors to source high potential investment deals and approach startups with high growth potential.
Startups pitch to investors, and they back startups financially in exchange for equity grants. They play a crucial role in helping startups raise capital to fund operations, development, and subsequent growth and startup scaling.
Investor equity is typically acquired through the purchase of shares in a startup. Investment terms, including the equity share earned, are commonly pre-defined in investment agreements. These agreements also specify any rights or preferences associated with the issued equity shares.
Types of Startup Equity
Startup equity is a dynamic and multifaceted concept that comes in various forms, each serving distinct purposes. Here's a breakdown of the primary types of startup equity.
Common Stock
Common stock, in the context of equity compensation in a startup, represents an ownership stake in the given company as the remaining value of all shares of stock. Owners of common stock have voting rights to elect members of a board of directors. Individuals who are issued this equity type can expect to gain dividends and the residual value of assets upon liquidation. On the flip side, they are exposed to greater risk compared to preferred stockholders.
Preferred Stock
Preferred stockholders have certain rights and preferences over common stockholders. These rights may include priority in receiving dividends, protection in the event of liquidation, and the ability to transform their shares into common stock.
Stock Options
A stock option is the right to purchase a specific number of company shares at a predetermined price. They are commonly used as part of employee compensation packages and often come with vesting schedules.
Restricted Stock Units (RSUs)
RSUs are awards of company shares that vest over time or upon achieving specific employee performance milestones. Upon vesting, RSUs are treated as income, with a portion of the shares withheld to compensate for income tax obligations. Following this, the employee acquires ownership of the remaining claims, which entitles them to the right to sell these shares.
The Role of Equity in Raising Capital for Your Startup
Now that you know what startup equity is and navigate different types of grants and awards to employees, co-founders, and advisors, we can move on to equally important matters.
To answer the question of "how does equity in a startup work to incentivize investors?", you need to know how equity is leveraged in the capital-raising process. Especially for startups in the early stages of launching a startup, when traditional financing options like bank loans or credits may be challenging to obtain, the capital-raising process can include equity financing.
Equity financing represents one of the most preferred methods of capital acquisition for startups. In this fundraising approach, investors acquire a slice of your business pie in exchange for cash injections. Here's how startup equity is leveraged in the financing process:
- Seed funding. Many startups initiate their venture journey by raising seed funding from angel investors, friends, family, or through crowdfunding campaigns. In exchange for capital and with an understanding of startup equity, these early-stage investors receive equity in the form of common or preferred shares.
- Venture capital (VC). As startups scale and require more substantial capital injections, they often turn to venture capitalists with pitch decks and financing requests. VCs provide funding in exchange for equity ownership, often taking preferred stock with specific rights and protection against risks.
- Convertible debt. Startups may issue convertible notes or convertible preferred stock to early investors. It allows them to offer financial support to a startup while postponing the assessment of the startup's value until a specific date.
- Initial public offering (IPO). When a startup matures and chooses to go public, it offers shares of common stock to the public through an IPO. This allows the company to raise significant funding flows and provides marketability to current equity holders.
- Equity crowdfunding. Some startups opt to raise funds from collective investors through equity crowdfunding platforms. Investors operating on these platforms obtain equity shares in exchange for their direct contributions.
Equity is a powerful motivator for investors, as it means they have a vested interest in seeing the startup succeed. When it does, the value of their ownership reaches new heights.
However, for founders, there's a trade-off to consider. With each round of financing, where the startup gets more money from investors, the founders' ownership in the company shrinks. This concept is known as dilution, and it's something we'll cover soon in this startup equity guide.
Additionally, the backyards of each signed deal matter a lot. The terms and conditions attached to the equity given to investors can have a big impact on how the startup operates and grows. Eventually, founders should carefully review and understand these terms to make sure they're in the best position for the company's long-term success.
How to Manage Equity When Scaling
As your startup adds extra layers and evolves, managing equity becomes challenging. It turns into a continuous process that requires careful planning, communication, adaptability, and full alignment with the company's vision and objectives. Here are some key considerations to include when drafting equity management strategies for your startup.
Set Up an Equity Pool for Future Hires
When creating an equity pool for future hires, you arrange a slice of the company's ownership for consecutive allocation to new team members as part of their compensation package. Establishing and managing this pool efficiently as your startup matures is essential to align with your employee's financial interests.
Here's what you can do to succeed with these activities and safeguard your startup budget:
- determine the pool size based on your hiring needs over a distinct period;
- ensure the equity pool is updated regularly to accommodate new hires and retain existing talent;
- define clear criteria for distributing equity from the pool, considering factors like seniority, job role, and performance.
Minimize Dilution Risks
As your startup grows and seeks additional funding, you'll likely go through various funding rounds, such as seed, Series A, B, etc. In these rounds, investors will acquire new shares and equity portions. These actions dilute the ownership percentage for existing stakeholders, including founders and early investors. Dilution can occur regardless of the valuation, although it mostly affects businesses that are funded with substantial cash injections.
To protect your equity stake and mitigate the aftermaths of dilution, consider negotiating certain terms in your investment agreements, including:
- pro-rata rights (these rights empower investors to preserve their original ownership level in future investment rounds);
- explore alternative funding prospects (understanding how equity works in a startup and choosing alternative funding sources like debt financing or grants can be a wise strategy to avoid the dilution of your equity; however, it's vital to thoroughly assess these options and balance their advantages and shortcomings before arriving at an ultimate decision).
Factor in Legal and Tax Implications
Consulting legal and tax professionals is crucial to navigate complex equity-related regulations during startup company formation. That happens because tax implications and liabilities involve different parties, including equity recipients and originators: investors, employees, and startup owners. Some of the most important decisions startup entrepreneurs need to make include:
- ensure your equity distribution plans comply with applicable local and state laws and regulations;
- learn tax implications for both the company and recipients, including income and capital gains tax;
- monitor the changes in tax laws that may impact equity allocation. Regular reviews ensure your equity plans remain compliant and optimized for both current and future wealth preservation.
Arrange Prospective Exit Events
You need to consider potential exit scenarios and plan how equity will be distributed and cashed out. It is necessary to show the startup’s founders, investors, and team members that you have a well-defined strategy for consecutive payouts. There are different ways for a private company to exit, which affects how you can exercise your equity options. To succeed, you need to:
- define a clear exit strategy, whether it's through acquisition, an initial public offering (IPO), or other scenarios;
- identify the order of priority for equity payments, considering investors, founders, advisors, and employees;
- ensure all agreements are in place to facilitate a frictionless exit process.
Educate Employees on Their Long-Term Equity Gains
Help your colleagues see the big picture behind the package of benefits obtained when receiving a share of your company. Is startup equity explained to every team member? Do they know how to get a compensation and realize the value of startup equity? Find answers to these questions and include a solid education strategy to your growth plans:
- share resources, organize workshops, or develop documentation to explain equity types and options;
- help employees understand the implications of exercising chosen options, including tax and legal liabilities;
- emphasize the long-term value of issued equity and disclose its potential benefits when it is time to go public or launch other exit options.
Observe and Adjust the Equity Strategy Regularly
As your startup proceeds with the natural growth stages, regularly observe and refine your equity strategy to align with changing goals, stakeholders' expectations, and market conditions:
- consider how shifts in your company's size, valuation, and place on the market affect your equity strategy;
- revisit your equity pool, vesting schedules, and communication tactics to support the startup growth strategy and the company's trajectory.
Concluding Thoughts on Startup Equity
This guide to startup equity explored the principles behind successfully allocating shared company assets. We focused on the most efficient tactics for equity distribution, identified the primary equity recipients, and highlighted the best strategies for equity management.
Backed with this knowledge, you will be fully equipped to land new investors, attract and engage top talent, and develop a sense of a shared purpose among your co-founders.
If you need more direction, note that helping startups is Upsilon’s specialty. So, feel free to turn to us for MVP development services and contact our experts if you need a consultation!
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