What is equity in a startup?
Essentially, startup equity describes ownership of a company, typically expressed as a percentage of shares of stock. On day one, founders own 100%. If you have more than one founder, you can choose how you want to share ownership: 50/50, 60/40, 40/40/20 ,etc. It will depend on how many founders you have and their contribution to the success of your company. However, to build your business, you will likely need to exchange equity for funding and to lure new employees.
Early on, founders need to give up a significant percentage of equity to match the risk investors are taking by funding your startup. But as you grow and demonstrate greater success, your startup equity increases in value and investors are typically willing to pay more — or inversely accept less equity in exchange for their funding.
When VCs invest capital in exchange for equity in your company, you are forming a business relationship. If your company turns a profit, investors make returns proportionate to the percentage of equity they have in your startup. On the other hand, if your startup fails, the investors lose their money. However, VCs are willing to take this risk because owning a percentage of a successful startup can be very profitable — and keeps the ecosystem moving when they use the proceeds to make investments in the next generation of startups.
Stock, shares and equity — what’s the difference?
“Stock” and “equity” are often used interchangeably. Stock is a general term — much like equity — that is used to describe an amount of ownership interest in your company. Shares, on the other hand, are how your company’s stock is divided.
Your percentage of ownership is equal to the number of shares you own divided by the total number of shares:
Startup equity distribution among employees
Equity is the currency of the tech and startup worlds. After founders divide the initial ownership among themselves and investors, they also use it to attract talent. Like VCs, these early-stage employees are taking on risk, and you need to compensate them for the salary cut they will likely take and long hours they will put in. Startup equity offers, however, also help to retain employees with the prospect of a big payday when the company exits through a buyout or Initial Public Offering (IPO).
Equity is the currency of the tech and startup worlds.
But how much equity should you offer? And what are the terms? There are general rules, but essentially the younger and smaller your company, the more startup equity you’ll need to offer.
How to share your startup’s equity wisely
There’s no correct answer for deciding the equity split among founders. Often, they default to a 50/50 split or another equal distribution to avoid an uncomfortable conversation. It’s an issue that can lead to big problems in a company’s future if not properly aired.
Sometimes a 50/50 split simply doesn’t make sense. Founders have different skills and commitment to the business. People can be in different stages in their personal lives, and founders play different roles.
“Generally, the CEO gets more,” says Peter Pham, a serial entrepreneur, angel investor, startup advisor and Co-Founder of Science, an incubator in Santa Monica, California. Pham cites a team that came into Science assuming they’d split their company 50/50. “We had to tell them, ‘Look, it can’t be 50-50. Because you’re the CEO and your partner is not, and the value of their role will diminish over time and yours will increase,’” Pham says. While the non-CEO founder deserved a large stake in the company, “the equity should be split based on value creation,” Pham adds.
The key is to have a serious conversation about ownership early on.
How to split your company safely
The key is to have a serious conversation about ownership early on. Figuring out what’s right for your team begins with a frank conversation. Discuss expectations, risk profile, commitment and personal circ*mstances. It is critical that founders “understand deeply each other’s interests and intentions,” says Roy Bahat, head of Bloomberg Beta, an early-stage venture firm backed by Bloomberg L.P.
Contributions to evaluate should go well beyond skills, experience and contributions solely at the time of founding. For example, the initial idea the company was founded on has value, and whomever dreamed up the initial concept should be fairly compensated. But the concept is only part of the evaluation, as it may be worth little unless realized through execution.
Peer into the future and anticipate how things might evolve. Bahat advises founders to think broadly. “I think it’s one of the most important decisions that founders make,” he says. Equity calculators can also help guide your discussions. Peer into the future and anticipate how things might evolve.
Build an equity distribution program
It will be necessary to offer startup equity to recruit board members, advisors and key employees, however sharing out equity is a challenge for first-time founders. Also, the stake an employee receives depends on a range of factors from skills to seniority as well as their original contribution when they were hired.
Serial entrepreneur Joe Beninato asks, “What’s the experience of the person coming over? You must look at each situation individually.”
Position and seniority play a big role in deciding whether to offer 1% or .05%. Online guides, like Index Ventures and Holloway Guide to Equity Compensation, provide compensation benchmarks to help founders decide the percentage of the company they give away when signing talent.
At a company’s earliest stages however, you can expect to give a senior engineer as much as 1% of a company. But an experienced business development employee would typically receive only a .35% cut. An engineer coming in at the mid-level can expect .45% versus .15% for a junior engineer, and so on. But Beninato says, “The percentages really vary dramatically. I don’t want to say it’s like a decaying exponential, but it’s something like that. The first people get more, and it goes down over time.”
Equity compensation is always subject to vesting schedules.
Regardless of its form, equity compensation is always subject to vesting schedules. You need to reward your team for staying with your company, and startups have typically used a four-year benchmark with a one-year cliff — this means, no ownership percentage is granted until an employee has worked at least twelve months. However, longer vesting schedules are becoming more commonplace as startups take longer to exit.
But keep in mind that equity is finite, so spend it carefully.
Crafting your startup’s exit strategy
Having a successful exit begins at the inception of your company and leadership team. Having the hard conversations early and fairly assessing everyone’s value to the enterprise is critical.
Having a successful exit begins at the inception of your company and leadership team.
Noam Wasserman, founding director of USC’s Founder Central Initiative, studied more than 6,000 startups over 15 years. He reported that startups that chose an even-split by default, bypassing difficult but important discussions, were three times more likely to have unhappy founding team members.
Unhappiness can even ruin success. “I’ve been at big liquidity events where everyone should be celebrating,” according to Scott Dettmer, a Silicon Valley-based lawyer who has been advising startups since the mid-1990s. “But two of the three founders say, ‘The third is getting more than he deserves’.” Discuss equity splits early, fully and openly to avoid that situation.
Running a startup is hard. Visit our Startup Insights for more on what you need to know at different stages of your startup’s early life. And, for the latest trends in the innovation economy, check out our State of the Markets report.
