How to Effectively Plan a Startup Equity Distribution?

In terms of attracting new employees, startups have a tremendous edge. In contrast to large corporations, startups can provide employees with the opportunity to become highly wealthy by participating in the company's ownership. You may learn more about early-stage startups' equity distribution techniques by reading this article.

Startup Equity Distribution Plan

When it comes to the startup equity distribution plan, there are as many perspectives. Before signing any equity split agreement, it's usually a good idea to seek the opinion of professionals. Keep reading to know a few valuable pointers.

What is Startup Equity?

Ownership interest in a company is generally referred to as startup equity. Businesses usually use stock as a form of equity. While it is possible to own equity in any asset, this is not always the case. When you start a business, you should know how equity shares are classified and who receives what.

Types of Startup Equity 

There are several ways a startup's owners might reward their employees and investors with premium pricing and other incentives based on their equity interest in the company. The common types of startup equity are listed below:

Convertible Debt Notes

A convertible debt note is a method of securing a loan from an investor by using the company's equity as collateral. The convertible note promises to either pay back the loan with interest or grant discounted equity during a subsequent financing cycle. In either case, investors receive their money back, plus interest, or a lesser price for a stake in the company. In order to obtain much-needed capital without having to give up any stock for a long time, this is a popular method for new enterprises.

After a convertible loan note has been in place for 12 to 18 months, the company should undertake a Series A financing round in which investors can purchase discounted ownership in the company.

Incentive Stock Option

As a reward to employees, companies offer Incentive Stock Options (ISOs), which allow them to purchase shares of stock at a reduced price and avoid paying capital gains taxes. As ISO profits are treated as capital gains rather than regular income, they receive a tax advantage.

Stock options that do not meet the Internal Revenue Code's standards to be referred to as ISOs are called Non-Qualified Stock Options (NSO). These profits are taxed as income rather than capital gains.

How does Startup Equity Work? 

Employees and investors are typically given a stake in the company in exchange for their contributions. It is determined by criteria such as the timing of the equity distribution, the level of participation and commitment, and the company's current worth. Founders, on average, receive the greatest initial equity. Stakeholders deserve to have a share in their company's success, which is why startup equity is so important.

Early investors also generally receive more equity than others who join the firm later because their investments are larger in relation to the company's initial valuation. It's also common for early employees to have a larger stake in the company than those who join later in the process. In addition to fundraising stages, equity distribution is tightly linked. Your financial situation inevitably shifts as you proceed through funding rounds, and in almost every case, how you allocate equity shifts as well.

Things to Consider Before Splitting Startup Equity 

An equity split between the company's founders, investors, and employees can be a difficult task to do. The following is a list of things to keep in mind while determining the correct equity split for your new business.

• Replacement of salary - Co-founders and employees may be ready to accept a lower wage because they feel their ownership part in the company will be worth more in the future. Among the best examples is Nike's logo designer, who was paid around $35 a share of the company's equity, which is now worth almost $640,000.
• The idea to split equity - As a thumb rule, the person who came up with the company's primary value proposition is entitled to the most stock. However, this isn't always the case. The value of a good idea does not outweigh the value of actual, physical contributions of capital and sweat equity.
• A reasonable equity split between two or more co-founders should be based on earlier developmental efforts contributed by each of them. As an example, one of the co-founders of Instagram ended up obtaining a 40% stock position because he was the creator of a company. Another co-founder came on board later and was given a 10% ownership in the company, and the balance was dispersed among investors and staff.
• Stage of a startup - The stages of a startup determine the share percentage. It is customary for co-founders and early employees of a startup to receive a higher share of the company's ownership (Before series A funding, seed round) as compensation for their work and risk-taking in the company's early stages.
• Vesting schedules - A vesting schedule is generally recommended regardless of how equity is allocated among co-founders. The equity split agreement specifies in detail when and how co-founders might exercise their stock option rights under a vesting schedule. An effective vesting schedule can help prevent a startup firm from being collapsed by the departure of one of its co-founders, who may take a significant chunk of the company's worth with them.

How to effectively split equity in a startup?

In the early stages of a new company, the founders possess all of the company's equity. As long as you are the only founder, you have full ownership of the business.

More individuals investing their time and money means more likely you will have to divide up the company's stock and give some of it away to those who have supported you. In some cases, you may want to grant a non-founder or financial backer an equity part in your company. A common example is when employees are compensated with equity rather than wages or salaries. The below brief explains how to split equity effectively.

Founders

Entrepreneurs who start a company with two or more co-founders face the challenge of dividing startup equity by role fairly and evenly. 

At this early stage, most likely, you still hold all of the company's equity. Splitting this among the founders before handing a stake to investors is a good idea. Each founder should receive a fair share even if their investment does not match that of the other co-founders in the ideal situation. When beginning a new firm, it's not only about how much money each founding partner contributes.

Other factors to consider include, but are not limited to:

• Each entrepreneur adds a unique set of skills and knowledge to the company.
• One partner's contribution of tangible assets or equipment
• The amount of time that each party devotes to the startup venture

It's reasonable for entrepreneurs to demand compensation for all of these variables.

Investors

In order to award equity to third-party investors, you need to have a firm foundation on how to distribute equity to founders who have reached an agreement on its division. The amount of equity you're ready to sell must be determined at every stage of investment, from the seed round through Series A, B, and C.

An equity stake in your company is exchanged for money from investors. Again, the quantity of stock received by each investor should reflect the amount invested. Well-known investors may try to cut the price or increase their equity stake because of their experience, unique knowledge, and/or success in the past.

Accepting a cheaper offer is up to the majority of stakeholders; however, consider how other investors may feel if they discover you have paid more for their part of the company. Whenever you transfer equity to a new outside investor, consider how much of your original investment is being lost.

For example, ensure that the company's founders have at least a 51% ownership in the company's equity.

Employees

Employee stock and vesting schedules might well be necessary at some point in a new company's life cycle. Typically, this is defined as:

• The primary founders of the company.
• First-time hires (the first 25 hires by the startup)
• Soon-to-be-hired staffers (the 26th and subsequent individuals to be hired)

They can have a huge impact on your company's success because they are the first ones to walk in. There is a chance that they can bring unique expertise or access to markets that you otherwise would not have. However, you may not be able to afford to pay your first staff a salary due to a lack of established income or cash flow.

You can avoid this problem if you give your first employees a stake in your company's long-term success through a stock offer. A common technique to figure this out is to compare the current value of your firm to the value it will hypothetically be worth when a new hire joins you. This increased value determines how much equity you can provide to that person and yet break even on hiring them. Even though you give away some stock, you can still make a profit if you give them less than the break-even point.

However, an equity share provides them with a genuine interest in ensuring that your company succeeds to the fullest potential extent.

Conclusion 

We hope you found this post helpful in figuring out how to split your shares in a way that doesn't insult anyone and doesn't get misplaced. 90% of the time, individuals agree on how the company's future profits will be split, preventing any potential issues as startups grow swiftly and unpredictably.