Digital Strategist and Consultant, Growth Hacking Specialist worked for both startups & big brands.
Startup equity is something that every startup founder struggles with even if they have an MBA. In fact, no one really thinks about this until it becomes important, which happens when they start a business or are being compensated by a business. Everyone who puts in a lot for the business deserves to get a piece of the cake in the business.
But in case you are beginning to freak out about who gets what in the company, this article is here to help you.
So, before can talk about how to split the startup equity in a company, let us understand all the main terms related to equity:
Equity: Equity is the stake of a shareholder in the company, which is also noted in the company’s balance sheet.
Fair market value: Also known as FMV in short, it is the current market value of the share.
Stock options: An employee benefit of an option given by the company to an employee to purchase shares in the company at a fixed or discount rate.
Valuation: This is the total estimated worth of the company that is determined by a professional appraiser.
Vesting: When employees or even founders are given equity in the company, for them to stick with the company for a long time, the equity has some milestones and/or time restrictions placed on them before they are provided to the employee. This is called vesting.
With this said, who are the people in a company that gets the startup equity? Well, there are four groups of people who may get a part of the startup equity including:
Each and every startup would offer equity to some combination of these four categories. And not every startup would offer equity to the employees, or the advisors in the company. Some companies would not take up investors just as soon as they start. But it is important to know how to distribute the startup equity amongst them in case you decide to offer equity to a few groups or even all.
However, the main startup split usually takes place between the founders in the company. And that is also the place where the tensions arise because when people talk about fairness in a startup, they are normally talking about how the startup equity was split amongst the founders. The simplest method is to split the equity evenly amongst the founders, but it is still not the right way. Mainly because, each founder contributes differently to the company. In fact, there have been surveys that proved most of the co-founders usually fallout and separate in later stages of the company.
Additionally, most of the companies usually split the startup equity within the first month of founding it. And while they do this, they forget to add terms outlining how they will adjust the equity once there is a major business event in the company. This event can include the adding of a new investor, giving out employee options, change in the business strategy or model, or even the departure of a founder. As a matter of fact, if you want a startup to run smoothly and successfully without any fallout, the best way is to have open conversations about all the terms and what can change in the future.
Well, if you are the sole founder of the business, it is all yours. Nonetheless, if you have a co-founder or many co-founders, then you will need to decide how to distribute the startup equity amongst yourselves fairly. The best way to keep in mind everyone’s contribution and then split accordingly. And as you work together to split the startup equity, you should also consider the following things:
Risk: Consider if all the founders are taking the same amount of risk by joining this venture. In case one of the founders is taking more risk than the others, such as putting all his/her savings into the business or quitting their full time job for it. These things need to be considered when splitting the startup equity.
Innovation: In case the company was created by the idea from one founder or his/her unique research, while the others handle the other duties, the ownership of the idea should be considered when splitting the startup equity. Nevertheless, if the company was started with a joint idea, then splitting the equity in equal parts is also a good choice.
Commitment: During the initial stages, a lot of co-founders work to build their companies for little to no pay. Nevertheless, when one co-founder takes on more responsibilities and demanding roles, or has offered more commitment to help the business stand and succeed, this is also considered a huge factor when determining the startup equity split.
An initial startup always needs employees. So, as you start off and build your startup, you will need to hire the best talent in the industry. And for you to get the best, you would encounter hurdles of a tight budget which can then impact the ability to offer robust employee salaries. Nonetheless, if you are not able to offer great salaries, you can also offer startup equity for employees as part of their compensation package.
A lot of professionals get partial ownership as an incentive in the companies that they work in. This makes them feel more secure as they know that the success of the company would mean that they would get a financial gain on a personal level. Here are some things that you need to keep in mind while you offer startup equity to your employees:
Type of share awarded: What is the plan for the equity you are distributing? A lot of the companies usually offer stock options to their employees. This is a plan where employees can purchase stocks at a fixed value. ESOs, the short of Employee Stock Options are an equity compensation offered to the employees by the companies they work in. Under this plan, the company offers the employee with the option to buy company stock at a specified price for a fixed time.
The terms of the ESOs are given in the employee stock options agreement by the company to the employee. The benefit of this is when the stock price increases, the employee would be able to gain more out of it by exercising the options and selling it in the open market. Vesting schedules are applied to the plan so that if the employee leaves, their shares are forfeited. Just to be clear, ESOs do not include voting rights.
Other than ESOs, a few companies choose to give their employees restricted stock options that allow the employees to get the shares when the value of it is low. But this option normally has more tax implications for the employees. This is why ESOs are the best option both for the company and the employee.
Percentage of ownership: You would have to determine how much ownership would be given to the employees with the plan you are offering. You will also have to take into account how many members you plan to offer equity too, their experience, and your company’s financial timeline.
Vesting schedule: You can’t just offer the shares to the employees instantly because they can leave with it. So, you need to add a vesting schedule to it. The most basic vesting plan is the 4-year plan with a one-year cliff. This means that the employee would get the first part of the shares after a year and then the rest in equal parts every month or year for the next 3 years.
At the end of the day, the startup equity offered to employees should incentivize them to stay in the company and help the company grow.
Startup equity for employees should be offered keeping in mind their role, how much they would contribute to the company and how much salary they are receiving. This means that if a highly experienced and professional developer is getting a huge salary, the equity package should not be a hefty one.
For you to understand things better, here are some important terms to know about:
Stock vesting - Stock vesting is basically a plan applied to the share plan that is offered to employees where they receive the right to these shares after working for a specific period of time with the company. In short, stock vesting makes sure the employee serves the company for a long time before they get the rights to the stock options.
Exercise shares - Exercising stock options means to purchase the shares of stock as per the stock option agreement.
FMV or Fair Market Value - To put in simply, the fair market value of an asset is the price of the asset at which it would be sold in the market. The FMV of an asset is determined by keeping in mind some conditions where the sellers and buyers have the needed knowledge about the asset, behaving in their own best interest, given time to complete the transaction and free of undue pressure to trade.
409a Valuation - As per section 409A of the Internal Revenue Code (IRC), companies have to get their common stock valued at or above the FMV of the shares. This valuation has to be conducted by a third party professional, if not, the IRS would penalize the company.
Cliff period - Cliff period is a time period after which the employee gets the rights to their reward. For instance, if the cliff period is one year, the employee will get the shares after a year. It is unlike the normal vesting where the employees have the rights to earn the awards evenly over a period of time, like an even percent of the shares are given every month for the complete vesting time.
Authorized shares - Authorized shares are the total number of shares mentioned in the articles of incorporation of the company. It is the shares that make the company and that can be issued further by the company in exchange for assets or services.
Preference shares - Preference shares of the company with the dividend rights where the shareholders get paid from the company assets before the common shareholders. Although, most of the preference shares have a fixed dividend, and do not hold any voting rights.
For many years now, companies have been creating cap tables on excel sheets. Although it is okay to use an excel sheet for your cap table, you should know that it will consume a lot of your time. Basically, it is hard to collaborate, build and maintain an excel sheet cap table. At the start up stage, it is okay to add the details of the startup equity in the cap table. But as the company grows, it would become highly complicated.
The table would become less accurate and each person in your team might have a different table all together. This would eventually lead to confusion and mistakes. That is why it is better to create it using the latest technology, which is the cap table software. It is the easiest way to keep all your data updated in an electronic capitalization table. In fact, you will be able to take care of a lot of transactions easily that would also be recorded in the application. It would be a single source of truth.
All the details will be updated in real time which would allow the shareholders and managers to see it. This means that everyone would not have a different version of the cap table. Using software like Eqvista would also save you time when handling the other important share issues including 409A valuations, taxes, and compliance.
All-in-all, the best way to issue startup equity for Employees is by using an application. Just ensure that you select the right amount of shares and add a vesting schedule to it. The next step is to decide who you want to award the equity to now. And move on from here.