September 18, 2020
Founding a startup is an inspiring venture. You’ve got a great idea and some keen minds on board, and you’re looking to get something great going. Opportunities for starting up your own company have never been better with tons of accelerators, hackathons, and mentors accessible online and in cities worldwide. But being a startup, you’re likely bootstrapping a lot of the costs and hiring people on lower than market salaries initially.
Startups use equity to sweeten the pot and get talented individuals on board who will have a stake in the company’s success. You only have a certain amount of stock to give out, and a decent amount needs to be saved for investors. So how do you go about dividing up stock in your startup?
We’ve put together some questions for you to consider when making this critical business decision. But before we dive in, let’s get some definitions out of the way as things can be a bit confusing. Equity is typically split in shares and options. If you get shares, you immediately own a piece of the company, have to purchase them at a set price (often this is something like $0.01 per share), and you have to pay taxes upon purchasing. However, options usually vest over time and the owner generally has to buy them at fair market value once they can be converted to shares.
How much of the startup equity will be yours?
Typically, about 10-20% of the equity remains in the hands of the original founders by the time you hit Series C funding and beyond. So will you split it up evenly or find a way of dividing it up unevenly, yet fairly?
Working at a startup is often really hard work. You’re working with limited resources, your core team is wearing multiple hats, and people are pulling all-nighters. You’re going to need to keep the founders motivated enough to stick it out. If you unevenly split up the equity, you’re creating a hierarchy right off the bat among the founders. Even if one person had the original idea and is working extra hard now, will that still be the case 5 years down the road?
If you do decide that an unequal split is the best choice, you’ll have to decide on a method. You can use equity as an incentive for attaining certain milestones to keep things competitive and productive, for example. Or use a matrix like the founder’s pie calculator.
Whichever way you decide to split the equity among the founders, ensure that it’s fair to everyone and that they are all on board with the system. If someone feels slighted at the start, it’s going to make it that much harder for them to put in their all when the going gets tough.
Will the equity have a vesting period or cliff?
One problem often faced by startups that split up the equity pie carelessly is when one of the original founders leaves and takes a large slice of the shares with them. One way to get around this problem is to include a vesting period.
For example, if you one of the founders or an employee that has been awarded 3,600 shares subject to a 3 year vesting period, that means you will vest 100 shares for every month you remain with the company. If you leave the company before 3 years, let’s say after only 12 months, you will only own 1,200 shares of the company, and the rest will go back to the company.
Vesting has the benefit of incentivizing founders and employees to stay long term and frees many companies from the situation where former employees that aren’t contributing anything anymore to the company from possessing valuable shares that could be allocated to future hires.
How much stock do you want for employees?
One of the biggest perks about workings at a startup is getting equity. When a startup is brand new and just starting to build their product and flesh out their core team, they often don’t have much in terms of budget for salaries. Developers and experienced professionals whose skills are often critical to a startup’s success need to be attracted to a lower-than-market salary. So, how much equity is enough?
This is going to depend heavily on the role you’re trying to fill, the person’s expertise, and what stage in your development you’re in. For that reason, we’ve split up equity for employees into 4 groups:
Startup equity: This is what you’re giving new employees to make the compensation package more competitive to attract talent early on.
Promotion equity: In place of a salary bump, you can give employees a bit more equity instead.
Bonus equity: Just as with a usual end-of-year bonus, an equity bonus can be used as an incentive to ensure employees are going above and beyond.
Evergreen equity: Since most employee equity is vested stock options, once the usual 4 years grows closer, employees may be looking to jump ship. If a bit more stock is added over time as they continue, this can incentivize employees to stay with the company longer.
For your first few hires, you’re likely going to have to base your estimates on market norms in your area and sector to see what others have done in the past. According to Leo Polovets from Susa Ventures, for a small company of up to 10 people, equity of 0.5%-2% is considered the standard. However, for a larger startup with 50-200 people, something more like 0.01-0.2% is more common. This can definitely vary, but these figures at least give you a starting point for your calculations.
How much capital do you need?
Notice here we’re not asking, “how much equity do you want to give investors,” rather, it’s what you need from them in exchange for pieces of your company. You need to know how much you’re looking for and get a valuation of your company to see how much you need to sell off in order to raise the necessary amount of capital.
Keep in mind you’re not only selling off ownership and profits to your investors, but also giving them a vote when it comes time to decide on a board of directors.
Board of Directors and Other Advisors
You will likely have mentors or other advisors along the way who help you grow your company by sharing their expertise or networks with you. While the equity varies depending on how critical they were to your growth, a good ballpark figure to have in mind is 0.01-.5% on average for advisers. Members of your board, once you get one later on, will typically expect about 0.5%-2% in equity.
Summary
While there are guides, formulas, and past examples to follow, there’s no simple way to know how to split your equity when you’re only just getting your startup off the ground. It’s important to stay fair and retain loyalty from investors and employees, however, it’s also critical to not give away too much of your own company too early.
A small business lawyer would be in the best position to help you calculate the splits from the outset and draft all the contracts and agreements for new employees and their options. As we’ve said before, we’re conscious of the fact that startups are on a shoestring budget and legal counsel is known to be expensive. However, BizCounsel is a great source for legal experts to fit small business budgets, so get started with BizCounsel today--it only takes 2 minutes!
Sources:
https://blog.salesflare.com/how-to-split-startup-equity
https://seedcamp.com/resources/how-does-an-early-stage-investor-value-a-startup/
https://www.codingvc.com/analyzing-angellist-job-postings-part-2-salary-and-equity-benchmarks
https://www.capshare.com/blog/4-key-insights-from-5000-cap-tables/
