Startup equity is a fundamental concept for founders and early employees, yet it’s often misunderstood. This guide breaks down the essentials of startup equity, from basic definitions to complex calculations, helping you navigate this crucial aspect of your company’s financial structure.
At its core, startup equity represents ownership in a company. It’s typically divided into shares, with the total number of shares representing 100% ownership of the business. The basic relationship between company value, share price, and number of shares is expressed by this simple formula:
Company Value = Share Price * Number of Shares
This formula holds true whether you’re dealing with a fledgling startup or a trillion-dollar public company. For public companies, you might see “market capitalization” used interchangeably with company value or valuation.
Startup equity is typically distributed among various stakeholders, each playing a crucial role in the company’s growth and success. Founders, as the initial visionaries and builders of the company, usually retain a significant portion of the equity. This ownership stake reflects their foundational contributions and ongoing commitment to the business.
Employees are another key group that receives startup equity, often as part of their compensation package. This equity compensation can come in the form of stock options or restricted stock units (RSUs)(we will talk about these later).
Investors, such as venture capitalists or angel investors, typically receive equity in exchange for their financial investment in the company. This equity stake compensates them for the risk they take in funding the startup and provides them with a share of the potential upside.
Advisors, who provide valuable guidance and expertise, may also receive a small portion of equity as compensation for their services. This can be an effective way to attract experienced professionals who can contribute to the company’s strategic direction without requiring significant cash outlays.
When you first incorporate your startup, you’ll need to decide on an initial equity structure. Many incorporation services, like Stripe Atlas, will set up a default structure for you. A typical initial setup might look like this:
Using our formula, this gives an initial company value of $100 (10,000,000 * $0.00001). As a founder, you might purchase 8,500,000 shares for $85, leaving 1,500,000 shares for an employee option pool.
This may seem like an arbitrary starting point, but it provides flexibility for future equity distribution and fundraising rounds.
Not all shares are created equal in the startup world. There are typically two main types of shares:
Common shares represent the most basic form of ownership in a company and are typically issued to founders and employees. While they entitle holders to a portion of the company’s profits and voting rights, common shares generally lack the special privileges or protections that preferred shares offer, such as liquidation preferences or anti-dilution provisions.
Investors typically receive preferred shares. These often come with special rights, the most common being a liquidation preference. This means that in the event of a company sale or liquidation, preferred shareholders get paid back their initial investment before common shareholders receive anything.
For example, if investors put in $5 million for 50% of the company, and the company later sells for $7 million, the investors would get their $5 million back first. The remaining $2 million would be split among common shareholders, despite them technically owning 50% of the company. This scenario illustrates the power of liquidation preferences in favoring preferred shareholders. In more extreme cases, if the company sold for exactly $5 million, the preferred shareholders would recoup their entire investment, leaving nothing for common shareholders. This structure incentivizes investors by providing downside protection, but it can significantly impact the potential returns for founders and employees holding common shares, especially in modest exit scenarios.
When a startup raises capital, it typically doesn’t sell existing shares. Instead, it creates and sells new shares, a process known as dilution. Here’s how it works:
After this round:
While your ownership percentage decreases from 85% to about 70.8%, the value of your equity significantly increases due to the higher company valuation.
If you’re interested in exploring dilution further, including strategies to mitigate its effects on founder and employee equity, check out our blog section for in-depth articles on the topic.
As your startup grows and raises capital, you’ll encounter two different share prices:
The internal price is crucial for equity compensation and tax purposes. It’s determined by a 409A valuation, which we’ll discuss next.
A 409A valuation is an independent assessment of your company’s fair market value. It’s required by the IRS and needs to be updated at least annually or whenever a material event (like a funding round) occurs.
The 409A valuation determines your company’s internal share price, which is used for granting stock options or shares to employees. Typically, you want this price to be as low as possible (while still being defensible) because:
In early stages, you might aim for a 409A price that’s less than 10% of your preferred share price. As your company matures, this typically settles around 20% of the preferred price.
Vesting is the process by which employees (and often founders) earn their equity over time. This mechanism ensures that individuals receive their full equity stake only after contributing to the company for a specified period, typically several years. Vesting serves multiple purposes: it incentivizes long-term commitment, aligns individual interests with the company’s success, and protects the company from dilution if someone leaves prematurely. For founders, vesting can be particularly important when seeking investment, as many investors require founder vesting to ensure the key people driving the company’s vision remain committed to its long-term success.
A typical vesting schedule might look like this:
For example, if an employee is granted options for 48,000 shares on a 4-year vesting schedule with a 1-year cliff:
Vesting protects the company by ensuring that employees stick around to earn their equity, rather than granting it all upfront.
When offering equity to employees, it’s important to help them understand its potential value. Here’s a basic formula:
Value of Equity = Number of Shares * (Preferred Share Price – 409A Share Price)
Let’s say you want to offer an engineer 1% of the company:
Over a 4-year vesting period, this equates to about $27,000 per year in equity compensation.
It’s crucial to explain to employees that while their purchase price (the 409A price) is locked in, the value of their equity can increase as the company grows and the preferred price rises. Additionally, understanding startup equity compensation is essential for both employees and the company, as it involves various types of equity, ownership implications, and tax considerations.
When granting equity to employees, companies typically use either stock options or Restricted Stock Units (RSUs). Here’s a quick comparison:
Typical equity compensation varies significantly based on factors such as job role, level, industry, company stage, and location. For instance, early-stage startups might offer more stock options, while later-stage companies could provide a mix of RSUs and options to align with their growth and stability.
Stock options are a form of equity compensation that gives employees the right to purchase company shares at a predetermined price, known as the strike price or exercise price.
Options provide a potential for significant financial gain if the company’s value grows, as employees can purchase shares at the lower, fixed price and potentially sell them at a higher market price. However, they also come with the risk that if the company’s value doesn’t increase above the strike price, the options may become worthless.
Exercising options is a pivotal moment for employees holding stock options, as it involves converting these options into actual shares of the company. When an employee exercises their options, they are essentially purchasing shares at a predetermined price, known as the strike price. This price is set at the time the options are granted and is typically lower than the current market price of the shares.
The primary benefit of exercising options lies in the potential profit from the difference between the strike price and the current market price. For example, if the strike price is $1 per share and the current market price is $5 per share, the employee can buy shares at the lower price and potentially sell them at the higher market price, realizing a significant gain.
However, exercising options is not without its complexities. It can have tax implications, as the difference between the strike price and the market price may be considered taxable income. Employees should carefully evaluate their financial situation and consult with a tax advisor to understand the potential tax liabilities and benefits.
Restricted Stock Units (RSUs) are another form of equity compensation that represents a company’s promise to give an employee a set number of shares upon meeting certain vesting conditions. Unlike stock options:
RSUs provide a more predictable value to employees as they’re worth something even if the company’s stock price doesn’t increase, making them less risky than options. However, they offer less potential for outsized gains compared to options if the company’s value grows significantly.
The choice between options and RSUs depends on the company’s stage, tax considerations, and overall compensation strategy.
Many early-stage startups use alternative funding instruments like SAFEs (Simple Agreement for Future Equity) or convertible notes. These postpone the actual issuance of equity until a later “priced” round.
SAFEs (Simple Agreements for Future Equity) are financing instruments designed to streamline early-stage funding for startups. SAFEs act as a promise to provide equity to an investor in a future funding round, rather than issuing shares immediately. This allows startups to raise capital quickly without the need to determine a specific valuation or negotiate complex terms, deferring those decisions to a later priced round when the company’s value may be easier to assess.
Convertible notes are debt instruments that function as short-term loans to startups, with the intention of converting into equity at a future funding round. Unlike SAFEs, convertible notes accrue interest and have a maturity date, providing investors with additional protections. They typically convert to equity at a discount to the price of the next priced round, rewarding early investors for their higher risk, while allowing startups to delay valuation discussions and raise funds quickly.
Both instruments allow startups to raise money quickly without setting a valuation, but they can complicate your cap table if not managed carefully.
As your startup grows and you issue more equity, managing your capitalization table (cap table) becomes increasingly important. A cap table tracks all the equity ownership in your company, including:
Many startups use Excel templates (you can find our free Cap table template in the tools section) or specialized software like Carta, Pulley, or AngelList Stack to manage their cap tables. These tools can help with:
Proper cap table management is crucial for making informed decisions about equity grants, fundraising, and potential exits.
The ultimate goal for most startups is an “exit” – either an acquisition or an Initial Public Offering (IPO). How these events affect equity holders depends on the specifics of the deal and the rights attached to different classes of shares.
In an acquisition, the proceeds are typically distributed in this order:
The specific terms of preferred shares can significantly impact how proceeds are distributed, so it’s crucial to understand these terms when raising capital. These terms might include multiple liquidation preferences, caps on returns, or other provisions that affect the distribution waterfall.
In an IPO, preferred shares usually convert to common shares. This simplifies the capital structure but can dilute common shareholders. After the IPO, shareholders can sell their shares on the public market, subject to any lock-up periods. Lock-up periods, typically lasting 180 days, prevent insiders from selling immediately after the IPO to stabilize the stock price. The IPO process involves extensive regulatory filings, underwriting, and marketing efforts to transition the company from private to public ownership.
Understanding these exit scenarios is vital for founders and employees to make informed decisions about their equity and to navigate potential conflicts between different classes of shareholders during an exit event.
Conflicts or disputes over equity can arise in various situations, such as disagreements among founders, employees, or investors regarding the distribution of equity or the company’s valuation. To effectively resolve these conflicts, it’s essential to have a clear and transparent equity management system in place.
One of the foundational tools for managing equity is a well-maintained cap table (as mentioned earlier in the Cap table management section). A clear cap table helps prevent misunderstandings and provides a transparent view of the company’s equity distribution.
Understanding vesting schedules and equity grants is also important. Vesting schedules ensure that equity is earned over time, aligning the interests of employees and founders with the long-term success of the company. Clear documentation of these schedules can prevent disputes by setting transparent expectations for when and how equity is earned.
In cases where conflicts do arise, seeking the advice of a mediator or a lawyer who specializes in startup equity can be invaluable. These professionals can provide objective guidance and help navigate complex equity issues, ensuring that resolutions are fair and aligned with the company’s goals.
Understanding startup equity is crucial for founders, employees, and investors alike. While the concepts can seem complex, breaking them down into manageable pieces – from basic share structures to vesting schedules and exit scenarios – can help you navigate this vital aspect of startup finance.
Remember, equity structures can have long-lasting implications for your company and its stakeholders. When in doubt, consult with legal and financial professionals to ensure you’re making informed decisions about your startup’s equity.
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Startup equity is a fundamental concept for founders and early employees, yet it’s often misunderstood. This guide breaks down the essentials of startup equity, from basic definitions to complex calculations, helping you navigate this crucial aspect of your company’s financial structure.
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