Welcome to Startup 123 by Infusion Lawyers. In today’s highly competitive business environment, startups need all the help they can get to successfully start, grow, scale, and operate their businesses. Startup 123 makes access to information, resources, and tips on everything startup not only easy but also keep them as simple as ‘123’. Last time, we considered everything you need to know about startup capital. This week, let’s look at equity split so you know how to distribute founder/employee stock.
Startups have one big advantage in attracting talent. While big companies can offer big paychecks and great benefits, startups can offer employees the chance at becoming very rich through sharing company ownership. Here is an introduction to the methods companies use to decide how to split up equity fairly between the founders and employees at early-stage startups.
There are as many different opinions about the how to to structure an equity split for a startup company as there are startups. It is always a good idea to seek out the advice of experienced professionals before finalizing any equity split agreement.
What Is an Equity Split?
Equity refers to non-cash compensation that represents partial ownership in a company. The equity is usually divided up, or split, among the early founders, financial supporters and sometimes employees who join the startup in its earliest stages. Often, founders agree to give talented employees a small share in company ownership as a replacement for the big salaries they could earn elsewhere, and as compensation for accepting all of the uncertainties that come with working at a startup. One of the most famous examples is Instagram, where the 13 original employees split a 10 percent equity stake in the company, which amounted to $100 million after the company was sold to Facebook.
Factors to Consider in a Fair Equity Split
Determining a proper and fair equity split among founders, investors and employees can be daunting. Below is a list of important factors to consider with calculating the right equity split for your new company.
Ideation — The person who came up with the main value proposition of the company often deserves the largest portion of equity ownership. This is not always the case, however. Actual, concrete contributions of capital and sweat equity, for example, may be more valuable to your startup than one good idea.
A rational equity split among two or more co-founders should normally be based on a realistic assessment of the relative amount of early development work contributed by each. In the case of Instagram, for example, one of its two co-founders ended up with a 40 percent equity stake because he was the founder whose technological innovation led to the creation of a company that was folded into Instagram. The other co-founder joined later in the process and received a 10 percent equity stake in the company, with the balance distributed to early investors and company employees.
Startup Stage — Normally, co-founders or employees who join a company in the earliest stages of development (before the seed round, before series A funding, etc.) deserve a larger piece of equity to reward them for their investment of time and assumption of risk.
Salary Replacement — Sometimes co-founders and employees are willing to accept a much lower salary based on what they believe their ownership stake in the company will be worth in the future. A good example is the designer of Nike’s logo, who was paid just $35 plus a piece of equity, which is now worth over $640,000.
Seed Capital — The amount of the investment as a percentage of the startup’s valuation may properly be considered in equity distribution. A 50/50 split for otherwise equal co-founders, for example, might fairly be adjusted to 60/40 in favor of the founder who put more seed capital into the business.
Other considerations break down in terms of past and future contributions. Past contribution factors to consider include, among others:
Time spent by each person presenting the business model to potential investors.
Each person’s individual contribution to the company’s intellectual property.
Future contribution factors to consider include, among others:
Time to be spent on business development.
Ability to resolve future problems based on the individual’s professional connections and experience.
Value of opportunities lost to the individual due to his or her commitment to the startup.
Regardless of how you decide to split equity among co-founders, it is highly recommended that a vesting schedule be implemented. A vesting schedule details when and how co-founders can exercise the stock options granted in the company’s equity split agreement. The use of a vesting schedule helps eliminate problems that, without a vesting schedule, could sink a young company in the event a co-founder decides to leave and take a major portion of the company’s value with her.
A typical vesting schedule provides for incremental vesting over a four or five year period with a large portion of options vesting at the end of the first year.
Example of an Equity Split
The global equity firm Advent International provides this example for an equity split after the first round of funding:
Founders: 20 to 30 percent divided among co-founders. Company contribution is rarely exactly 50/50 and the equity split should be based on a variety of factors, including those discussed above.
Angel Investors: 20 to 30 percent.
Venture Capital Providers: 30 to 40 percent.
Option pool: 20 percent, which can be divided up among employees.
This example is presented to show how a company might structure its equity split. Keep in mind that ownership percentages for your company should reflect its unique nature, needs and business strategy.
It is also important to keep in mind that the specific elements (such as number of shares, price of shares, percent of outstanding option pool, equity relative to other employees and strike price of options) making up an individual’s equity share are less important than the actual equity percentage of the company received.
What Tools Can Help Navigate an Equity Split?
Many startup founders can get bogged down in details without a solid organization platform to manage all of their equity data. Consider using an automated cap-table management tool, such as this one offered by eShares.
Equity calculators, such as the those offered by Founder Solutions and Foundrs.com, can also be useful. Equity calculators take into consideration a variety of factors (ideation, time spent away from other projects, per-hour pay estimation, etc.) in calculating equity splits. Foundrs.com also offers this helpful venture capital calculator.
Is Equity the Same as Stock?
No. Stock is a form of company equity, but equity consists of more than stock. Other forms of company equity include stock options, bonds, warrants, paid-in capital, retained earnings, etc. Stock options, however, are not part of equity until they are exercised.
What Are The Types of Stock Options Commonly Offered to Employees in an Equity Split Agreement?
There are two major types of stock options typically offered to employees: non-qualified stock options (NQOs) and incentive stock options (ISOs). NQOs may be granted to consultants, directors and others, as well as employees. NQO’s do not offer any special tax treatment to their recipients. ISOs, on the other hand, are only available to employees, and feature more favorable tax treatment for their holders, particularly when options are exercised. Details regarding each type of stock option should be carefully reviewed with your company’s financial and tax advisors before being granted.
Other Quick Tips to Consider
Anyone with less than a 10% equity share should likely not be considered a co-founder, but instead as a first employee whose compensation should be supplemented with some level of salary.
More co-founders is not necessarily a good thing. One or two co-founders is ideal. There should probably be no more than four co-founders, however. More than that and a reassessment of individual company roles should be considered.
Don’t let your emotions dictate your equity split decisions. Be sure to put some real time and effort into an objective assessment of the value of each equity holder’s contribution. This is particularly true when family members are involved.
Be realistic, but not stingy. Remember that a larger equity share usually means more incentive to help the company succeed.
Be patient. It can take some time to assess the relative value of each individual’s contribution to the company. A simple, even equity split among co-founders, for example, may be seen by potential investors as a sign of managerial immaturity, and may also result in personal animosity as the company moves forward.
Consider holding back some shares from allocation at the beginning. As the company moves forward, it is likely that, due to greater than expected contributions to the company, some founders or early employees will deserve more compensation than originally allocated. Shares held back can be used to correct such compensation inequalities.