How to Split Equity in your Startup

When your Startup is gaining traction, your first priority will be to create an all-star team to help you grow your startup and only way to attract talent is through ESOP / Equity in exchange for their skills and services, but distributing equity among team / advisors is a difficult procedure.

So, to assist you, we'll go through what startup equity is,how it works in a business, how it's commonly structured, and how to value and distribute it.

As a founder, you want to ensure that the process of distributing ownership of your company is intelligent and productive. And, ascorny as it may appear, the best way to grasp startup ownership is to imagine it as a pie.

There is only so much pie that can be divided and shared —and the worth of each piece grows as your company grows in success.

If you own 100% of your company as the founder, you own the entire pie. And, while keeping your firm's whole value to yourself may sound desirable in principle, the fact is that you can only make as much as your company is worth — and holding 100% ownership isn't beneficial to your company's growth.

If you want your pie to be more valuable as a whole, you must be willing to give up some of its pieces.

How does Equity Work in a Startup?

Startup equity is based on the assumption that a company's stakeholders are entitled to exactly what the moniker implies - a stake in the company. This usually entails giving early contributors, such as employees and investors, a part of ownership.

Timing, degree of participation, amount of commitment, and the company's valuation at the time of equity distribution all influence that percentage. Founders receive the greatest initial stock, which is unsurprising.

Early investors also tend to receive more equity than later investors since their investments are proportionately larger relative to the company's early valuation. Employees who help get things started frequently have a higher amount of ownership than those who join the company later on.

The allocation of equity is very directly related to the stages of finance. As funding rounds proceed, your financial conditions change and in almost every case, how you allocate equity changes as well.

Typical Startup Equity Distribution

As previously said, startup stock allocation varies depending on a variety of criteria, including timing, business model, industry, CEO preferences, and the number of stakeholders engaged. There is no single, "only way this happens" paradigm for the process. Still, there are several trends and data that describe the equity distribution of a typical company.

Here's an example of how equity distribution often occurs asa startup grows and proceeds through the funding rounds.

As you can see, startup equity is quite fluid and can changedramatically as a firm grows. And knowing the worth of your personal equity iscritical for everyone associated with a growing firm – in any position. Here's an example of how you can do it.

How to Value Equity in a Startup

How you can value your equity at a startup leans on a few factors 

1. Last Preferred Price

The most recent preferred price represents what investors paid for a single share in the company's most recent funding round. It'scommonly used as a gauge for the likelihood of a startup's success.

2. Post-Money Valuation

The post-money valuation of a startup measures the company's overall value following a round of funding. It is computed by adding the pre-money valuation (the value of a firm before to a round of investment) and the amount of fresh equity.

3. Hypothetical Exit Value

The value at which a corporation would exit — that is, the value that a company would create if it were sold — is known as the hypothetical exit value. Typically, startups do not readily provide this information. If you want a more realistic statistic, look into similar companies and see what theirs have looked like.

4. Number of Options in Your Grant

This one should go without saying. The number of grant possibilitiesis precisely the number of grant alternatives.

5. Strike Price

A strike price is the cost per share incurred if youexercise your options.

Who should receive equity in your startup will be determined by how your company is structured. Typically, equity is distributed among the founders (and co-founders), employees, outside investors, and corporate advisers. Let's take a look at who these parties are and how their equity awards should be distributed.

How to Distribute Equity in a Startup

• Founders and Co-Founders
• Employees
• Investors
• Advisors

1. Founders and Co-Founders

If you are the single creator of your company, determining your own ownership is rather simple. If you have a co-founder (or numerous co-founders), deciding how equity should be split among the persons involved isa critical choice that should not be taken lightly.

If you want your startup to flourish in the long run, it iscritical to have open, honest dialogues with your co-founders early and regularly. When deciding how to distribute stock with your co-founders, keepthe following aspects in mind:

• Risk — Is this venture putting all of the co-founders at the same level of risk? If one founder is taking on more risk than another, such as quitting their full-time job or initially spending more capital? When splitting equity, several potential aspects should be considered.
• Level of commitment — Many co-founders work for little or no salary in the early phases of their companies. However, if one co-founder has taken on more difficult jobs and responsibilities — or has proven a stronger dedication to assisting the business's success — this could be considered when assessing equity.
• Innovation — When distributing equity, ownership of the original idea can be regarded if the firm focuses around a co-idea founder's or distinctive research while their partners undertake other jobs. However, if the organization was created on a shared vision, dividing equally may be an option.
• Equal splits (such as 50-50 or 33-33-33), or a senior controlling partnership, in which one founder has a bigger interest, are common equity distribution arrangements among co-founders (such as 60-40).

2. Employees

As you grow your startup, you will begin to hire talented team members who can take your company to the next level. You, like many other founders, may face restricted funds in the beginning, which may limit your capacity to provide competitive staff compensation. If your initial employee salaries fall short of the market rate, you can give stock as part of their compensation package.

Many professionals are incentivized by partial ownership inthe companies for which they work, realizing that the company's success might result in personal financial advantage.

Consider the following aspects when deciding how to provide equity to your employees:

• Percentage of ownership — You'll need to decide how much ownership you want to give your staff. This usually starts with establishing an employee equity pool or determining how much of your equity pie will be allocated to employees. When deciding how much ownership to provide employees, consider how many team members you intend to hire, your employee's level of expertise, and your company's financing schedule.
• Vesting schedule — Next, you must decide when your employees will be able to receive their profits. A four-year vesting plan with a one-year cliff is the most prevalent. This means that after a year of employment, an employee can begin vesting their equity. After the first year, they will own a quarter of their equity award, with the rest vested monthly or quarterly. Despite the fact that this is popular, you can use the vesting plan that works best for your company.
• Type of shares awarded — How do you intend to distribute stock to employees? Many startups prefer to provide their staff stock options. This means that employees can buy stock at a predetermined strike price. Some businesses choose to provide their employees restricted stock, which comprises of shares handed to recipients at a low value. This method may have higher upfront tax implications for employees, which should be considered.
• Education — Finally, if your organization provides stock to employees, make sure they understand how it works. Any company that offers employee equity must provide education and a venue for employees to ask questions and understand their alternatives.

Employee equity, in theory, should incentivise employees tostay with your company and contribute to its growth and success.

3. Investors

Those that participate in your company, whether angel investors, venture capitalists, or friends and family, should earn a piece of the equity pie. When an investor invests in a startup, they are effectively assuming financial risk in the goal of earning a financial return.

The amount of equity received by an investor will vary depending on the valuation of your firm at the time of investment and the magnitude of their investment. If you choose the fundraising route and obtain money from outside investors to build your firm, you should discuss equity when pitching for and negotiating financing.

4. Advisors

Typically, early-stage startups have an advisory board of experienced founders and industry experts who provide strategic direction forthe company; these parties are frequently compensated with equity.

There are no specific guidelines for awarding equity to advisors who volunteer their time and expertise to help your startup grow. However, many businesses provide 0.2% to 1% stock to its advisors.

As you build advising partnerships, you should explicitlydefine expectations with advisers early on so they understand how much of a commitment their role requires in exchange for the amount of ownership youchoose to offer.

Startup Equity from the Employees' Perspective

The amount of equity you are offered as a startup employeeis determined by numerous factors. There is no single formula that can precisely anticipate your equity before it is divided. The size of your sliceof the pie is determined by your seniority, position, tenure in the company,and experience.

A senior engineer who is employee number five at a startup is almost certain to acquire a larger interest in the company than a junior salesperson who is employee number 30.

When it comes to stock distribution, timing is moreimportant than most other factors. If you join a business early, you'll have abetter chance of receiving more ownership than someone hired later – even ifthey're more experienced and their position is more labor-intensive ormission-critical.

Finally, how much equity you give and to whom will be determined by what is optimal for your company's growth and success.

About Jordensky

At Jordensky, we are committed to providing an experience of the highest caliber while specializing in accounting, taxes, MIS, and CFO services for startups and expanding businesses.

When you work with Jordensky, you get a team of finance experts who take the finance work off your plate– ”so you can focus on your business.