Tetiana Horban, CEU iLab
September 21, 2020
To turn an ambitious idea into a real company, a startup team needs two key things (among others):
While you can learn about how to benefit from startup mentoring and get valuable advice for your business from another article, here we will explain the basics of equity in a startup. Read on to learn more.
Unlike companies with predictable cash flows and valuable physical assets, startups have little chances of getting a loan (if at all) and not getting into trouble. So, a startup can get the first money in these three ways:
In brief, bootstrapping suits startups which do not need a lot of capital to build and test their product. Thus, a team can rely on money from personal savings and revenues from the first sales.
VC investing is rather for startups who aim to shoot far, need a lot of money, and are confident enough to make VC investors believe in them. VC doesn’t oblige startups to repay the money, but on the other hand, investors are purchasing a percentage in a startup from the founders.
Finally, angel investors are usually high net worth people who help startups with their own money at early stages. Since this type of investment is risky, startup investing makes up to 10% of angel investors’ portfolios.
In either case, comes the question: how big a slice of a pie each co-founder/investor or anybody else involved in the process should get? Before you get the answer, let’s clarify what equity is.
Equity in a startup is the percentage of the company’s shares that will be sold to startup investors. Thus, investors will be given not only ownership but also rights to the potential profits of the startup. It is usually distributed in the form of stock options.
As a startup succeeds, all its subsequent investors will be willing to pay more per share in the next rounds of funding. This is one of the factors that motivate startups to grow.
Now, who are these investors? Are they only VC investors or can those be employees? Find the answer below.
In general, four main groups of actors can get startup equity:
The most typical case is when ownership is shared in percentages between co-founders. Different startups may have different combinations of these four categories. But not all startups offer ownership to advisors, investors, and employees.
Let’s look at each category in more detail.
Startup attorney Matthew Rossetti says that 60% of the time startup founders end up in court because of issues in splitting the equity. Indeed, should it be split evenly or according to the involvement of each co-founder?
First, look at how much each co-founder is ready to contribute in terms of money, time, and effort. It is not likely that everyone will do the same amount of work. The one who is ready to contribute the most shall get the largest slice of a pie.
Second, focus on the present and not the future. Some startup teams take on the “fix or fight” approach, according to which you split the equity based on how much you expect each co-founder to contribute in the future. But the problem is no one knows that will happen in the future, so better go for the “dynamic split”, which depends on what co-founders are ready to do at the moment.
Third, consider other factors, not just money, time, and effort. These factors can be:
All this should help you decide how much of startup equity each co-founder should get. Note that it is better to split it among co-founders before you move on to third persons like investors, advisors, or employees.
This category of equity holders is the one that gets a much larger slice of a pie compared to advisors/mentors, employees, and sometimes even co-founders themselves. Types of investors include but are not limited to:
These investors get the largest percentage of equity because their primary role is to give money. They take a huge risk piling money into a startup that is not guaranteed to succeed; thus, they need a proper reward.
So how to distribute equity among founder/co-founders and investors? You should decide it based, on the following factors, as Ryan Rutan, Chief Innovation Officer of Startups.com says:
While the first factor is pretty obvious, evaluating your startup might be challenging. The best way to go about it is to talk to startup founders in your niche or the most similar one. The more ideas you get, the easier it will be to establish what is a “norm” for your case.
SEE OUR ARTICLE ABOUT STARTUP VALUATION HERE
By reaching out to your peers, you can also find out how much percentage of equity they gave to investors and for which reasons. That’s why networking is crucial for a startup.
Also, try to estimate if it’s likely that huge investment will boost your project and make you more likely to succeed over a certain period. If you understand that you need a lot of money to deliver the first results, better go for VC investment. Amazon, Google, and Facebook once were just like that – they relied on VC support. If you aren’t sure you can bring skyrocketing results in the long run but just average ones, better go for funding from your relatives or friends. Whatever your case is, just make sure you have given it a thought.
After you get at least a rough idea of what the value of your startup is, you can start negotiating with investors. At the end of the day, the amount you give to them will depend on how you pitch your startup to them and how big of an award they would go for.
Assigning equity percentage to advisors and mentors is tricky as some people prefer to get compensated for their consulting and guidance, while others would do it free of charge. So how should you go about it? Who should you give the equity and how much?
According to Kris Kelso, an entrepreneur, and executive advisor, there are no strict rules or guidelines for compensating advisors with equity. Nevertheless, if you expect an advisor to be involved in your project for about two-five hours per month, compensating them with a 0.5-1% in equity should be good enough. And, of course, a lot depends on the advisor’s expertise, background, prominence, and so on.
Dan Martell, the founder of Clarity, advises distinguishing between formal and personal advisors. Formal advisors, according to Dan, are those who create value for the company and who are listed on the site. It is recommended to assign them 0.1-0.5% of the ownership, and 1% in exceptional cases if they perform outstandingly. Personal advisors, who can also be called mentors, are those people who can advise you on strategy a couple of times per year and would go without compensation, says Dan.
Péter Szilágyi, head of the FinTech Section at CEU iLab, warns about issues of involving a mentor into a startup by assigning equity:
“Some startup mentors will want equity for purported guidance, contacts and support. This is to give them a performance incentive, typically 0.15-1% depending on the startup stage and level of commitment. However, startup founders need to be careful. It is a big mistake to tie yourself to someone without a good understanding of how he or she will contribute. It is also important that you establish contractual guarantees with a carefully drafted Founder Advisor Standard Template (FAST) Agreement.”
Péter doubts if it is necessary to assigning equity to mentors at all and urges startups to consider alternatives for awarding people who help them succeed:
“It is highly debatable whether mentors should be offered equity at all, if mentoring is all they do. New founders can be quite myopic in handing out equity, forgetting that startups move through stages fast and what now seems like an essential service can play a minute role further down the line. Equity that you have given away to someone can become very painful when you want to raise new funding rounds, tie down key employees or work on an exit. They are other ways to get people to work for you including salaries, profit sharing, deferred payments etc,”
Employees at a startup are true risk-takers. They know they might be paid less than their market rate, they know a startup may sink any moment, they know they may stop receiving a salary for a couple of months should anything happen, and so on. Yet, they come for the experience and drive. Thus, they shall be rewarded.
If you know you cut your startup employees’ salary, give them compensation in the form of equity. Not only this will help you retain them but also lure in new talents.
But once again, how much in percentage should an employee get? TechCrunch has reviewed Index Ventures’s handbook for entrepreneurs and found the following: an employee at a startup should get from 0.05% to 1% of ownership.
You should consider three things when determining the size of a cut an employee will get:
So, employees in executive positions can get as much as a 1% cut, those in mid-level can expect 0.35-0.45%, while junior level positions – 0.5-0.15%.
Regarding the field of work, a junior engineer shall get a 0.15% cut, while a junior business development person, designer, or marketing specialist can expect 0.05%.
Timing can be even the most important as the earlier an employee joins your startup, the more risks they take. So, the person who joined you earlier and stayed devoted and committed for a longer time should get larger shares.
Before distributing the equity, make sure you have done the research and spoke to your peers to see how much your company is worth, how much investors of startups in your niche get, discuss this with your co-founders and you will find your unique solution.
If you still struggle to find it, you can try applying formulas for determining how equity should be split. Founder Institute explains some of them, so you can dig deeper into it and see what suits you. Or you can use various online tools and startup equity calculators like Compensation and Equity Calculator, Slicing Pie, Spliquity, or others.
At the end of the day, decide what’s better for your startup. It’s all in your hands.
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