How Much Equity to Give to New Co-Founders and Employees
The journey to founding and running a startup from an idea is indeed very exciting for entrepreneurs even though the process carries its own share of risks and tough decisions to make. One of the most difficult decisions you will have to make as a founder is how to distribute equity among your co-founder(s) and earliest employees. Equity negotiations can be a cause of disagreements and stress and yet, are absolutely necessary.
With respect to the division of equity, there is really no one-size-fits-all solution that may be cited. However, this article makes the task easier by introducing you to: 1) what compensation methods are available for new co-founders & first employees, 2) some factors to help determine how much equity founders get, 3) fixing employee equity, and 4) suggestions (formulas) for distributing equity shares.
WHAT COMPENSATION METHODS ARE AVAILABLE FOR NEW CO-FOUNDERS & FIRST EMPLOYEES
Equity share is a term that refers to non-cash compensation in terms of company ownership. Considering the fact that executing an equity compensation program is a complicated affair, companies have to plan and utilize appropriate accounting, legal and tax advice and planning. Typically, founders get equity share in the startup’s initial period and either forego their salary or settle for a low one. Equity compensation helps to attract and keep employees in a startup environment because these companies generally are short of the initial funds to get superior employees.
Stock options are a kind of stock-based compensation (involving an agreement whereby an employee, typically a high-placed executive gets company stock instead of or in addition to cash as salary). The intention behind offering stock compensation is to provide the employee with a considerable portion of the company’s stake, expecting this to motivate him to work harder or operate in the best interest of shareholders. If the company’s share price increases, stock compensation can be quite lucrative for the employee.
Stock options are of two types namely non-qualified stock options (NQOs) and incentive stock options (ISOs). NQOs do not give the recipient any special tax treatment and may be granted to consultants, directors and employees. ISOs are a production of the tax code. As long as a set of statutory requirements are met, the holder or recipient will get favorable tax treatment. However, owing to this pleasing treatment, there is a limit on the availability of this stock option. Typically, no tax effect applies to the optionee when he is being vested or granted either stock option.
Apart from stock options, a startup may consider other kinds of stock-based compensation such as restricted stock, California style or early exercise option, or profits interests. Whichever the kind of stock compensation opted for, it carries its own distinct set of advantages and disadvantages.
Fixed salary is common for employees whereas equity sharing is more the norm for co-founders.
Considering the future expectations of your company, managing a trade-off between the three compensation methods discussed above might just be superior to any other combination.
SOME FACTORS TO HELP DETERMINE HOW MUCH EQUITY FOUNDERS GET
Though the way equity is split varies with individual situation, here are some factors that are typically taken into consideration:
Who came up with the idea?
The person who came up with the original idea for the business gets a premium. His premium further increases if he is also the one who started the early development efforts and gathered together the original team. Depending on the contributions in this area, share holdings are boosted by 5 to 30 percent. An only founder gets 100 percent equity at the idea stage.
Stage of the startup
As the startup grows (from idea stage through co-founder, family and friends, seed round, Series A, and IPO stages) and it gets more and more funding, the more company’s equity has to be given up in return for new financing. At the same time, you as a founder or one of the founders are getting a share of a pie that keeps growing bigger with your business’ growth.
Salary or no salary
It is not unusual for start-up founders to forego a salary or settle for a reduced salary in the initial days of a start-up. When founders forego a salary in the initial period, they typically get considerable ownership in exchange. Some may say that foregone salary should not be made up for in terms of equity, firstly, because it is practically impossible to settle on the correct amount of equity for the sacrificed salary. Secondly, the practice can trigger certain issues with respect to tax, accounting, and withholding.
Usually, people with a prominent role/position in the company get a premium stake over those with a non-key role. Thus, a CTO or CEO gets a much bigger stake than for example, a graphic designer or office manager. With respect to equity sharing among co-founders, one can think in terms of the co-founder’s anticipated role in the organization on the basis of his degree of skill, capability, and the firm’s requirements. However, considering that your firm’s needs and possibly even the roles of the founders, could change considerably over time it would be wise not to base the equity distribution too much on just one skill or contribution.
Nature of contribution
The contribution of a founder could for example, include one or more of these: the idea, patents, capital, business expertise, or ongoing work. Comprehend the nature of contribution and its value and give the fair due based on contribution. For a co-founder who makes considerable capital contribution, you may consider giving them additional founder shares in return. Alternatively, you can consider distributing founder equity on the basis of the individual level of work contribution (sweat equity) from each individual. In that case, you would give a founder’s financial contributions the same treatment as you would give those of a seed investor – by issuing series seed preferred stock or convertible debt.
Money or funding (External investors)
A commonly accepted formula for distributing equity within the hierarchical organization is this:
In the case of a single phase of investments
Founders: 50 to 70 percent
Investors: 20 to 30 percent
Option pool: 10 to 20 percent
In the case of multiple phases of investments
Founders: 20 to 30 percent
Investors: 50 to 70 percent
Option pool: 10 to 20 percent
With respect to dividing equity among individual investors, a simple formula is this, if you have to raise $3 million but the investors feel the company’s value amounts to $10 million, you should hand over 30 percent of the company to them for their money.
When founders contribute to the startup venture, they may be coming from any of various situations – while some may have been close to a considerable raise, some others may have been dealing with unemployment. The earnings that a founder was used to prior to deciding to co-found could impact the extent of equity he asks for. To retain a founder’s interest, it may be necessary to suggest a more attractive offer.
Part-time or full-time
A part-time founder gets less equity than the one who devotes his entire time (possibly after quitting an existing job) to the venture. The reason is obvious – he has less weight of risk on his shoulders and is also giving in less time and value commitment to the company. Generally, a part-timer gets under half the equity that his full-time counterpart gets.
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FIXING EMPLOYEE EQUITY
The objective of employee equity is to make the first employees sensitive to feel an emotional ownership with your/your company’s great idea, its gripping product and the organization you are asking them to help grow.
Factors affecting employee equity
The percentage equity a hire gets depends on factors such as domain expertise, how early he joins (if he joins earlier, there is more risk and less stock), how critical the person is to the company and its funding, experience with associated ventures, whether or not he is replaceable, and connections. An equity premium may be considered if the employee is irreplaceable.
How dilution affects employee equity
The percentage of equity an employee gets over time would gradually come down as more investors join and the company has to issue more stock (dilution). If, for example, an employee started off with 5 percent of equity, followed by which the company received two rounds of funding, the employee’s stock may be reduced to two-thirds or even half the original percentage for each funding round.
Here’s a reality check. The early staff of a pre-funded startup that ultimately raises some rounds of capital can expect to endure considerable dilution, if the outcome is positive. If the outcome is less than positive, considering preferences, the employee may have to expect nothing more than what’s necessary to keep them on the job, if that’s required at the acquiring company.
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SUGGESTIONS (FORMULAS) FOR DISTRIBUTING EQUITY SHARES
Here are some suggestions for a sample model of ownership (equity) distribution.
If you are the sole person who came up with the idea for your business at this stage, you get to keep 100 percent.
Ideally, a startup should have a minimum of two founding members and no more than five partners. In this model, let’s assume that there are two co-founders. Your co-founder contributes considerable value, is doing half the work and is taking a great risk by co-founding. Though you came up with the idea, considering that your co-founder is doing so much for the business, it is only fair to give her a 50 percent share of the equity pie.
If there are more co-founders, you might want to consider creating a table with the names of all the founders, the eight factors mentioned above for determining equity distribution and/or any other factors you may feel necessary. You can also consider creating a table with these five key factors alone – idea, business plan, commitment and risk, domain expertise, and responsibilities. Attach a value (weight) to each of the factors from 1 to 10 and multiply it by the founder’s contribution to that factor to come up with an equity allocation formula.
Family & Friends Stage
With respect to family and friends, it may be better to consider their contribution as a loan and just repay it instead of going for equity allocation.
Key investors that figure in the seed round are angel investors. While an angel investor invests her own money in a promising venture, a venture capitalist invests money from other people. In addition, unlike venture capitalists (VCs), a lot of angel investors don’t invest purely for profit. A key motivating factor for them may be the enjoyment associated with assisting a young business to succeed.
Consider that your angel investor has a minimum of $1 million in the bank or has an annual income of $200,000. Let’s say he assumes your business is worth $1 million and decides to invest $200,000. To decide the percentage equity you should give to the angel, calculate the post-money valuation and divide the investment by this amount.
Thus: post-money valuation= $1,000,000 + $200,000= $1,200,000
Equity percentage = $200,000/$1,200,000 = 1/6 or 16.7%
A usual range for the option pool would be 15 to 20% to begin with. You can consider paying your first employees market salaries.
The first VC round makes up Series A.
Let’s assume that the venture capitalist puts your company’s current value at $4 million (pre-money valuation) and decides to invest $2 million.
Thus, post-money valuation= $4,000,000 + $2,000,000 = $6,000,000
Equity percentage= $2,000,000/$6,000,000= 1/3 or 33 .3%
Following Series A, you may continue to Series B and C. At some point, you may reach one of any three situations:
- Your funding is over with no investors to help and your business dies,
- You acquire enough funding to develop something which a bigger company desires to buy,
- Your progress is so good that following a number of funding rounds, you go public (Initial Public Offering or IPO).
Post Series A
With respect to option pools at this stage, the median range can be assumed at approximately 15 to 25 percent depending on the company’s headcount requirements.
Initial Public Offering
Initial Public Offering or IPO refers to a company’s first sale of stock to the public. The majority of IPOs are offered by small companies in search of a new source of financing. Through this source of financing, a company can raise funds from millions of normal people. One of the key reasons why you could choose to go public is that the stocks you sell on the stock market can be bought by anybody. Owing to the fact that anyone can purchase the stocks, you would probably be able to see a good amount of stock without much delay compared to approaching individual investors and requesting them to invest. This makes it an easier option for acquiring money. However, an IPO is not without risk. One cannot tell how much demand would be there for the stock following its initial offering. The risk is because of the uncertainty with respect to the stock’s resale value.
The IPO stage is a cash-out day for employees who accepted stock in exchange for living with the risk of a possible startup failure, and working for low salaries.
Whatever kind of math you apply to split founder equity, at the end of the day, all parties affected should be happy about the distribution. The ideal win-win situation is to create the right kind of incentive to make people continue to toil for your company without it being too much of a financial burden for you.
In closing, a few last words of advice. Irrespective of the initial equity split, it may be wise to seriously think about vesting your founder shares over a minimum period of two years at least. By vesting, you would be enabling the shares to be metered out so that a partner who defects early or changes his mind, would not carry off half the company.
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