Equity is such a hot topic in the startup world. It is a great way to incentivize co-founders, employees, investors, and advisors, but can also be incredibly difficult to understand. However, we here at the Founder Institute have created an exhaustive two-part guide that dives deep into the ins and outs of splitting equity. This installment focuses on splitting equity with co-founders, employees, and advisors.
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What is equity and how does it work?
Equity refers to the percentage of a company that is split amongst the founders, employees, investors, and others, and is typically distributed in the form of stock. The concept of equity is especially important in the startup world, as companies that are still in their formative stages rarely have enough capital to pay team members a competitive salary, and offering a percentage of the company - or equity - to employees is often used to attract talent. Giving equity to employees is also a useful way to incentivize productivity, as the more they help the company perform, the greater the value of their equity.
What are the different types of stock?
Once your startup is off the ground, there will be a few different types of stock that you’ll need to be aware of throughout the various stages of your company. In the Silicon Valley Startup Attorney article, “Founders & Startup 101: I) Forms of Equity”, Chris Barsness outlines the most important terms that founders need to know in the world of startup equity and vesting. Below is a summary of the most important definitions you need to know:
Founder’s Stock - the stock issued by the company to the founders of the company.
Common Stock - the general basic form of equity in a corporation, often represented by a physical stock certificate or, in some cases, in electronic form with a broker.
Restricted Stock - a designation that can apply to any type of stock, usually meaning that the stock has some form of restrictions on transfer, such as being unable to sell it without complying with those restrictions.
Preferred Stock - preferred stock has greater rights and preferences than common stock, but is issued in the same manner.
What are the different types of equity shares?
If you receive funding from investors, expect to have to give them equity shares in exchange, along with rights to vote, share profits, and to claim assets. The equity shares that founders give to investors are a certificate of ownership in the company that investors are entitled to to share the net profits and have a residual claim over the assets of the company in the event of liquidation.
The eFinanceManagement article “Equity Share and its Types” by Sanjay Bulaki Borad, does a great job of describing the various types of equity shares you’ll encounter. Here are some of the most common types:
Authorized Share Capital: the maximum amount of capital which can be issued by a company to an investor.
Issued Share Capital: the part of authorized capital which is offered to investors.
Subscribed Share Capital: the part of Issued capital which is accepted and agreed by the investor.
Paid Up Capital: the part of subscribed capital, the amount of which is paid by the investor.
Remember, an investor’s right to vote and their liability to the company is limited by the amount they invested in the company.
How do I split equity with my co-founder(s)?
Splitting equity with co-founders is often a sensitive subject for entrepreneurs, but an important one nonetheless. While there are numerous ways to split equity between co-founders, Dan Shapiro, CEO of Glowforge and Founder Institute Mentor, covered this exact topic in the GeekWire article, “The only wrong answer is 50/50: Calculating the co-founder equity split”.
Below are some of the most important considerations:
Whoever came up with the idea gets more. If you brought the original concept to the table, increase your share holdings by about 5 percent.
Full-time founders should receive more. If you’re working more, then you’re risking a lot more if the project fails, which means that you are entitled to more if the project succeeds.
If you’re the CEO, you’re entitled to more equity. If you think that’s unfair, remember that market rate for a great CEO is higher than market rate for a great CTO, which means that’s how it is everywhere.
Reputation is important for equity entitlement. If you’re a beginning entrepreneur and your partner is an experienced founder with an established reputation, they deserve more equity. If that founder has an expansive network that benefits the company, they deserve more equity. If that founder can help secure more funding for your company, they deserve more equity.
How do I split equity with employees?
As it is with splitting equity with co-founders, compensating employees with stock can be tricky. Luckily, we’ve explored this topic in-depth in our previous blog post, “Startup Equity & Vesting: How to Compensate Team Members Without Money”. Here are some of the most important takeaways:
How Many Options Should be Reserved for Employees?
A startup’s stock option plan must set aside a specific number of shares for eligible employees. While this number is often determined by the company’s board of directors, the number is generally around 5% to 20% for most startups.
How Many Options Should be Given to Each Employee?
Currently, there is no widely accepted number of stock options that should be given to each individual employee. However, it’s important for founders to remember that the actual number of options isn’t as important as the overall percentage of the company those stock options represents.
What Should the Exercise Price Be?
“Exercise price” is the amount that the employee has to pay for the stock when they exercise their stock option. Usually, exercise prices are the stock’s fair market value at the time the option is granted to each employee.
How Long Do Employees Have the Right to Exercise their Options?
In most cases, employees have between 30 and 90 days to exercise their options after their employment with the company has ended, a time period that is fairly standard amongst most companies.
How Does a Company Determine the Value of its Stock?
Unfortunately, there is no standard do-it-yourself method that companies can use to valuate their stock. To determine the fair market value of its common stock and set the exercise price of its options, the company must hire a third-party valuation expert.
How much equity should I give to advisors?
As you might expect, there is no set amount of equity that every startup gives to their advisors. However, that is why the Founder Institute created the FAST Agreement (Founder / Advisor Standard Template), designed to help entrepreneurs facilitate productive working relationships, trading advice, and support for a standardized amount of equity. This is agreement is included here, and is free for you to download and modify for free.
Download FAST here.
There are three levels of company maturity that influence the equity compensation: idea, startup, or growth. There are also three levels of engagement for an advisor that also influence the compensation: standard, strategic, or expert. So, for example, if an advisor provides an early-stage startup with an expert level of help by meeting with the team monthly, recruiting some talent, and taking a customer call, then that advisor will earn 1% of the company in the form of restricted stock or options vesting over a two year time period; while a similar level of engagement for a growth stage company is compensated with just 0.6%. The FAST equity compensation framework is outlined below:
|Standard: Monthly Meetings
|Strategic: Add Recruiting
|Expert: Add Contacts & Projects
Click here for more information on how to use the FAST Agreement.
As in anything in the startup world, there are only a handful of tried and true methods of building a successful company, which means you're going to have to make up your own way of doing things. Unfortunately, when it comes to the financial aspect of your startup, you're left with little room to experiment, as a miscalculation can put you at risk. Hopefully, this blog post gave you some necssary insights into how best to manage the equity of your company, and helped put you on the right track.