Startup Funding Masterclass: Part Five
One of the trickiest parts about being a startup founder is deciding how to split equity. You can only give away so much before it doesn’t feel like yours anymore.
In this article we will focus on the three key parties beyond investors that typically receive equity throughout the lifetime of your startup:
- Directors and Advisors
For more information on how to split equity with investors, take a look at our previous article on startup funding rounds.
This post is Part Five in a new Masterclass series on Startup Funding. Funding is the fuel that every business runs on. Knowing the ins and outs of funding is therefore essential if you want your startup to be successful. We searched for a compact-yet-comprehensive guide on startup funding and found it nowhere, so we decided to build one ourselves. This is that essential guide.
We bring it to you in partnership with Belgium’s largest startup and scale-up accelerator Start it @KBC, supporting and promoting more than 1.000 entrepreneurs with innovative ideas and scalable business models.
– Jeroen Corthout, Co-Founder Salesflare, an easy-to-use sales CRM for small B2B companies
Before starting, let’s freshen up your knowledge on the differences between shares and options. When discussing equity ownership in the context of employees and advisors, we are often speaking about granting stock options versus actual shares.
For those of you who have a good understanding already, feel free to move on to the next section immediately.
Before diving in: the differences between shares and options
Equity compensation typically comes in two forms: shares or options. The differences can be summarised in four categories.
Ownership of the company
If you own shares of a company you are immediately a shareholder with the same rights as all other shareholders.
With options, however, you only own the right to buy shares at a predefined price (strike price) at a future date. This means that you are not a shareholder until you convert those options, by paying the strike price at the predefined date, and receive the shares.
So you have no dividend or voting rights until you become a shareholder by converting your options. Typically option holders choose to not convert until the event of an exit. At that time the options are converted right before the sale, after which the shares are sold with the rest of the company. A key reason to not take this route is the implications on your taxes, which depends heavily on your country’s tax regime.
When shares are issued and allocated the holder needs to buy them at a price. In most cases this price is set at the nominal value (typically $0.01 per share) requiring a minimum of cash.
For options, there is no price to be paid at the time of receipt, but the price at which the option can be converted is defined by the strike price.
This price could be set at the same nominal value of $0.01 per share, but in most countries this has a very negative tax implication, so typically the option strike price will be set at “fair market value”.
The fair market value is similar to what the investors have paid in the last funding round.
Together, this leads to the fact that the owner of the options will need the necessary cash to convert his options into shares.
This topic will be further explored later in this article. For now, it is important to understand that vesting allows you to define how people receive their shares over a period of time.
For example, a 4 year vesting period typically means that the person will receive 25% of the given shares in year one, 25% in year two, and so on. Additionally, various conditions can be set. One of the more common conditions is that the employee must remain with the company. So if the employee leaves at the end of year one, she only receives 25% of the shares.
The important distinction between shares and options in terms of vesting is that the options have forward vesting and the shares reverse vesting.
Staying with our example this means that the employee receives all shares on day one, but needs to return 75% of the shares if she leaves after one year.
In the case of options, the employee has no options on day one, and receives 25% after one year.
This again has implications on voting rights and dividends.
This is a very important topic for both the issuer and the receiver of the equity compensation. It is also very locally bound, so make sure to take a look at your local tax code or speak to an accountant.
Generally, the tax rules are as follows.
If you hand out shares at a discount (e.g. nominal vs market price) to someone, this is seen as an immediate income. Therefore, most probably this person (or company) needs to pay taxes on this income.
If you hand out options, no taxes need to be paid at the time of receipt. However, at the time of conversion, the difference between the market price and strike price is an income that is probably taxable.
For simplicity we are excluding potential capital gains taxes from the discussion.
All up to speed on shares and options? Let’s go. 👇
As Michael Seibel of the startup accelerator Y Combinator puts it; “These are the people you are going to war with”.
Deciding on how to divide your startup’s equity among co-founders is all about finding the right balance so that everyone remains motivated throughout the journey. Including yourself.
Let’s start with having a realistic view of what it means to be a founder of a successful startup at the end of the road. Take a close look at the following graph from Capshare, which is based on an analysis of 5000 cap tables, for reasonable expectations of founder ownership.
As you can see, the graph shows that founders typically hold between 10 - 20% of startup equity down the line. Now the question remains: “How much of this will be yours?”
Basically, there are two trains of thought when it comes to this subject. Either you go ahead and split the equity evenly, or you try to find a smart and fair way of dividing it unevenly.
Go ahead and divide your equity equally
There are a number of strong advocates for this approach on how to split equity in a startup. Proponents put it as follows.
How can you justify making any differences at the beginning of your startup, knowing that it is such a long and gruelling journey?
Even if you come up with the original idea, have the most experience, or are putting in the most effort right now, how can you justify that these differences will be so decisive when building a great company together for the next 7 or 9 years?
Perhaps, if you do not want to divide your equity equally with your co-founders, you have not found the right people?
These arguments are rooted in the belief that future execution is more important than initial ideas, and that an equal equity split results in the highest motivation among founders.
Of course, they also advocate for various protection mechanisms for when it all goes sour, but more on this later on.
Now, the proponents have some valid points, but that does not mean that everyone is comfortable with this decision; and perhaps they shouldn’t be.
Hold on, let’s think about it for a second
Before you go ahead and settle on splitting your startup’s equity equally, it might make sense to engage in a bit more reflection and ask yourself some additional questions.
Can you have a good relationship?
You don’t exactly have to be dating (some might even find this problematic), but it is important to reflect on your personal relationship before co-founding a startup.
Are you ready to spend more time with this person (or these people) than with your close friends and family combined?
Will you be able to go through difficult times together?
Have you ever handled disagreements and how would you settle disagreements with your co-founder(s)?
If any of these questions make you uncomfortable, then perhaps it is best to take another look at your choices and consider changing up your co-founding team.
Have you seen their ability to deliver quality work?
While your co-founder might present the ideal skill set on paper, it is important to understand her capability to deliver consistently.
Take a look at previous projects, talk to former coworkers, try to work on an unrelated project first, or use a testing period.
Do you share similar priorities and expectations?
In the beginning, people are easily excited and committed to a new project, but that might fade fast.
Try to understand why your co-founder is motivated to join you in the first place. Is it because of a shared mission? Or is it just because your co-founder is afraid to say no to you?
How do you see your roles and contributions in the long term?
Perhaps she is that awesome developer that you have been looking for. Finally, someone who is excited to build your vision into an MVP.
But what about in a year?
It is important that you do not base your decision on the company in its current state. If all goes well, you will find a co-founder capable of delivering value in the long term.
But how to split equity in a startup then?
There is no universally right way of doing this. But here are some tips.
Agree on a method
Perhaps you prefer to use a theoretical approach like the shareholder’s pie calculator. Or you decide to work with a contract to reward various milestones to come to an equity split.
Whatever method you choose, it is important that the method is clear to all parties involved. Make sure that the process is well understood, clearly defined and agreed upon. This should eliminate discussions down the line.
As Kevin Systrom of Instagram puts it: “You should just try to be as fair as possible for the stage of the company you’re at”. To Kevin, startup equity split is something that should be reconsidered often, while always aiming to be fair and generous.
How do I protect myself?
When you start the company it is you and your co-founder against the world, together forever.
But what if it is not forever? If things go wrong between co-founders, a little upfront planning can make the difference between a painful and a catastrophic outcome.
Protect yourself from a potential huge loss of time, a major cash drain at a bad moment, or even issues with existing investors.
A good shareholders agreement always plans for the worst outcome.
Founders are different from employees because they receive all their equity at the beginning. In order to make sure that the founders don’t leave, a reverse vesting strategy is used. Similar to “stock option vesting”, it rewards staying at the company, with the exception that in this case it gives the company the ability to repurchase the shares.
The amount of startup equity that can be bought back is dictated by the vesting period. The longer the founder remains with the company, the fewer shares can be repurchased.
A typical structure is a 4 year period with a one year cliff. Until the one-year point, everyone’s equity remains up for repurchase. After one year 25% will no longer be, and every month thereafter this amount increases by 1/48th.
Still, this might be slightly outdated, as Andreessen Horowitz puts it: “With companies staying private demonstrably longer these days (11 years for the 2014 tech IPO cohort), the work required to build the business into a successful venture has only just begun after 4 years.”
Distributing equity among employees in a startup is about setting up a long term incentive, so think about expanding the period to a longer time frame if you believe that makes sense for your business.
Consider the circumstances in which a founder can be removed. In most cases, founders have common board seats and control the board with common directors. In this situation, a co-founder can only be removed with agreement from the other co-founder.
In case you would like to keep more control, you can limit the influence of your co-founder by limiting her access to the board. A good way of doing so is by only allowing the CEO (presumably you) as employee in the board.
Also, consider what happens to board participation if a co-founder leaves. You probably don’t want to end up in a situation where a co-founder without active service to the company is able to make or block decisions for the company.
Mitigate this situation by making sure that board seats are conditioned upon continued service to the company. Not just for being a co-founder.
Imagine a situation where you are raising capital and your previous co-founder is looking to sell his equity on the secondary market. As you can imagine, it is not going to make your life any easier if you have to start working together with someone you didn’t choose. Let alone the risk of having to explain to investors why your co-founder is selling now.
Therefore, make sure to put a selling restriction in place. There are two main types.
Right of first refusal (ROFR)
With the ROFR agreement, the company has the right to match any offer.
While this does protect your company, it is hard to use in practice. In our example, you definitely don’t want to be using private or company cash to buy out a co-founder when you are trying to raise capital for future growth.
Blanket transfer restriction
In this scenario, the company (most likely the board) needs to sign off on any share transfers. This will allow for orderly and structured selling for all involved.
Of course you can’t just install these restrictions later on and push them to all shareholders. Shareholders will be very reluctant to give away their right to sell. So make sure to install this from the beginning, and make sure that you and your VCs are all aligned to create value for the long term.
One of the defining differences between startups and the corporate world is the almost universal practice to let employees share in the startup equity.
When implemented properly, employee equity ownership can:
- Align risk and reward for employees betting on an unproven company
- Reward long term value creation by employees
- Encourage employees to think about the company’s success first
It is also a very important tool to attract and retain top talent.
Types of equity incentives
Equity incentives can be divided into four groups.
First, there is the startup equity that should be used to attract new hires. Important here is to have a good view on what is a competitive compensation package for the position and profile that you are looking to fill. Also make sure that the equity is the correct tool for incentivisation. For example, sales functions might be better incentivised with a commission, while equity might be a better fit for engineers.
Secondly, there is equity for employees making a promotion. Make sure to bump their equity to the market standard for their position.
Thirdly, there is equity for outstanding performance. Make sure to only reward the actual top 10 - 20% and make it worthwhile, without upsetting other employees. A typical range is between 25% and 50% of what they would get if hired today.
Finally, there is the evergreen equity, often cited as the most important equity tool for retention.
As employees come close to the end of their vesting periods (cliff) the opportunity cost to leave lowers significantly. A great way to avoid this dynamic is by distributing additional equity at the right time.
For a typical 4-year vesting scheme you would start offering small yearly amounts after the 2.5 year mark with 4-year vesting periods.
Added up, these additional equity offerings will reduce the cliff and ensure a bigger opportunity cost for leaving.
How much should I expect to give away?
For your first key hires, you will probably not be able to use any magic formula. Instead, you can look at market rates in your geography and negotiate on a case by case basis.
In order to have some data-supported strategy, take a look at the work from Leo Polovets of Susa Ventures, which presents the following results:
- At 1–10 person companies, 0.5% — 2.0% is a pretty common range, though some companies fall outside of this range.
- For 11–50 person companies, 0.1% — 1.0% is typical.
- For 51–200 person companies, 0.01% — 0.2% is typical.
Overall the total option pool for employees set aside throughout the lifetime of a startup is typically around 20%.
4 tips on how to distribute startup equity among employees
Whatever method you choose to base your employee equity split on. Take into account the following tips.
Understand your employee’s needs
Equity is not as much of a sweetener to every employee as you might think.
Not only is this drastically depending on the tax treatment. But it is also culturally dependent.
Make sure to understand this, so you don’t go out giving away startup equity that is underappreciated.
Also, make sure to understand the living situation of your prospective employee. A person with kids might be happier with additional cash instead of equity ownership (ask, don’t assume).
Always remember that employees talk. They will benchmark their equity stakes with other employees.
So if you use a different approach than the market standard, make sure to equip them with the right arguments to defend their positions.
Employee equity ownership can often be misleading. Startup equity is not only about the most recent share price, but also about liquidation preferences and other often misunderstood caveats.
Make sure to communicate this correctly to employees to eradicate any misunderstanding. If it comes out at some point that you have been not transparent, it will be an incredibly difficult situation to manage.
Similar to the situation with your co-founders, limit the ability to sell startup equity. You do not want key employees selling right before a big investment round as this will instill doubt in your investors.
Still, try to allow for orderly and structured sell opportunities for your employees. There might be a ton of good reasons why an employee would like to take some cash off the table. And you can mitigate a lot of risks associated with selling employees by setting time limits or by establishing periods during which they can sell.
As a startup founder you are often looking for a good source of advice and experience.
It is not uncommon to pay these advisors with a small equity percentage. This way their motivation is more or less aligned with yours. And they don’t become the type of cash drain that advisors can be.
Depending on the level of the advisors, equity grants can range as follows:
- Regular advisors: 0.1% - 0.25%
- Mid range: 0.25% - 0.50%
- Expert level: 0.5% - 1.0%
To put this into perspective, expert level advisors should be people with vast industry experience, great connections, and the ability to open doors for you. Think former CEOs of one of the biggest players in your industry or target customer group. People who can truly make your company go 10x by helping with intros, partnerships and more.
In case the advisors you’re looking for are only meant to be board members, you can also opt for giving a fixed fee per board meeting instead of splitting your equity further.
Ask these questions first
Before considering to give away any equity we recommend to ask the following types of questions:
- How much time can you commit to this company on a weekly, monthly, quarterly basis?
- How many companies do you advise today and what are your other professional activities?
- Do you work with any companies that could result in a conflict of interest?
- What would current companies that you work for say about you?
- Can I speak to any current and any former companies that you worked with?
- What and when is the best time to reach you if we need something?
- What do you hope to gain out of this commitment?
As you can see most of these questions are around time commitment. This is however very difficult to judge in the beginning.
Therefore you should also protect yourself from waning commitment by setting up a good contract.
Use a vesting schedule
Similar to employee equity grants, it is not uncommon to work with a vesting schedule when working with advisors. Try to align the vesting period with the expected impact period of your advisor. If you bring him on board to open doors in the long term, a longer vesting period might be appropriate.
Here again it is not uncommon to work with a 4 year period and a 1 year cliff. This one year gives you the opportunity to test working together before allocating any equity. Make sure that the expected prestations are clearly stated in the contract, so that you can easily terminate it if needed.
Set the option strike price above fair market value
Another option to align interests is to set his option strike price at a future valuation. If your advisor can truly “10x” your company, then perhaps you can bring him on board with options that only vest once the companies valuation grows 2-5x. Those options will be worthless if the valuation does not rise within the option period, while being great compensation if the company achieves its target.
Take time to establish trust
As you can see, these methods are surely not perfect. Both leave a lot of opportunities to hand over equity to advisors that don’t add much value. Therefore try to be conservative in your expectations and spend enough time with advisors before committing. The most important thing in order to be successful is still to have a good relationship of mutual trust.
Ready to divide your equity pie? 🥧
We hope this post gave you the necessary knowledge and confidence you need to do it correctly! 👊
Let us know if you have any questions left; we’ll be happy to elaborate! Also, don’t forget to tune in next week for Part Six in our Startup Funding Masterclass: How to find and get investors!
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