Equity is non-cash compensation that represents partial ownership in a company. This equity is distributed among founders, investors, advisors, and employees in exchange for services or seed money.
Essentially, an entrepreneur is handing over a percentage of their company’s future earnings and growth in exchange for financial support or labour. Investors and employees who accept equity do so with the hope that the business will eventually succeed and they will be able to cash out with high returns in the future.
The specifics of your investment agreements may differ, but startup equity is important to your business well beyond the investment stage. Shares typically increase in value as your company grows, providing investors with a return on their investment. As a founder, it's critical to consider how much of your company's equity you're willing to give away, who the majority shareholder is, and how startup equity is divvied up among founders. You can also set limits on how investors and employees earn and access equity over time to protect your company as it grows.
Different types of equity
While equity essentially means ownership, there are a few different ways for people to own a piece of your company. Different types of equity include: Common shares, stock options, and preferred stock. Let’s delve deeper into these three options.
Someone’s initial investment in a startup is represented by common shares, also known as common stock. Entrepreneurs provide venture capitalists with common stock along with the right to a portion of the company’s assets. Those who own common stock are typically more involved in how a business is run and carry a larger responsibility as a startup grows.
A popular way to grant equity to employees while the business is still growing is by offering them stock options. With stock options, employers provide employees with the option to buy stocks at a predetermined price based on fair market value. If an employee chooses to purchase stocks, they can benefit from the growth in a company's value over time once they have met the holding requirements.
Startups can also issue preferred stock, which provides stockholders with a stake in the company but without the voting rights that common stock shareholders have. People who own preferred stock have a stronger claim to the assets of your startup than those who own common stock. If your company was to be liquidated, preferred shareholders would be paid out first, giving preferred stocks more financial security in exchange for less control of the business.
Who gets equity?
There’s different groups of people all eager to get a slice of the startup pie. The four main groups, however, are founders, advisors, investors, and employees.
Founder & Co-founder startup equity
When a company has a single founder, determining their own stake can be relatively simple. If there are multiple co-founders, however, deciding how equity should be distributed among them is a crucial decision.
The allocation of equity to co-founding team members should be a reward for the value they are expected to contribute. If the expected contributions are roughly equal, the initial equity should be distributed fairly evenly.
In order for the startup to succeed in the long run, the co-founders should have an open, honest conversation as early as possible. It’s vital for the co-founders to work together in deciding how to split the equity.
When calculating the equity distribution, co-founders should consider the following factors:
Risk - Are all co-founders facing the same amount of risk? If only one co-founder is quitting their full-time job or investing more capital, then it should be taken into account. Those who risk more should be rewarded.
Level of commitment - Are all co-founders equally as committed? During the early stages of a startup, many co-founders work for little or no pay to build their businesses. However, if one co-founder has taken on more demanding roles and responsibilities, or has demonstrated a greater commitment to helping the business succeed — this should definitely be considered when determining equity.
Innovation - If the company was founded from a joint idea and a shared vision, equally splitting the equity can be an option. However, if the original idea of the company came from one co-founder, this should be taken into account.
Advisor startup equity
Advisors are an invaluable component of the startup ecosystem. They’re the ones who give their time, advice, and expertise to startups. There are no strict guidelines on how much equity should be given to advisors but it’s usually dependent on the experience, knowledge, and prominence of the advisor.
Investor startup equity
It’s safe to say that investors typically receive a larger share of startup equity than advisors and employees. This is not surprising considering the fact that their role is to invest money into a startup. This can be incredibly risky as a startup may fail and the investor will lose their money. In exchange for this risk, they’re expecting a large return on their investment.
There’s no set limit on how much equity investors get. The amount of equity compensation is usually determined during conversations between the co-founders and the investor(s).
Employee startup equity
Startups are known for being relatively cash-strapped and given their need to preserve cash, they prefer to cut down on payments to employees. Instead of full salaries, they often offer equity compensation. When equity compensation and salary compensation are offered together, the salary is usually below the market rate.
An equity package can help a startup attract the best talent to its team. Early-stage startups are having to compete with much larger and more established players in the recruitment market, and it's a fact that in most scenarios, startups cannot match the salaries offered by larger companies.
Employees of a startup may feel more engaged and loyal if they own a piece of the company. Being an owner gives them a sense of being more than just an employee and provides powerful motivation and a feeling of job security.
So there we have it. That was startup equity explained in a nutshell. It’s clear to see that If used wisely, shares are the most valuable currency for entrepreneurs during the early stages of a startup.
To find out more about startups, check out our other posts on our blog.