How To Structure Startup Equity

How to Structure Startup Equity – Everything you wanted to know about Startup Equity Structure, Startup Equity Dilution, Startup Equity Compensation, Startup Equity for Employees, and Founders Equity.

Or, as we like to call it here…slicing your pie.

Ownership in a startup or startup equity structure is a tricky issue that you’re bound to face sometime or the other – if you’re a bootstrapping entrepreneur, or looking for a retirement fund alternative by participating in a startup.

To understand the concept of startup equity compensation better, you’ll need to start at the bare basics; right from equity.

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What is Startup Equity?

Any form of ownership represented through stocks is called equity. When you have a share of stock in your hand, you essentially hold a degree of ownership (in fractional terms) over the company. To know about the extent of ownership that you hold, you should know the overall number of shares issued by the company (often termed as the outstanding number of shares).

Breaking it down further, if a company has 100 shares overall and you own 10 shares, then you effectively own 10% of the company. But the catch here is that startups may not readily declare the outstanding number of shares when an employee joins their ranks, and you’ll need to know this in order to know if you’re getting a fair deal.

Startup Equity Tip: Never disclose the amounts of founders equity to anyone other than the founders.

Entrepreneurs must exercise caution while revealing the outstanding number of shares to an employee who’s not a part of the core team of founders. This is purely because such information can expose the internal framework and reveal funding details and other such confidential information.

Startup Equity Distribution of Stock

Now that the bare basics have been covered, you’ll need to learn about the two classes of stock. Stock can be classified into common and preferred categories, and while preferred stock may be limited to the founding members and investors, common stock is startup equity compensation given out to the employees in a startup.

  • Preferred Stock – As the name implies, preferred stock comes with more privileges and rights. An important factor here is that, because the stock is ‘preferred’, its owners will get paid first in the event that the company is either liquidated or acquired.
  • Common Stock – Common stock, true to its name, is the lesser preferred variety. While common stock can be rewarding, depending on the company’s overall growth, you should stay on the alert and see if preferred stock is too prevalent in the company.

Preferred stock vs common stock in a Startup Equity Structure

Let’s take a hypothetical scenario for example – if a company brings in $ 1 million by selling 1,000,000 shares at a dollar per share, and the shares sold under this condition are the preferred variety, then if the company is later acquired in the future for a $ 1 million or lesser, the entire money will go to the people who hold preferred stock.

Nothing will effectively be left for the common stockholders, and this is often a problem with huge companies that have more than $ 75 million of preferred stock. Unless the company gets acquired for $ 100 million or more, the common shareholders will hardly see much green.

But startups will have lesser number of Series A stock (preferred stock), so you’ll hardly have reason to worry.

What is startup equity dilution and how does it work?

As the startup grows in size, the core team will give the investors the go-ahead to create more stocks for its expansion, and these shares are created out of thin air. This will ultimately result in startup equity dilution diluting the value of the shares that you hold.

The math is quite simple, let’s take another startup equity dilution example to clear things up.

When the company starts out, let’s say that company has 100 outstanding shares overall and you hold 10 of them. Your ownership over the company is 10% in this scenario. As the company grows in size, if the number of outstanding shares is increased to 200, you’ll hold the same number of shares (10), but your ownership over the company will drop to a mere 5%. This is known as startup equity dilution, and this is inevitable, particularly in a startup.

You’ll hold the highest share at the beginning, and this will slowly come down as the company expands in size. The key employees in a startup may be granted more stock (after dilution occurs) in order to acknowledge their contribution to the company. When you negotiate for equity in a startup, quote a high value, because, in all probability your ownership will decrease from there due to startup equity dilution.

Startup Equity Compensation -Your Options

Equity vesting is also known as an earn in agreement, which is a form of startup equity structure and startup equity compensation.

If you’re an entrepreneur trying to divide your shares wisely, you should brush up on the concept of startup equity vesting. Employees don’t get their shares outright – they claim it over time. It’s based on performance or milestones.  When you provide an employee some stock, you should let it vest over time, so in this way, the employee will gain 25% of the allocated stock in the first year, 50% in the second year, in a linear manner. By the end of the fourth year, the employee will have 100% of his/her stock.

The first year is also termed as the cliff period in many startups. Under a one-year cliff, the employees will get nothing through the duration of the first year, but will acquire 25% of the allocated stock during their first year anniversary. This can help you avoid hit and run cases, where employees may stay in the company for just a few months and walk away with 25% of their allocated stock.

An Incentive Stock Option plan, or an earn in startup equity structure, is framed by many companies for this purpose, and the guidelines and regulations for vesting will be provided in the plan. The head honchos in a startup usually get to decide the vesting terms, and as an entrepreneur, you’ll need to decide (with your partners) on whether long intervals for vesting make sense or short ones do. Short intervals for vesting can actually help – you don’t want useless employees hanging around just because their vesting anniversary is coming up.

Startup Equity Distribution of Shares

The equity offered to an employee in a startup will be dependent on many factors like the company’s growth and development stage and the employee’s status as an asset or liability within the company.
If a tech startup has five engineers in all, although they may all have the same qualifications and job roles, the engineer who joined the company first will be given more equity purely because he joined the company at a time when the risk involved was high. The ones who join late will experience a gradual drop in their equity, thanks to the company’s growth from a nascent stage to well-established level.

Startups normally have something called the Incentive Stock Option pool from where they provide the stock for the initial hires till they get the next round of funding. Inquiring about this common pool and its size can help you gauge the percentage of ownership that you hold over the company, although such information might not be easily available.

Since startups may not be too wayward with cash, initial employees in a startup are given a basic salary (that’s roughly equal to the industry standards) and some stock. The first few employees in a startup may be provided with Founder’s Stock, which is quite similar to common stock, except for the fact that it comes with a buy-back guarantee.

If you hold 100 shares (founder’s stock, with a vesting period of four years) and you leave the company within two years, the company will buy back the unvested portion of the stock.
Startup equity compensation can vary from one company to another, but the basics involved are the same. Being aware of the terms and types involved can help you stay financially safe and secure.