Startup Equity: How Best to Manage It
Launching a business is not easy. As a young entrepreneur, you have to focus on different areas. Although your primary responsibilities include empowering and scaling a business, you must focus on equity. Equity management becomes critical when considering investors for funding your business.
What is Equity?
Your equity in a startup is defined, in the simplest terms, as the value of the percent of the company you own (shares). To determine how much equity those shares represent, subtract the business’ liabilities from its assets (found on the company’s balance sheet), and then multiply that number by the percent of shares you own.
For example, if the difference between assets and liabilities is $800,000, and you own 74% of the company’s shares, then your shares represent a current equity value of $592,000.
Have a Mind Like an Investor
Building a startup requires you to think like an investor. You have to give away equity to fund it. This is how many startups attract investors and put their business on the right path.
Investors are only interested in successful companies. They want to know if the business is built on solid ground and has growth potential, or if they can strategically exit to earn a profit on their investment.
If the answer to either of these questions is no, you will face difficulty funding your startup. But, if the answer is affirmative, then the next thing to focus on is equity management.
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Now let's get back to our discussion regarding equity management and its allocation, which eventually translates into stock and startup stock options.
How should you allocate equity in a way that gives you control but is still attractive for stakeholders?
Even though every business venture is unique, some basic guidelines apply to all of them. Following are the points that need to be focused for equity management in a startup:
Equity for Co-Founders
The company co-founders enjoy a large amount of equity in a startup. Sometimes it is equally divided among all the co-founders, or according to the contribution they provide to the company.
The more funds and engagement on the part of the co-founder, the more equity they get. Also, some other characteristics to focus when sharing equity include:
- The expertise and experience of co-founders.
- Network of clients and employees that the co-founder can bring to the startup.
- The involvement of physical assets to bring security to the startup.
These points should be taken into consideration while assigning equity among co-founders. They may not need any other incentives if they have willingly offered large amounts to take the business in the direction of success. A fair distribution of equity among founders recognizes their contribution.Some startups begin on a shoestring, and to keep them going and protect their equity, a founder (or their family members) may need to take on side gigs or work for fast cash on the side. This keeps their household afloat while they put their major assets into the startup. It’s part of going “all-in” as a founder, and while it’s hard work, it becomes a charming story after your startup becomes wildly successful.
In fact, if a founder or their early partners are good at things like web development, graphic design, or content creation and can provide these services to others, those skills can become regular, part-time work for dependable extra money that helps support founders until serious investors become part of the equity group..
- Equity for Investors
Speaking of investors, they are often the luckiest of all the stakeholders because they usually get the biggest slice of the pie. In other words, they get the biggest rewards because they take the largest share of the risk in terms of funds.
There are many types of investors. The three main categories are:
- Angel investors
- Venture capitalists
- Family members and friends
Angel investors mainly back a new startup when no others are there to back the business. They are not afraid to put money even if they risk not achieving the desired results.
Next come the venture capitalists. They invest money in a new startup to receive the fruit of their investment. They provide funds to startups having the potential to grow significantly and make serious profits, or that have already shown significant growth.
Family members and friends prove to be an asset for a startup as they are not always concerned about their potential profit, but are focused on the startup flourishing and becoming a success.
Investors have no guarantee that a startup will climb high, yet they provide funds for its growth. So, in exchange for shouldering the risk, they typically get a large equity share.
- Equity for Advisors
Advisors hold a significant position in a startup as they give the best advice to take a new business to the next level. Some advisors will work in exchange for a specific amount of equity in the startup, while others work for a salary or contract with no equity. However, it is a good practice to set aside some equity for advisors, even if they don’t require it.
Successful businesses recommend providing 0.5-1% equity for advisors to reward them, as a percentage of potential success can make anyone work harder toward the company's success.
Advisors can also better perform if given equity according to their working capacity. Sometimes the more the incentive, the greater the outcome, which can yield positive results for a startup.
Equity for Employees
In any startup, it’s the job of employees to do their best work and make the company grow. Employees are given equity according to their contribution and experience. Generally, employee equity is not more than 0.5% or 1% in some cases, depending on the degree of involvement and expertise they bring to the startup's success.
The devotion and time that they give a company should not go unnoticed. Hard work, good performance, and commitment can be rewarded with equity. The more encouraged and incentivized employees are toward a company, the more commitment and drive they will show, contributing to business growth.
The company can also use equity to attract deeply experienced employees who are top performers when they might not otherwise be able to compete for top talent based on salary alone. This is a case where using employee equity is especially valuable to a startup.
Managing startup equity is not child's play. In fact, an early understanding of how to approach equity division and allocation can ensure the long-term success of a startup. Equity should be divided and distributed only after very thorough research into the value a stakeholder or their expertise brings to the company. The main equity share goes initially to the co-founders. The rest of the equity management is made according to the needs of the company for operating cash and a qualified, committed team. Also, managing equity well will reassure your potential investors that you fully understand and appreciate the value of equity, which can help attract them to your venture, giving it the best possible opportunity to succeed.