How does equity work in a startup? Initially, the equity holder in a startup will mostly be a single founder or a team of founders that are responsible for the business idea. However, as time passes and your startup starts to grow, you may feel the need to increase the number of equity holders in the form of investors or future employees.
So whether you are thinking about launching a startup alone or if you are thinking about adding founders or investors to the new company, you need to be familiar with startup equity.
Equity can be a great tool when it comes to making sure everyone who has spent their time and money on a startup gets an ownership stake in the company. With that said, a lot of startup founders and even beginner investors aren’t sure what startup equity is and how it works.
So in order to help anyone who might want to know more about startup equity, we have created this helpful article which we suggest you keep reading until the end.
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What is equity in a startup?
And, how does equity work in a startup? Equity is a percentage of the company’s ownership that the founders must give to investors in exchange for money or give to employees or advisors as a form of compensation. So, startup equity is a company’s ownership, which can also be shown as a percentage of shares of stock.
It’s important that the founders share ownership in a fair way taking into account their roles and how much they care about the business.
Early on, founders have to give up a big chunk of equity to make up for the risk that investors are taking by putting money into a risky new startup.
But as your business grows and gets more success, the value of your startup’s equity goes up, and investors are usually willing to pay more or take less equity in exchange for any future investments they make.
Who can get equity in a startup?
As mentioned above, the founder or founders of a startup should have some percentage of equity in the startup. However, there are other parties that might get equity in a startup as well. So without further ado, here are some entities that may be granted equity in a startup:
Founders can decide how much equity they get based on how much they are willing to put into the startup. Since each founder puts in a different amount of money and/or time, it can be hard to figure out how the equity in a startup is split between the founders.
There are different ways to divide equity among founders, and it’s best to settle any disagreements about equity among founders early on and even in advance of registering your company to avoid problems later.
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Investors will typically get a bigger share of a startup’s equity than anyone else. Ultimately, often even more than the founders. This is because the main thing they do for a startup is put money into it. In exchange for the risk of putting up that much money, investors hope to get a lot of equity in return. This gives them financial returns, and control over decision-making to protect their investment.
Negotiations will be held before the investment is made to decide how much equity compensation an investor will get. To get the most out of the talks, you need to find out how much your startup is worth, and negotiate the specific terms.
Employees & Advisors
A startup can’t pay their employees competitive pay simply because they usually don’t have enough funds in the initial stages.
Giving early-stage employees startup equity makes up for this gap, encourages them to work harder because they are now part owners of your company, and keeps them with the company if you choose to vest your employee’s stock over a four-year period, which is common.
In addition to these key players, a startup may also offer equity to its advisors as a form of compensation for services. This may be up to a couple of percentage points of the total ownership, per advisor. So, take the time to understand how does equity work in a startup and how much to offer your stakeholders.
Even as you’re working out whether offering equity for funding is a good idea, you should also research alternative sources of funding for your business. Check out this video I have created that you can use as a valuable starting point.
How does startup equity work?
By now, you should know that the amount of equity a stakeholder gets can vary greatly. So, in simple words, startup equity works by giving people compensation for the work they put into making the startup grow.
The amount of equity a stakeholder gets depends on things like the amount of contribution, the level of commitment, and the value of the company at the time equity is given out. That is why founders and investors hold the most amount of equity in a startup because these individuals tend to put in the most effort and take the most risk when launching a startup.
In addition, early-stage investors tend to get more equity in return for their investment because they took a bigger risk by putting their money in a company whose future is uncertain.
What are the advantages and disadvantages of offering equity as a founder?
By now, you should be able to tell that offering equity can come with some real benefits for your startup, especially when it comes to seeking investment from investors. However, similar to most types of financing, there are certain advantages and disadvantages associated with startup equity. Make sure to understand what they are when working out how does equity work in a startup.
So without further ado, here are some advantages and disadvantages of offering equity that every startup owner should know before issuing it to investors:
Advantages of offering equity
- Minimize the burden: With equity, you don’t have to pay back a loan. The startup doesn’t have to make a loan payment every month, which is important if it doesn’t start making money right away. This gives you the freedom to put more money into your business so it can grow.
- No need for a perfect credit score: If you don’t have creditworthiness because you have bad credit or don’t have a credit score yet, offering equity can be better than debt financing. You don’t need to have a perfect credit score when you offer equity to an investor.
- Learning opportunity: With equity financing, you effectively make partnerships with investors who know more about your line of business or have more experience. Some of them might have a lot of business contacts, which could help your business by giving you access to their knowledge and business network.
Disadvantages of offering equity:
- You have to share profits: Your investors will want a cut of your profits if you go with equity financing. The trade-off could be worth it if you can use their money and/or their business knowledge and experience to your advantage. However, for some founders, the obligation to share profits may be considered a disadvantage of offering equity to investors. It can end up being a lot more money than repaying a loan.
- You have to share decision-making powers: For equity financing and all of its possible benefits, you have to give up some control of the business. That is because when investors have a stake in your company, they will want to be involved in key decisions that affect the profitability of the company, and even how you operate.
What types of investors are likely to accept equity?
Here is a list of types of investors that are commonly known to accept equity in return for their investment. Reading up about them will help you understand how does equity work in a startup.
- Angel investors: Angel investors are wealthy people who are willing to exchange equity for investment. Angel investors may also bring their business skills, experience, and connections, which help the company in the long run.
- Crowdfunding platforms: Crowdfunding platforms come in many forms. This includes those enabling startups to raise equity funding from a variety of accredited individual investors, and institutions.
- Venture capital firms: Venture capital firms are the most obvious form of startup investors who put their money into businesses they think will grow quickly and go public in the future. They put more money into businesses than angel investors and get a bigger share of the business in return.
Keep in mind that in fundraising, storytelling is everything. In this regard, for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.
Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.
Should startups offer equity as compensation to their employees?
As mentioned at the start of the article, most new startups don’t have the funds in hand to attract talented employees solely based on salary packages. Instead, they need to use a combination of traditional compensation and equity to retain talent. So here are some reasons why a startup may want to offer equity to their employees.
Help maintain cash flow:
It’s hard for startups in their early stages to maintain decent cash flow. Cash flow problems can last longer than the first couple of years, which makes equity-based compensation an attractive choice. Startup equity can help preserve precious cash, which could otherwise put your solvency at risk.
Attracting talented individuals:
Finding the best people is always a top priority for startups. However, unlike large firms that have massive revenues, startups don’t have the reserves to pay high corporate salaries. Startups use equity compensation to stay competitive when it comes to hiring and keeping top talent by offering them an opportunity to get substantial returns on their work down the road.
Reduce employee turnover:
Startup equity is meant to keep employees with the company longer and reduce employee turnover. In the majority of cases, employee equity is restricted through a process called “vesting.” To own their shares, employees must spend a certain amount of time or meet certain performance goals in order to access the equity they are entitled to.
Increased participation by employees:
Since startups have fewer employees than large corporations, they need to make sure that employees are performing to the best of their abilities. Even if a startup’s workforce is going to be only a sliver of the size of its closest competitors, loyalty and hard work are what help a startup grow. When employees know that their work will directly increase the value of their equity, they are more likely to work harder and achieve their targets.
While you might be tempted to offer equity compensation to your employees after reading the above-mentioned benefits, it is important to note that this form of compensation also has its disadvantages. You may end up making your company’s taxes more complicated, not to mention there are specific rules associated with equity compensation that you need to follow to avoid penalties. So, unless you have legal experts on board, you can end up doing more harm than good by offering equity to your employees. So, make sure to research the implications of how does equity work in a startup when offered to employees.
Startup equity might seem like a complex topic at first glance, but once you know the basics of equity and how it works it starts to seem less complicated. Now that you have read all about startup equity and how it might impact your startup, you are much more prepared to use it for your startup.
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