Startup culture promises freedom. Today, startups contribute to the GDPs across the world, and are influencing the way people do business worldwide.
It is common practice that startups outsource web development or design. It helps startup founders to focus on their core competencies and get ready to launch a product.
While entrepreneurs run their business and make difficult decisions, their product is in safe hands of professionals. This is the most efficient way to take off your business.
But the tricky question here is how to pay your outsourcing team? Startups in their earliest stage may haven’t much money to pay for services. Until they found an investor.
And then there is a brilliant idea — why not pay by trading equity? Let me explain the disadvantages of this decision.
In this article, we will explain what is an equity offering and why it is not the best option. We will also look at various aspects of nurturing a successful startup.
Here is a list of important issues we will address:
- What factors are important to run a startup
- How outsourcing impacts the costs of running a startup
- The implications of trading equity instead of paying cash
- Reasons you should by all means resist trading your equity
- Alternatives to equity payment when you have tight budget
What is Important in Running a Startup?
Competition is common in today’s world. Thus, there are two critical elements for startup survival and success. They are speed and control.
Speed ensures your product reaches the market faster.
Control enables you to reap benefits from your success.
These elements are trade-offs. There are other responsibilities beyond building a product, such as managing, marketing, etc.
Outsourcing Contributes to Reduction of Startup Running Costs
A primary reason for outsourcing is to cut costs. At an early stage, startups do not operate with much money. They also need to settle down various decisions to attract investors.
There are many benefits of outsourcing product development. It can cut development costs down by up to 70%. This is more affordable than managing an in-house team over long period of time.
Outsourcing keeps overhead costs low, or at least reasonable, until you deliver a successful product.
What Does the Equity Option Mean for Startups?
Equity trade is a tempting option when a startup carries out a high-priced development. Especially if a founder has a tight budget.
Freelance contractors and organized outsourcing teams sometimes provide estimates. The estimates cover costs and offer a reduction in exchange for equity.
But, deferring “payment” raises the cost of equity against upfront fees. Yet, you have to get a full picture to notice it.
The question remains, should you give away an equity to build your product? Use equity to launch your product and get to revenue. Never use it for one-time expenses.
Use the equity in the business for talent, since the talent is rare. Use it when you want people to stay until you achieve your goals for the business. And only if they themselves want to fulfil their ambitions and use all their skills to make your company succeed.
You may also use equity to get funding for startup. You need money to pay for talent and company development.
Startup equity is not limitless. If you give away a part of it without due consideration, you’ll end up with little to nothing sooner than later. By then, you will give away everything and jeopardize the existence of your company.
Let’s remember the words of the legendary Felix Dennis. In his book How To Get Rich he advised that to become wealthy, you should never give away equity. It is more important down the road that you fight to keep every startup equity percentage you can now.
A payment happens once.
But if you sell equity in your company, this decision may influence every business decision after.
Every startup idea is in its own unique place. There are key factors that determine how to make decisions on equity and costs.
It is always better to resolve any issues related to payment before jumping into the working process. You negotiate the price, agree on it, but nothing will stop you from changing it by mutual agreement later.
There are expenses that don’t add value to your business (like rent or office furniture). But if they are necessary, pay for them in cash.
The Other Perspective – Questions to Ponder Equity Trading
Some questions are critical if you trade equity instead of paying for services.
These questions include but are not limited to:
- Are you, as a startup founder or appreneur, ready to be fully committed to your startup? Do you expect the contractors to take more responsibilities than they should?
- Are you capable of getting your startup off the ground?
- Do you have the requisite skills to run and grow a business for a period of at least 5 years?
- Will you be able to monetize your app idea?
- How can you guarantee profitability of your idea?
- Are you sure that your idea might be a matter of a fleeting interest?
The main takeaway is that someone else will try hard to develop your project. If they accept to work for equity, everything comes with a cost.
They will miss opportunities to work with others, who are ready to pay right away.
Top 5 Reasons You Should Pay Outsourcing Teams Instead of Giving Equity Away
1. An outsourcing team may perceive the value of the equity not as you expect
The first downside if offering equity to contractors is that they usually prefer cash payments. But this issue is more pressing that it may seem.
Usually, outsourcers or freelance contractors think that a 5% equity in a startup is too little. Thus, they aim for higher, let’s say, 10%. And even if they accept a 5% offer, they consider it to be a token amount.
But it may cause the situation when the contractors set priorities not in your favor and choose to work with someone, who offers cash right away.
Giving away 5% of your equity to a contractor might cost you 3 months of time to market. Meanwhile, you would have to always make the freelancer prioritize your business.
At the end of the day, if your product is successful, you would have to pay contractors an amount of money they never expected a 5% equity would ever cost.
Let’s say, your business is now worth $2 million. It means that the contractor will earn $100 000 for a web or mobile app development or design.
If you think that your business can cost more in the nearest future, you are right. But, paying in equity dilutes your business. It is more than about compensation for services startup needs.
You should also take into account that many freelancers survive on a short financial leash.
So, their attitude can be caused not by undervaluing your company’s equity. Those contractors, who make lots of money and set high prices, are usually not interested in being paid in equity.
But even if they agree, they are likely to take equity plus a reduced cash rate.
2. Equity brings contractors too close to your business. Make sure they are reliable long-term business partners
An outsourcing team can be a reliable and long-term business partner. But you need to be sure in your contractors before giving away equity to them.
Equity is not only about money. It is more about business plans, goals, and decisions. Would you want a designer to come into marketing or management decisions?
Thus, you need to understand the real value you’re giving away when you consider trading equity for services.
As a majority owner, you decide a lot, but you cannot keep minority owners passive. They have far more rights than you realize.
3. The impatience of (all) humans
People are mostly impatient. Founders are not exempt. Why is this so important?
Everyone wants to believe their equity shares in a startup will have even more value in 6 months or a year. But in reality, it takes around 3 years or even more until a company becomes appropriate for acquisition.
You don’t want to constantly deal with contractors, who are not ready to wait and want you to buy out their equity stake. This is the reason you need to find ways to make outright payments.
4. You communicate your perception of value to potential investors
Let’s say you choose a short-term convenience of offering equity for services.
Any founder can understand you, but in the eyes of investors, this decision defines your attitude. They consider sharing equity with minor characters shows that you don’t value your company enough.
Since you complicate your cap table with a few short-term assets, investors are likely to include uneven term sheet clauses with stronger than usual board representation. The reasons are obvious — they don’t think you are able to negotiate them out.
If the cap table is too complicated, any angel or VC investor won’t consider your offer for their investment. It might not be worth the trouble in their assessment.
5. Redefining the relationships
In the early stages, it may seem logical to give business equity to a developer or designer you’re working with. Your product will be constantly revised and need alterations to meet the users’ requirements. And you cannot do it alone.
By giving equity away you alter your relationships with the developers. It raises the expectations and changes the way you treat an outsourcing team.
Meanwhile, when you pay an outsourcing team in cash, the only thing you care about is the quality of the provided services.
But when you are giving away a part of your equity, you have to ask yourself whether you’re comfortable going into business with this particular person.
Because he or she will own a percentage of the company and gain a more active role in running your business.
Outsourcing teams are simple contractors. They don’t get tied into projects long-term and they don’t think about what happens a year from the time they create an MVP of an app. Simply put, they’re not your partners – they are just there to get work done and leave.
When you’re just starting out, it could be tempting to offer equity to an outsourcing development team instead of paying them in cash. However, this arrangement doesn’t benefit anyone. The outsourced team will take longer to get paid (if ever) and your product will suffer from poor quality because the developers will not be deeply invested in the long-term quality. Simply put, nobody wins in this arrangement.
Malte Scholz, a product manager and co-founder at Airfocus(Video) Warren Buffett: Why Real Estate Is a LOUSY Investment?
Alternatives to Offering Equity to an Outsourcing Team
Startups in their early stages usually have a tight budget. So, what to do if your budget is limited? Well, instead of an equity option, you can offer deferred compensation. The issue is not whether you can pay cash, it is whether you can pay cash “right now.”
How does it work? You can offer cash payments that will be made at particular dates in the future. For example, it can be monthly- or quarterly-based payments. If they aren’t made, they can be converted to stock.
This method is preferable. If there is money available, it is better when startup pays any amount of it. Even if it lowers the stock payout a bit.
Development of a Minimum Viable Product
There are many founders, who believe that the product needs to be polished and have all the planned features to enter the market. This conviction often leads to trading startups equity for services.
But the concept of a minimum viable product can help with this. You need to define your business needs to get going and move to the next level.
Be sure you aren’t developing for development’s sake. You need to focus on acquiring the customers your business needs. And you don’t need too much design or development to start selling. It’s better to resist your desire to create a perfect product and save it for later.
Be Flexible with Agreements
Make your agreements terminable at will. This move gives you room to negotiate when you’re stuck. It sometimes happens that an outsourcing team fails to meet your expectations.
You can compensate them and save your equity.
A good example of a truly flexible agreement is being branded advocate. You can mention an outsourcing company in the footer of your website.
If your product makes big , their brand will also gain traction. Priceless!
Do Not Trade Equity Of Your Startup
In most cases, giving equity can lead to unpleasant consequences. It may work only if the partner is reliable and is ready for long-term involvement in your mutual venture.
If the contractor considers your equity as a lottery ticket, you should certainly refuse.
Cash payments for work almost always result in superior products and results. Any startup has little net worth at the beginning.
Without an adequate payment, an outsourcing team may jump ship if there is something more promising insight. Quite logically, that people work harder when they have a stake.
Giving away equity should be your last resort.
And it should be done only in case you trust your partners and are comfortable working with them.
Reserve your equity for employees, and as an incentive to grow your company in the coming years.
The main takeaway is that someone else will try hard to develop your project. If they accept to work for equity, everything comes with a cost. They will miss opportunities to work with others, who are ready to pay right away.
As a rule, independent startup advisors get up to 5% of shares (or no equity at all). Investors claim 20-30% of startup shares, while founders should have over 60% in total. You may also leave some available pool (5%), but don't forget to allocate 10% to employees.
Founders don't get preferred stock. But it's nearly impossible to raise venture capital without issuing preferred stock, or preferred shares. In most cases, VCs today won't hand over a dime in exchange for common shares, the form of equity extended to founders and employees.
One factor affecting the founder's choices is the perception of a venture's potential. Founders often make different decisions when they believe their start-ups have the potential to grow into extremely valuable companies than when they believe their ventures won't be that valuable.
Perhaps counterintuitively, founders of a company do not automatically own equity in it. Instead, they purchase their shares (often described as “founder stock”) from the company shortly after incorporation.
The basic formula is simple: if your company needs to raise $100,000, and investors believe the company is worth $2 million, you will have to give the investors 5% of the company. The remainder of the investor category of equity can be reserved for future investors.
- Talk with your attorney.
- Think about vesting of founder stock.
- Keep it clean: use the right agreements.
- Be careful how you discuss equity.
- Know how the option grant process works.
Founder's equity or founder's stock is a class of stock issued to founders or early members of a company. In reality, founder's stock is simply common stock issued to founders. Common stock is the basic form of stock issued by every corporation.
Founders shares are low-priced common stock issued when a startup company is incorporated. The shares are typically spread among initial parties, proportionate to their role or investment in the company. The shares are allocated at this point, but do not become vested, or owned, until a later time.
Founders stock refers to the shares issued to the originators of a company. Often, the stock does not receive any returns up to the point that a dividend is payable to the common stockholders. Founders stock comes with a vesting schedule, which determines when the shares are exercisable.
Shares that are subject to vesting have the substantial risk of being forfeited; they'll generally be repurchased at a nominal price if the founder leaves the company.
How long should a founder stay at a company? Investors and execs can be divided on the question, but researchers believe they've worked it out: any time in the three years after IPO.
Many startup founders fail because they make crucial mistakes on the way to build a company they wish to have. By examination of startups that went successfully and those that failed, we can distinguish a pattern of common mistakes, that if avoided, will increase your chances of success.
20% Shareholder means a Shareholder whose Aggregate Ownership of Shares (as determined on a Common Equivalents basis) divided by the Aggregate Ownership of Shares (as determined on a Common Equivalents basis) by all Shareholders is 20% or more.
Q: Is 1% the standard equity offer? 1% may make sense for an employee joining after a Series A financing, but do not make the mistake of thinking that an early-stage employee is the same as a post-Series A employee. First, your ownership percentage will be significantly diluted at the Series A financing.
Tech co-founder equity: If you're just starting out and could use support in every aspect of crafting your startup, be ready to part with a sizable amount of equity (up to 50%).
|Series A investors||25%|
|Employee option pool||15%|
Startup financial advisor David Ehrenberg suggests that 5 to 10 percent is a fair equity stake for CEOs who join the company later. Research by SaaStr backs up this suggestion. The average founder/CEO holds roughly 14 percent equity at the company's IPO, while an outside CEO holds an average of 6 to 8 percent.
Hence, if active founders (plus management team) hold less than 40% today, it will be less than 25% by the end of series A. While this number looks fine once you have raised multiple rounds, it can make some investors nervous at series A.
In a series A round, founders are advised to give up around 20-25% of equity to investors. These equity investments are often dependent on the kind of startup or business. Some businesses may give up more, while others must give out less equity.
When you have a new start-up—who owns how much of the company? This is one of the toughest decisions you’ll have to make as a founder, but it’s also one of the most important to get right from the get-go. Here's what to consider to before you get started.
One camp believes that founder equity should never be evenly split because it can result in stalemates, which can kill a company fast.. Instead, the founders who execute on the idea deserve more equity.. Full-time versus part-time: If one co-founder is quitting her job to dedicate herself full-time to the company and the other is working part-time, the part-time founder deserves less equity because she’s both taking on less risk and providing less value and time commitment to the company.. Capital Contributions: One co-founder may be in a position to make a significant capital contribution to the company, and you might think she could just get additional founder shares in return.. But, it’s typically better to allocate founder equity based upon each person’s actual level of work contribution (called “sweat equity”) and treat financial contributions from a founder the same way you would that of a seed investor—by issuing convertible debt or series seed preferred stock.. For example, if the company requires significant technology innovation and one founder is a world-class VP of engineering, she may deserve more equity.. Just remember that the needs of your company, and perhaps the roles of the founders, will change significantly over time—don’t skew the equity split too much over a single contribution or skill.. Future Employees: Similarly, it’s important to think about founder equity stakes relative to the employees that get brought on afterward .. Control: Founder equity should not be allocated based upon how the company should be controlled or managed—you should have a separate agreement that specifies how important decisions get made.. No matter how you divide the founder equity, those shares should be subject to vesting restrictions, so that until the shares are “vested,” the founder does not fully own them.. But, it's inevitable that your shares will be diluted as the company grows in order to attract employees and investors, and there are very few examples of successful founders owning 100% of their companies at the time of a sale or IPO.
Rigid equity splits cause problems down the line.
This builds on Noam’s work over the last fifteen years, which has shown that even the best of ideas can falter when the founding team neglects to carefully consider early decisions about the team: the relationships, roles, and rewards that will make the founders a winning team.. When and How to Split Founder Equity. Her cofounder?. They were also much more likely to split the equity equally.. The same goes for the discussion of a “pre-nup” within a founding team.
Reprint: R0802G Why do people start businesses? For the money and the chance to control their own companies, certainly. But new research from Harvard Business School professor Wasserman shows that those goals are largely incompatible. The author’s studies indicate that a founder who gives up more equity to attract cofounders, new hires, and investors builds a more valuable company than one who parts with less equity. More often than not, however, those superior returns come from replacing the founder with a professional CEO more experienced with the needs of a growing company. This fundamental tension requires founders to make “rich” versus “king” trade-offs to maximize either their wealth or their control over the company. Founders seeking to remain in control (as John Gabbert of the furniture retailer Room & Board has done) would do well to restrict themselves to businesses where large amounts of capital aren’t required and where they already have the skills and contacts they need. They may also want to wait until late in their careers, after they have developed broader management skills, before setting up shop. Entrepreneurs who focus on wealth, such as Jim Triandiflou, who founded Ockham Technologies, can make the leap sooner because they won’t mind taking money from investors or depending on executives to manage their ventures. Such founders will often bring in new CEOs themselves and be more likely to work with their boards to develop new, post-succession roles for themselves. Choosing between money and power allows entrepreneurs to come to grips with what success means to them. Founders who want to manage empires will not believe they are successes if they lose control, even if they end up rich. Conversely, founders who understand that their goal is to amass wealth will not view themselves as failures when they step down from the top job.
At every step in their venture’s life, entrepreneurs face a choice between making money and controlling their businesses.. Startup founders who give up more equity to attract cofounders, key executives, and investors build more valuable companies than those who part with less equity.. Angel investors may allow entrepreneurs to retain control to a greater degree than venture capital firms do, but in both cases, outside directors will join the company’s board.. Indeed, in analyzing the boards of 450 privately held ventures, I found that outside investors control the board more often where the CEO is a founder, where the CEO has a background in science or technology rather than in marketing or sales, and where the CEO has on average 13 years of experience.. In such cases, investors allow founder-CEOs to lead their enterprises longer, since the founder will have to come back for more capital, but at some point outsiders will gain control of the board.. My research shows that a founder who gives up more equity to attract cofounders, nonfounding hires, and investors builds a more valuable company than one who parts with less equity.. Choosing money: A founder who gives up more equity to attract investors builds a more valuable company than one who parts with less—and ends up with a more valuable slice, too.. The “king” choices allow the founder to retain control of decision making by staying CEO and maintaining control over the board—but often only by building a less valuable company.. Similarly, at Wily Technology, a Silicon Valley enterprise software company, founder Lew Cirne gave up control of the board and the company in exchange for financial backing from Greylock Partners and other venture capital firms.. They are more likely to remain sole founders, to use their own capital instead of taking money from investors, to resist deals that affect their management control, and to attract executives who will not threaten their desire to run the company.. Choosing power: Founders motivated by control will make decisions that enable them to lead the business at the expense of increasing its value.. Founders often make different decisions when they believe their start-ups have the potential to grow into extremely valuable companies than when they believe their ventures won’t be that valuable.. The author’s studies indicate that a founder who gives up more equity to attract cofounders, new hires, and investors builds a more valuable company than one who parts with less equity.. This fundamental tension requires founders to make “rich” versus “king” trade-offs to maximize either their wealth or their control over the company.
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Equity developed because of problems in the common law of which there were several: the main one being the method by which the cases had to be started in the common law courts.. A litigant could now bring his proceedings in one court which would apply both the rules of common law and equity and Judicature Acts confirmed that in the case of conflict, equity would prevail.. At last the Judicature Act 1873-75 finally fused the two systems of law, common law and equity, and provided that both were available in all law courts.. Where a principle of equity conflicts with one of common law, equity prevails under Judicature Act.. In fact the Judicature Act helped to stop the conflict between common law and equity and definitely express the supremacy of equity and a lawful and definite relationship between the two.. Among the historical differences of common law and equity it is well seen that common law system was founded mainly by Henry II in the twelfth century but the notion of equity was founded in the thirteenth century by the Lord Chancellor of king.. Equity developed with many remedies which the common law failed to make .Even today the judges first try to give the result basing upon common law and if it is not justified and the litigant asked for equity then he goes on to equity.. “Under the name of justice, equity and good conscience, the general law of British India, save so far as the authority of native law was preserved, came to be so much of English law as was considered applicable or rather was not considered inapplicable to the conditions of Indian society.”15 According to Rankin, “the influence of the Common law in India is due not so much to a “reception”, though that has played no inconsiderable part, as to a process of codification carried out on the grand scale…”16 But in fact the English law in Indian subcontinent like the Roman law in Mediaeval Europe, “enjoyed a persuasive authority as being an embodiment of written reason, and impressed its own character on a formally independent jurisprudence.”‘7. Recognition in Indian subcontinent – The maxim have been recognized in India under various enactments – Contract Act, Section 42, illustrates tenancy in common as regards devolution of liabilities, Section 43 illustrates that one of a number of joint promisors who has performed the promise is entitled to compel the other promisors to contribute equally with him, Sections 69 and 70 illustrate the doctrine of marshalling, Sections 146 and 147 explain that co-sureties are liable to contribute equally, Under the Transfer of Property Act, Section 56 illustrates the doctrine of marshalling, Section 82 speaks about contribution to mortgage debt by co-mortgagors, Section 330 of the Succession Act incorporates and illustrates the principle of rate able distribution of assets explaining that the legacies abate rate ably, (viii) Under the Indian Trusts Act, Section 27, there is contribution also as between co-trustees, Section 73 of the Civil Procedure Code, Section 45 of the Transfer of Property Act also illustrates the incorporation and application of this principle.. Recognition in Indian subcontinent – The principle contained in the maxim has been recognized in the following enactments, Section 40 of the Transfer of Property Act, Section 12 of the Specific Relief Act, Section 53-A of the Transfer of Property Act, Section 91 of the Trust Act.. EQUITY ACTS IN PERSONAM Meaning – Courts of equity, described as courts of conscience, operate primarily in personam binding the conscience of a person and thus bringing an individual’s conscience under its sway.. Cases wherein it was successfully applied – On the basis of the principles of Justice, Equity and Good Conscience the Courts successfully applied the principles of English law in the following cases.. Statutes or Acts wherein it was successfully applied – Statutory recognition of the principles Of equity is found in the The Specific Relief Act, 1877, The Transfer of Property Act, 1882, The Law of Contract, 1872 , Guardian and Wards Act, 1890, The Trust Act, 1882, The Code of Civil Procedure, 1908, The Code of Criminal Procedure, 1898.. The Specific Relief Act, 1877 – The provisions of the Act regarding Sections 12-44, 52 -57, recognize, the principles of equity to a large extent, such as, which contract can be specifically enforced (section 12 – 20), which contract cannot be specifically enforced (section 21 – 30), Rectification of Instrument (section 31 – 34), Rescission of contract (section 35 -38), Cancellation of instrument (section 39-41), Declaratory suit (section 42), Result of Declaratory suit (section 43), Appointment of receiver (section 44), Preventive relief (section 52 – 57).
Knowing how to split co-founder equity is one of the hardest questions when starting a business. George Whitehead of Octopus Ventures gives his insight.
We asked George Whitehead of Octopus Ventures and Alastair Peet of Shoosmiths to talk about the issues faced by start-ups when deciding how to divide company equity among its co-founders and early employees.. But these cautionary tales do serve as a reminder that co-founder equity splits can make or break a company.. For these founders, there are two ways of looking at things: bring talented people on early and accept you will get diluted, but with the prospect of ending up part of a bigger, more successful company.. While there are many published anecdotes in praise of 50/50 splits between co-founders, it is important that entrepreneurs don’t default into a joint venture position, says Alastair, splitting the business down the middle and putting in place the kinds of decision-making provisos you’d expect to see when, say, two corporates come together to work on a project.. Alastair believes Europe and the UK have a unique culture around company equity, which stymies the size of business we grow.. But we need to educate founders that they can think big, and pushing the business onto better things, and quickly, might involve them giving up more equity than they may have originally thought.”. “You don’t need to jump the first time someone offers you cash.” A bad deal may result in a business taking, for example, a convertible loan note; handing over equity in return for making an early success of things.. In addition to coming to the right decision around equity splits, founders also need to think about how to make a business look as attractive as possible from an investment perspective.. Again, says Alastair, this is about founders being alive to the fact that building a successful company will mean recruiting and incentivising the best people.. As George explains: “Octopus is the kind of company where everyone feels part of what we’re building, and encouraging share ownership plays a huge part of this.. People who work at Octopus know that they have a stake in the business and feel that they are part of the Octopus family.”
One of the most difficult decisions an entrepreneur has to make as a founder is how to distribute equity among your co-founder(s) and earliest employees.
However, this article makes the task easier by introducing you to: 1) what compensation methods are available for new co-founders & first employees , 2) some factors to help determine how much equity founders get , 3) fixing employee equity , and 4) suggestions (formulas) for distributing equity shares .. Alternatively, you can consider distributing founder equity on the basis of the individual level of work contribution (sweat equity) from each individual.. With respect to dividing equity among individual investors, a simple formula is this, if you have to raise $3 million but the investors feel the company’s value amounts to $10 million, you should hand over 30 percent of the company to them for their money.. Kevin Systrom: The Equity Question The objective of employee equity is to make the first employees sensitive to feel an emotional ownership with your/your company’s great idea, its gripping product and the organization you are asking them to help grow.. The percentage of equity an employee gets over time would gradually come down as more investors join and the company has to issue more stock (dilution).. If, for example, an employee started off with 5 percent of equity, followed by which the company received two rounds of funding, the employee’s stock may be reduced to two-thirds or even half the original percentage for each funding round.. Entrepreneur Advice From Founders: How Much Equity to Give Co-Founders Here are some suggestions for a sample model of ownership (equity) distribution.
In a post on his SoCal CTO blog, Tony Karrer, Founder and CTO of TechEmpower, Founder and CTO of Aggregage and organizer of the LA CTO Forum and Startup Specia
Early Employees (Employees # 1-25). Later Employees (Employees # 26-125). The first few people into a startup are on a spectrum of founder vs. early employee.. For your first key hires, three, five, maybe as much as ten, you will probably not be able to use any kind of formula.. If the company's valuation is $2 million, $90k is 4.5%.. Logically, that's correct, but I personally would put a risk premium on equity compensation.. I also believe that early employees should be bringing higher value than early investor dollars as they can and should contribute to the concept greater than an investor.. A risk premium is a multiplier that says that any equity compensation should be viewed as being worth less than cash for that employee because of the risk.. There's also the aspect that the equity that you typically get as part of equity compensation is behind other equity in preference and thus effectively has lower value.. Unlike the founders, the employees have to wait until their grants vest, working at a company no longer of their choosing for two years.
Chris Dixon's blog.
A friend asked me recently if I knew of any good guidelines for dividing up equity between founders, and specifically what to do in the case when a co-founder provides seed capital.. Obviously the main consideration should be the relative importance of each founder to the future prospects of the venture.. Probably way too many founders divide things evenly just to avoid a difficult conversation.. (As an aside – you should also figure out titles early on.. When founders say “we are co-CEOs” or “we don’t have titles” that more often than not means there is a big fight looming.. One thing I’ve also noticed is people tend to overvalue past contributions (coming up with the idea, spending time developing it, building a prototype, etc) and undervalue future contributions.. Remember that an equity grant is typically for the next 4 years of work (hence 4 years of vesting).. Imagine yourself 2 years from now after working day and night, and ask yourself in that situation if the split still seems fair.. One way to figure out how much this is worth is to estimate how much having that founder increases your valuation at the next financing and then, say, split the difference.. So if having her means you can raise $2M by giving away 30% of your company instead of 40% of your company, let that founder have an extra 5%.. If one founder had the idea for the company, it is sometimes reasonable to give that person additional equity.. If that idea involves a bona fide technology breakthrough, they could be entitled to considerably more equity, say 10-20% (or you may have to give some of that to a university or other IP owner).. But if the idea is more abstract and doesn’t have real IP behind it (“User generated X” “A marketplace for Y”) that should only earn a few extra points of equity, if any.. I did this once and just had my partner write an IOU on a single sheet of paper, without using lawyers.. When you raise further money the best thing is to have that loan convert into equity at the same terms as the rest of the investors (it looks a somewhat bad to investors to take their fresh capital and pay it right out to a founder – unless the founder is in dire financial straights).
Last but not least, some of your “sweat equity” investors were the early employees who took stock in exchange for working at low salaries and living with the risk that your startup might fold.
The more funding you get, the more company you give up.. That ‘piece of company’ is ‘equity.’ Everyone you give it to becomes a co-owner of your company.. When you take outside investment and your company grows, your pie becomes bigger.. Now you are a “private company,” and asking for money from “the public,” that is people you don’t know would be a “public solicitation,” which is illegal for private companies.. They are the “sophisticated investors” – that is people who the government thinks are smart enough to decide whether to invest in an ultra-risky company, like yours.. The bad news is that angels were giving that money to companies that they valued at $2.5 million.. We have to add the ‘pre-money valuation’ (how much the company is worth before new money comes in) and the investment. Through an IPO a company can sell stocks on the stock market and anyone can buy them.. All those people who have invested in your company so far, including you, are holding the so-called ‘restricted stock’ – basically this is stock that you can’t simply go and sell for cash.. The people who have invested so far want to finally convert or sell their restricted stock and get cash or unrestricted stock, which is almost as good as cash.
The historical reasons behind creation of equity as a system of law and the differences that exist between equity and common law.
This document elaborates on the historical reasons behind creation of equity as a system of law, the differences that exist between equity and common law.. Common law proves to be a self-sufficient legal system or source of law when compared to equity.. This can be attested by the fact that equity presupposes the existence of common law and if we abolished the equity system, we would still have a coherent system of law, common law, but not vice versa.. The equity system of law was developed as a measure to address the rigidity of the common law system.. Because of the nature of equity, a conflict between the two systems was in the offing and so between the years 1873-75, the court of chancery abolished the courts that propagated the equity system of law, by means of the Judicature Act (Holmes O. W., 1881).
3 key things to consider when agreeing the equity split between you and your co-founder(s)
So, how should cofounders split the equity in the business?. From the equity split itself to what happens if one of the founders walks away before the job is done, these are the top 3 things you should consider before it all gets serious.. Make sure the equity split is fair and clear from the outset.. Make sure the equity split is fair and clear from the outset.. In effect, this would mean that each of the 3 full-time co-founders would end with 625,000 founder options while the 'evenings' founder' would take 125,000 options for that year.. For example, if the four cofounders split the equity 25% each without reverse vesting right at the start of the company, one of the founders could disappear into the sunset whilst keeping the same amount of equity as each of the other three – who may work for several years before the company is acquired.. Using the example above of 4 founders with 25% each, they could receive 5% of equity in options each for every year they work with the company for the first 5 years.. The remaining options should be split among the other co-founders in the following years.
Josh Rottner & Pat Mitchell, Cooley LLP
Source: Giphy So long as the purchase price that a founder pays for her or his shares of stock in a C Corporation is equal to the fair market value of the shares at the time of the purchase, then the purchase will generally not be a taxable event for the founder.. Under the tax laws, if shares are sold at less than their fair market value, then the difference between the actual purchase price and the fair market value of the shares is taxable to person acquiring the shares.. However as discussed below, we are generally able to structure this for a company’s initial founders (though not for future equity holders) so that they can pay the purchase price by transferring their intellectual property to the company in lieu of paying cash out of their own pockets.. It’s best to issue the founders’ shares when a company is first formed, because at that time the fair market value of the shares (and correspondingly, the purchase price that needs to be paid) is almost zero since the company’s only real assets are the ideas of the founding team.. So we strongly urge our clients to issue the founders’ shares immediately upon forming the company so that they can avoid having to come up with extra cash to pay the purchase price, or worse, the tax problems that would follow if the cash or intellectual property that they paid as the purchase price for their shares is less than the fair market value of those shares.. Founders are sometimes surprised by this, but unless an agreement is in place expressly assigning intellectual property to a company, then the individual that invented a piece of IP may own it regardless of whether they invented it within the scope of their work for the company.. We’ll discuss how to address this with the Company’s employees in a future post (spoiler alert: the key is to have everyone that does any work at all for your company sign an agreement assigning the IP created during their employment to the company when they start working), but founders are in a unique position in that they will not only develop IP while they work for the company, but they also created IP before the company was formed.. When I say this to clients, many founders respond that there is no intellectual property that predates the company’s formation, but IP doesn’t include only patents, trademarks or copyrights — even the initial ideas and concepts for the business that you and your co-founders came up with as you decided to form your startup constitute IP that the new company will need to run its business.. Because founders are generating IP before the company is formed, we need to make sure that all of the founders contribute this IP to the company so the company owns the great ideas (and perhaps other IP) on which it is based.. The company needs these IP rights to operate its business without infringing on the founders’ individual property rights, so if this IP isn’t contributed to the company, investors will be nervous about funding the company.. Luckily, the founders’ pre-formation IP is also a valuable property right that the founders can use to pay for their initial equity — in essence they sell this IP to the company in exchange for their initial shares.. Having the founders acquire their initial equity by using their pre-formation IP to pay the purchase price not only helps to make sure that the company owns all of the IP that it needs to operate its business as expected, but has the added benefit of allowing a founder to purchase her or his shares without paying cash out of their own pocket for their initial shares.. Mechanically, the way to do this is to document the founder stock issuance with a restricted stock purchase agreement issuing the shares to the founder with vesting, and then have the purchase price paid with a technology assignment agreement in which the founder assigns her or his IP to the company in exchange for the shares.
When you have a new start-up—who owns how much of the company? This is one of the toughest decisions you’ll have to make as a founder, but it’s also one of the most important to get right from the get-go. Here's what to consider to before you get started.
Even minor differences in equity can mean a lot down the road, so starting off with everyone on the same page (and feeling good about the agreement) will prevent big issues from coming up in the future.. Instead, the founders who execute on the idea deserve more equity.. Typically, this person should get less than half of the equity that a full-time founder is getting.. But, it’s typically better to allocate founder equity based upon each person’s actual level of work contribution (called “sweat equity”) and treat financial contributions from a founder the same way you would that of a seed investor—by issuing convertible debt or series seed preferred stock.. Just remember that the needs of your company, and perhaps the roles of the founders, will change significantly over time—don’t skew the equity split too much over a single contribution or skill.. The allocation of equity should take into account both past and future contributions to the company.. Under a typical vesting schedule for employees, shares vest over a four-year period, with 25% vesting at the end of the first year (called a “one-year cliff”), which ensures employees stay around for a year before owning any of the company.. When founders launch a start-up , they own the entire thing.. When you raise Series A funding, you’ll issue additional shares of stock that will go to your investors, and you can expect those investors to take anywhere from 25% to 50% of the company.. In general, when you’re setting up equity at the beginning, it’s a good idea to leave between 10% to 20% in the pie for employees.. But when it’s all said and done, each co-founder should feel good about the equity divide.. John is also a key contributor to the Goodwin Procter Founder's Workbench , an online resource for start-ups, emerging companies and the entrepreneurial community.. More from Nithya B. Das and John J. Egan III
See if this sounds familiar: A couple buddies come up with this super cool idea to completely dominate the SaaS market for tools that help companies save billions by monetizing their social media reach . These buddies know the technology, have the contacts and VC’s want to pour money into this “change the world” company. […]
What I mean by founders equity is the founders stock in a C-corp.. These are the golden three that will start and build your new company into what will become the next “insert your favorite successful company here.” In this scenario, the distribution of founders equity is pretty easy — each person gets a third.. I know, the temptation is huge to take the money but the cost of this money is more than the equity you give up.. Founders agreement: Writing down the deal between founders is a great way to avoid the challenges of equity distribution.. Sweat Equity to Founders Stock Conversion: Most founders choose to convert all that sweat equity into stock via some conversation factor.. In the end, dealing with dividing your founders equity up front and transparently will set up your new venture up for success.
As an attorney, I regularly counsel entrepreneurs, investors, emerging and established companies, and associations on a broad range of domestic and international corporate and commercial legal matters. I have also funded, managed, and sold businesses of my own in highly competitive domestic and glob
The first and most guiding of all steps is how to divide the equity within the hierarchical organization; that is, what are the allotted percentages for the Founder Group, the Investor Group, and the Option Pool Group (for the directors, advisors, and employees).. Step 2—Dividing equity among Founders.. Some bring patents or product ideas.. Thus, how do we then quantify what the founders bring to the table?. The idea behind the Founders’ Pie Calculator is to come up with a weight for each of these five elements and then assign a value to each founder on a scale of 0-to-10.. The “business guy” who is bringing business and industry knowledge to the company.. From this hypothetical example, the Founders’ Pie Calculator would determine the allocation of the Founders group’s equity in the Start-Up:. Step 3—Dividing equity among Investors.. Step 4—Dividing equity for Board of Directors & Other Advisors.. Typically, for a Board of Directors, it ranges from 1/2% to 2%, and for and other advisors, it ranges from 1/10th of percent to 1/2%.. Step 5—Dividing equity for Employees.. Once you have assembled a core team that is operating the business, you need to move from art to science in terms of granting employee equity.. In light of the above Step 4 and Step 5 discussions, the Option Pool Group (for the directors, advisors, and employees) will have many factors that affect option allocations including the quality of the existing team, the size of the opportunity, and the experience of the new hire.
How you distribute startup equity can have significant bearing on the success and sustainability of your budding business. Learn how to do it right in this article.
So to help you with the process, we'll review what startup equity is, see how it works in a startup, go over how it's typically structured, and pin down how to value and distribute it.. This typically refers to the value of shares that founders, investors, and employees are issued.. There's only so much pie that can be divided and shared — and the value of each piece increases as your business becomes more successful.. If you, as a founder, own 100% of your business, you own the entire pie.. That percentage is dictated by factors like timing, degree of contribution, level of commitment, and the company's valuation at the time of equity distribution.. As we touched on earlier, startup equity distribution varies based on factors — including timing, business model, industry, CEO preferences, and number of stakeholders involved.. Equity is usually divided among founders (and co-founders), employees, outside investors, and company advisors.. Founders and Co-Founders Employees Investors Advisors. As you work with your co-founders to determine how to split equity, you’ll want to consider the following factors:. Level of commitment — In the initial stages, many co-founders work to build their companies for little to no pay.. When determining how to offer equity to your employees, here are important factors to consider:. Percentage of ownership — You’ll need to determine how much ownership you plan to award to employees.. This typically begins by designating an employee equity pool, or specifying how much of your equity pie will be awarded to employees.. This means an employee can begin vesting their equity after a year of being at the company.. As a startup employee, the amount of equity you're offered rests on several factors.
Follow this formula that makes the equity conversation about each founder’s value, contribution, and commitment level.
Over time, different work styles, personalities, and issues around contribution emerge.. One founder may be putting more hours in, or another may be contributing more capital, which cause questions around the equity split to pop up.. A startup is all about “execution” — meaning the equity should be allocated based on the value that each partner brings to the table.”. For that reason making sure the startup has the resources and capital to grow, and execute on the idea, is ultimately why the business founder should be allocated more equity.. Depending on the founder team, each of these contributions will have a different weight.. Each element’s weight is then multiplied by the ranked level of the founder and added up to indicate the founder’s equity split.. In this case, Founder 1 would have 33%, Founder 2 44.2%, Founder 3 16.5% and Founder 4 6.2% of the company.. The process takes time, may be uncomfortable, but will give a founder team security that their equity split is fair.. Fairness also means that everyone should leave the equity conversation valued.. As part of the work I do as a mediator for equity restructuring conversations, a lot of the final pushes toward a solution comes down to everyone feeling equally valued (even if the equity redistribution isn’t equal).. Give everyone an equal ability to contribute, making sure that the final equity decision you come up with makes everyone feel valued for what they are bringing to the table.
To split startup equity, consider the following: ✅ expertise, ✅ time and commitment, ✅ business plan, ✅ responsibilities, ✅ risks, and ✅ money invested. You may also need legal and IT staffing help…
You’llalsolearnthe typical startup equity structure, what happens to share allocation if a startup is purchased by another company, and how to scale up in these conditions.. Whenthinkingabouthowtoshare allocation for a startup, thefirstquestionshouldbe: how many shares should a startup issue?. In Poland, therearemanyoffshore software development teams thatworkasan offshore development center of US-basedtechcompanies.. Several US tech companies are illustrative offshoring examples that have made use of stock options for their Eastern European software development teams, and this practice is just going to continue.. If your company wants to purchase a startup or a smaller tech company in Eastern European countries like Ukraine or Poland and needs M&A assistance, our team can provide you with proper legal and compliance services for IT .. The second step was to prepare a due diligence report that verified the legality of employment relations in the acquired company and proved that the company has ownership over its IP rights.. Moreover, Alcor can also deliver other operational functions that your business might need in Eastern Europe: legal & compliance support, payroll & accounting management, IT recruitment marketing services like employer branding and even stock option clarification for developers.A few years ago, the leading online fraud detection & management solutions provider from the USA – Sift – wanted to set up their software hub in Eastern Europe.. If a startup is not looking for investments but soon is going to be bought by another company, share allocation will be a task for the new owner.And in thecase you have already handledthis process among co-founders and began working with investors,you can get complete legal support and tech staffing assistance at Alcor.
Receiving equity in a start-up is no simple matter. Here are some key questions to ask to make sure you know what you're getting.
Investors buy equity in a company with money, but you’ll be earning it through your investment of time and effort.. Ask the company founders or executives about valuation.). Should your start-up exit at a great valuation, your equity could turn into cash.. So, if you were granted “in the money” stock options with strike price of $1, and you were to exercise your options on the same day, you would pay $1 for each stock, and own that stock valued at exactly $1.. In other words, you’ll mostly likely be granted stock options with a vesting schedule that requires you to work at the start-up for a period of time before you can exercise any of your options.. Make sure to ask about the specifics of your company’s vesting schedule to know exactly how much you’ll own and when.. Again, vesting means that you’ll earn your equity grant in partial amounts over time.. Once you’ve been with the company for a full year, a quarter of your total equity grant will become yours.. Once you have fully vested stock or have exercised your fully vested options, you have two options: You can hold your stock until there is an exit event or sell the stock in a private transaction to either outside investors or back to the company.. For example, Sharepost serviced Facebook employees selling their equity to private investors before the company went public on May 2012.. If you leave in good terms with the company, you may be able to negotiate a special privilege where the company lends you the strike price or immediately buys back a number of shares upon exercise to help you cover the cost of exercising.
Unless you are greatly concerned about control issues, each time you dilute you should be increasing your economic value. If you dilute your ownership from 40% to 36%, you still hold the same number of shares, but the per-share value should have increased. For example, if you entice Terry Mathews (of Newbridge and Mitel fame) to your board by paying him 10%, it is quite likely that your shares will double or triple in value (i.e. market value for sure and hopefully also intrinsic value because of strengthened leadership). If your 40% was worth $1 million, your resulting 36% may now be worth $3 million!
However, if you do not fit this description entirely (I might add that,. if you do not possess at least one of these attributes, you might want. to re-think starting your own business), then you will likely have to bring. "partners" into your company by giving them equity, i.e. some share ownership.. What share of the company should he get?. For more mature companies and especially for publicly-listed companies,. it is possible to provide managers with incentive stock options as an additional. incentive in the form of a reward if the company performs well and if the. stock price reflects this performance.. So, let's issue 10 million shares and give our 3%. person 300,000 shares.. Larger public companies. may have 100 million or more shares issued.. When companies go public, i.e.. list their shares for trading, there are often stock splits such that 5. or 10 new shares are traded for each existing share in order to give a. company a "normal" number of shares and a "normal" price range.. If only a handful,. then you could simply issue 100 shares with the percentage points being. equivalent to the number of shares.. For example, if you start with 10 million shares and. then deal others in so that you end up with 15 million shares and then. you decide to go public, resulting in over 20 million shares, this may. be too large a number and you may have to do a roll-back or consolidation. (see next paragraph).. When companies split their. shares, they do so simply by exchanging new shares for old shares with. all the shareholders.. Also, if a smaller, more junior company has 500 million. shares outstanding (which can happen), it may be better, for market reasons,. to have a tigher "float" (i.e. number of issued shares trading on the market).. Small public companies (with annual sales. below $10 million) such as those trading on a junior stock exchange, like. Vancouver, would have between 5 and 10 million shares issued.. Senior companies. (with annual sales in excess of $100 million) such as those trading on. Toronto, might have more than 50 million shares issued.. It implies a certain. degree of control (i.e. risk management) insofar as the shareholders appoint. the management team and it implies a sharing in the value of the company. - however measured (i.e. profits, the net worth, market value, etc).. The most important aspect of share ownership is that. as the value of the company increases, one's share of the value also increases.. It is not uncommon for a founder of a high. tech venture to own a million shares (which cost him very little in the. form of cash) and see these shares appreciate to a value of several million. dollars in a relatively short time frame.
Preferred stock cuts investors' risk but can cut employees out in the event of a failed startup. Here's what founders need to know to protect themselves.
Given those conditions, Gaviria says most venture capitalists will ask for and receive a liquidation preference called “1x, non participating.” Since liquidation preferences are expressed as a multiple of the initial investment, the 1x means they will receive a dollar back for every dollar invested, a full recouping of their money — as long as there’s enough to cover this.. If an investor has negotiated an anti-dilution clause, their stake in the company is maintained through formulas that turn each preferred share into more than one common share.. If a company lacks leverage, investors sensing big risks might even try to negotiate for “participating preferred shares,” also known as the “double dip.” Says Gaviria: “Preferred participating is the thing you want to be wary of.”. If any proceeds remain after that, the participating preferred investor would then pocket an additional share proportional to their percentage ownership stake in the company on a pro rata basis with common shareholders.. “If a company sells for $100 million,” says Gaviria, “an investor with participating preferred shares might take their original $20 million investment off the top and then take 20% (their percentage share of the company) of the remaining $80 million such that common gets 80 cents on the dollar on the amount remaining after the preference.” In later rounds, common shareholders could end up with as little as 30 or 40 cents on the dollar, Gaviria adds.. In the worst case scenario for founders and employees ($2M exit with 2.0x liquidation), common stockholders with 80% ownership will receive $1 million — the same amount as preferred shareholders with 20% stake.. Exit ValueReturn based on ownership stakeReturn based on 1x liquidationReturn based on 1.5x liquidationReturn based on 2x liquidation $6 million$1.2 million $500,000$750,000$1 million$4 million$800,000$500,000$750,000$1 million$2 million$400,000$500,000$750,000$1 million It’s important to remember the terms of preferred shares are negotiated between founders and investors.