Your startup is gaining momentum and you are bringing in a top team to help you build your company. You want to offer them equity shares in exchange for their talents and services. You also realize that sooner or later you will have to attract investments, for which investors will also ask for a stake in your business. But let's be honest, distributing capital in a startup is not an intuitive process. Probably, you've already learned countless new processes and skills needed to grow your business. So there's one more thing you need to learn: sharing your startup the right way, and this article will help you do it.
One of the first and most important financial questions for all startups is how to divide equity shares in a hierarchical organization, that is, what will be the percentages for the group of founders, the group of investors, and the group of options (for directors, advisors, and employees).
It is common practice for many well-known US private equity firms (such as Advent International, Madison Dearborn Partners LLC, and Austin Ventures). They love to create joint partnerships with startup teams and are closely involved in overseeing the strategic development of companies. Most often, the percentage of equity shares in a startup is set as follows:
As you can see from the illustration, it all depends on the number of investment phases. If we are talking about one phase, then the startup remains largely in the hands of its founders. If there are several phases, then the main block of equity shares will be distributed among investors, but the founders will only become richer from this. How can this be? We will explain it below. There is a metric tonne of nuances here. Let's figure them out.
Equity sharing among founders
According to HBS professor Noam Wasserman's book, The Founder's Dilemmas: Anticipating and Avoiding the Pitfalls That Can Sink a Startup, 73% of teams that started their own project faced the need to share financial responsibilities and income levels about a month after launch. and the vast majority of co-founding teams faced great uncertainty about the future of the project early on. The division of cash flows and shares of influence at an early stage made the project inflexible regarding possible further changes (project optimization, team restructuring, etc.)
The ambiguities were only exacerbated when, at the level of personal influence, the overall project development strategy, and the business model of the startup, the skills of one of the co-founders became more valuable and significant, and someone's role decreased. In addition, the motivation of each of the co-founders in the work on the project is also different, and through the prism of this motivation, he/she begins to realize the value of their skills and their capabilities. As a result, in the future, even greater problems may arise (when it is necessary to reconsider the roles in the project or the size of the equity shares of the participants).
How to deal with split equity shares? To begin with, at the stage of creating a project, you need to understand that everything tends to change, even if specific changes cannot be initially predicted. Therefore, it is necessary to provide for a dynamic structure of partnership and division of equity shares in a startup, and not be guided by a static formula like "50/50", "60/40" and the like. But how can we quantify what the founders bring? There is a way.
Use the Founders Pie Calculator, an equity allocation tool developed by L. Frank Demmler, professor at Carnegie Mellon University. He invented an interesting way to divide equity capital among the founders in a way that is logical and fair.
Professor Demmler's calculator provides a way to quantify the elements of the decision-making process, namely:
- Preparation of a business plan;
- Liabilities and risk;
- Job responsibilities.
The idea behind the Calculator is to put a value between 0-10 for each of these five elements (depending on their importance to your startup), then assign each founder a score on a scale of 0-10. Then you take the value of each metric and multiply it by Founders' points to get a weighted score. From there, you can get a percentage of "fairness".
Let's look at a hypothetical example. Let's say we have a high-tech startup with four members of the founding team:
- An inventor recognized as a technology leader.
- A businessman who brings business and industry knowledge to the startup.
- A technologist who is the "right hand" of the inventor.
- A guy who was in the right place at the right time, but won’t contribute much to the startup.
Based on this hypothetical example, the Founder Pie Calculator determines the distribution of the equity share of the group of Founders in the starting line-up as fairly as possible.
Equity sharing among investors
Those who invest in your startup, whether they are angel investors, venture capitalists, or friends, should also get a slice of your business's stock pie. When investors put money in a startup, they are essentially taking on financial risk in order to generate financial returns.
How many equity shares an investor receives depends on the valuation of your startup, when they invest, and on the size of his investment. All this is worth discussing at the stage of investment negotiations.
The basic formula is simple: if you need to raise $ 3 million, and the auditors believe that the startup is worth $ 10 million, then investors’ money will cost you a 30% equity share in the company. But you will not become poorer from this. Let's say you've invested $1 million in your startup. And they managed to sell 50% of the “pie” to the investor for $1 million. The total cost of your “pie” is now $ 2 million. If initially, you owned 100% of the company or $1 million, then after such a transaction you own 50% of the company or the same $1 million. That is, your equity share in percent decreased, but in money, it remained the same. If a few months later another investor bought 50% of your stake for 3 million, the total cost of the company will already be 5 million. Now you have 25% of the company or $ 1.25 million. Ultimately, the cash equivalent of your stake is more important than the percentage.
However, to get a $ 10 million valuation (or, for that matter, any meaningful startup valuation), among hundreds of other factors, you definitely need key ones:
- great idea and really good elevator pitch;
- a convincing prototype or MVP (Minimum Viable Product) of your software, which illustrates the technical potential of your startup, displays the business logic of your project; niche, market with the potential to capture its significant share;
- an effective business plan with a clear, concise summary of your business that also discusses your goals and pathways for your idea, your business model, your management team, financial projections, and your exit strategy, as well as such questions as: “How big is your target market? How fast does it grow? Where are the opportunities and threats and how will you deal with them?"
Please note that ownership of an investor equity share does not imply any additional obligation or liability as part of a negotiation. Once the block of equity shares is bought back, or "transferred", it belongs to the investors, possibly forever. It also gives investors the right to vote on the company's board of directors, its governing body.
Also, remember not to scatter equity shares too much. Let's say a startup gives the investor of round A 35%, despite the fact that it has already given 15% to the incubator and the business angel. In round B, investors will receive another 15-20%, in round C they will demand 10-15%, and another 10% will be given to employees in the form of options. Then the equity share of the startup’s founder will remain just scanty, and any motivation to move on will disappear. Think carefully before giving away a significant portion of your creation.
Once you have agreed on funding, it is time to document this in the form of a term sheet. The term sheet is a document that outlines the terms and conditions under which an investor will make a financial investment in your startup. Term sheets usually consist of three sections:
- Corporate Governance
Term sheets are not mandatory. If an investor provides you with a list of terms and conditions, it does not mean that they intend to stop financing. The investor is still completing the legal review. If they discover something that he or she does not like, they may withdraw from the transaction. If everything is okay, it's time to sign a shareholders agreement.
The shareholder agreement defines the relationship between the shareholders of a company. The document regulates the following issues:
- corporate governance, for example, the size and composition of the board of directors and related procedural issues.
- procedural issues, including the frequency of board meetings and quorum
- covenants of the corporation - including obligations in respect of information provided to investors, as well as acquisition and maintenance of director and officer liability insurance.
- working with shares - a clear statement of any restrictions or obligations associated with the transfer of equity shares
- provisions for the resolution of any future disputes between shareholders
An investor lawyer usually prepares the first draft of legal documents. The documents contain additional information on the issues specified in the term sheet. If you have agreed on a detailed list of conditions, there should be no surprises during the preparation of legal documentation.
Equity sharing among key employees
Key people in a startup make your idea a reality. As well as sharing the risks with you, because if something goes wrong and the startup is not successful, their pieces of the pie will not be converted into money. The point of giving them some of the company's stock (options) is to stimulate early employees to be emotionally involved with your great idea and its technological execution, along with the company you are asking them to nurture.
Although there may be many important employees for a startup, it is worth highlighting the so-called “grants”. Grants are highly effective, capable of solving issues in their area of expertise alone and are inspired by dreams of success. These can be entrepreneurs, freelancers, colleagues, and acquaintances who are interested in creating profitable businesses from scratch and are competent in the work required to launch your product.
Solving one-off tasks is usually easier to pay a contractor than to hire a partner for this. If the task becomes regular and it becomes too expensive to pay the contractor, it's time to find a grant and offer him a share.
7 ingredients that grants contribute to the pie:
- Time. Probably the most important ingredient grants have to offer.
- Ideas. About products, promotion, sales.
- Relationship. People with whom you or your grants have a good relationship can become your clients, investors, partners, advisors.
- Intellectual property. Patents, registered trademarks, and other registration methods in which grants may have experience.
- Money. You can pay in slices of the pie for many of the ingredients your startup needs, but you can't do without money at all. Sometimes we are talking about small investments at first and grants can provide them.
- Place. For an office, shop, studio that needs to be rented if all your employees do not work in a separate room.
- Other resources. Anything you can use from time to time. For example, one of your grants at another company may have employees who are willing to perform tasks for you.
For your first key employees, perhaps the first two to five, you probably won't be able to use any formula; it is rather the art of negotiating. However, for those hiring the first few employees, the rule of thumb is that they are likely to be looking for some small fraction of the capital (i.e. 1%, 2%, 5%, 10%). As a rule, the equity share of TOP management ranges from 1/2% to 2%, and for other specialists - from 1/10% to 1/2%. It is clear that these key guys are employees, not founders.
Once you've put together the core team that runs the business, you need to move from art to science in terms of providing employees with equity. Most importantly, you need to move from a share of capital to a dollar value of capital, because providing capital in the form of equity shares is very expensive in the long run. Invariably, participation rates are not equal (usually the upper limit of these ranges is for verified elite investors); however, try to keep each of the participants happy with their property and its reasoning.
We hope this article was useful to you. Remember that it is purely advisory and you do not have to strictly follow every paragraph described here. However, this article can give you a good idea of how to divide your pie in a way that doesn't offend anyone and doesn't get lost. Well, do not forget the most important point: do not divide the cake before you "bake" it. In 90% of cases, people tend to agree on how the revenues from the future company will be divided in advance. It seems that this should prevent possible disputes, but in fact, startups develop very quickly and unpredictably. Better to spend this time looking for qualified ‘’baking specialists’’.