Equity isn’t equal. Determining how equity will be allocated can be an uncomfortable conversation and is rarely simple. However, establishing a clear understanding and implementing a forward-thinking strategy for equity distribution at the earliest stage can help set up your startup for success.
In this blog, we’ll discuss typical ways founders split ownership, how stock is legally issued, how equity dilutes over time, and what legal frameworks should be in place throughout the life of your new company.
What Is Startup Equity?
Startup equity comprises the value of the company at a particular point in time. At first, equity is owned by the founders and distributed accordingly, typically structured as common stock. Until the company is acquired or goes public, this equity represents future realized value. As advisors, investors, and employees join the company, equity forms diversify into various types of stock and stock options. Equity also represents investment potential, as investors typically receive preferred stock in exchange for capital.
More than stock value, equity also comprises the rights attached to those stocks. Voting rights are often granted along with some stock forms, so it’s imperative that founders remain vigilant of the long-term implications that come with startup equity as it is distributed throughout the life of the company.
How Is Equity Distributed Upon Formation?
Equity allocation requires unique handling for each business. Once a startup is incorporated, the founders own and/or reserve 100% of the company and its equity, but that equity is not always equally divided amongst them. Founders should consider experience, expertise, ideas, and risk when splitting equity amongst multiple individuals, as values should be proportional to contributions. If equity is split equally by default, founders risk unhappiness down the road.
To avoid contentious distribution conversations, open equity value discussions are key from the get-go. Ensure transparency between founders, and ensure proper documentation is filed once an agreement is reached. These documents should be reviewed by an attorney at the earliest stage, and reviewed any time equity distribution changes occur.
How Is Founder Stock Issued?
Founders receive equity as founder stock – a form of common stock issued at a low value in the earliest stages of a startup. These shares are the foundation of a startup’s ownership structure, and vest over time as the company’s value increases.
Founder stocks are either granted or sold to the individuals by the company. If sold, the company should instate a stock purchase agreement. Rather, if shares are granted in exchange for valuable business contributions, documentation could take the form of a founder agreement. In either case, clear documentation helps ensure transparency for all parties, and it’s a good idea to have an attorney review the details.
What Equity Split Should Founders Maintain?
Founders must remember equity dilution is normal in early-stage businesses. During funding rounds, the value of each share may decrease, but capital infusion can facilitate the company’s overall value expansion. Venture capitalists often receive preferred equity shares in exchange for their investment. This is a typical startup structure; however, considerations should be made regarding what the investment is worth and how it will affect company growth.
If founder equity drops below 50%, the founders are no longer majority shareholders. When investor shareholders obtain majority ownership of the startup, they also obtain a majority of the voting rights. This means they also have a controlling interest in the company, giving them veto rights and the ability to direct corporate decisions and the company’s growth strategy.
If maintaining control of your startup is the founders’ goal, leadership must cohesively weigh the value of obtaining venture capital investments and maintaining majority ownership. An attorney can help decipher legalities and structure documents accordingly.
Should Founders Offer Advisory Shares?
For early-stage companies, compensating advisors in the form of equity, commonly referred to as advisor shares, is a standard practice. Advisors typically bring valuable expertise, facilitate beneficial business connections, and maintain an interest in the company’s success.
While there is not one strict formula, advisory shares are typically less than 2% of the company’s equity. Restricted stock or options vesting are among the most common forms of advisory shares, reducing founder risk while still leveraging equity shares in exchange for market expertise.
When Should Leadership Revise Equity Distribution?
Sensible equity allocation shifts at many points throughout the life of a company. As investors, advisors, and employees onboard throughout the startup phase and beyond, fair equity distribution must be reconsidered.
Team Changes
Any changes in startup leadership should trigger a revision. Whether a founding member leaves the company or an additional member is brought on, reallocation may be necessary. Ensure all members are on the same page, and have a startup attorney ensure all documentation aligns with the new structure.
If company equity is part of compensation packages for C-suite employees, that inclusion will also require distribution revisions. The same is true if an employee option pool is created.
Major Milestones
From completing prototypes to launching new product lines, companies reaching major milestones may review equity allocation to consider it still reflects the value of each shareholder’s contributions.
Milestones can be time- or performance-based as well. Founders or employees reaching certain goals or major anniversaries may deserve bonuses in the form of equity, which would trigger the need for legal revision and updated documentation.
New Funding Rounds
Equity dilution occurs at each funding round, from seed to later series stages. Investors are typically compensated with equity shares, and as new investors infuse capital into a company, new distribution contracts are required. This dilutes the percentage of founder equity shares; however, the value of those shares can increase significantly. Each funding round triggers the need for an equity distribution revision, and startup attorneys can advise the most beneficial way to structure new contracts.
What If Equity Owners Leave the Company?
Vesting exists to protect startup interests throughout the life of the company. Structuring founder shares so that they are earned over time — typically over four years — prevents founders from walking away with a large ownership portion before contributing real long-term value to the company. Rather, they are more likely to maintain contributions for a longer time period.
Various situations requiring founders to walk away do arise. When they do, founders retain the value of their vested shares, and the unvested shares disappear. This is known as reverse dilution, as the percentage of remaining equity owners increases proportionately.
Early exit consideration is why many startups distribute restricted shares. This structure ensures the company retains the right to repurchase distributed shares at the original price if this founder leaves too early.
How Do I Ensure Equity Allocations Are Properly Structured?
It’s never too early to hire a lawyer. Startup attorneys like the experts at HJF can help structure equity allocations, documentation, and periodic reviews to protect startup equity from the ideation phase and into the company’s future.
If you are an entrepreneur and are considering company formation, reach out to our expert team of startup attorneys at (917) 267-8184. You can also visit hjflaw.com/contact to schedule a free consultation.