Tech Word For The Week: Startup Equity

Tech Word for The Week is a weekly series where we look to explain commonly used words in the tech ecosystem in a simple, engaging way.

Startup equity is the amount of ownership shareholders have in a startup. It is the percentage of the startup’s stock sold to stakeholders (such as investors, advisors, and employees). This gives them the right to share in the profit or loss of the startup.

During their formative years, one of the few things startups offer the people who believe in them is equity. But sharing startup equity is something that needs to be done thoughtfully. This will ensure all key stakeholders are adequately compensated.

A simple way to understand startup equity is to think of it as a birthday cake. You could decide to eat the cake all alone or invite your friends to share in it. If you invite your friends, you give them a part of the cake as a reward for celebrating with you (although this kind of cake is not taken away). This means you and your friends hold a part of the cake (startup).

There are commonly two types of startup equity, which are common stocks and preferred stocks. As the name implies, preferred shareholders are paid first during profit sharing before common stockholders. Preferred stocks are issued to investors while common stocks are given to founders and employees.

The startup equity confers some benefits on its holders. Some of them are: a right to vote during annual general meetings and contribute to the decision making process, dividends, special discounts on the product/service, etc.

Startup Equity Distribution

Founders:

Sharing the ownership stakes if a single founder is starting out is straightforward. But if there are two or more founders, the sharing ratio has to be handled decisively. Some metrics need to be considered in the sharing process. These metrics include: commitment to the business, level of risk taken by each founder, idea contributions.

There are different equity sharing models which can be used. It depends on the nature of the co-founders relationship. Common equity splits include: 50:50, 33:33:33, 60:40. The role of each founder can also play a big part on the degree of the ownership they get.

Investors

Another category of people who get a share of the cake(startup equity) are your investors. These include venture capitalists, angel investors, and other people who invest money. The equity each investor will get depends on the value of the startup at the time they invest and size of the startup.

For believing in the startup and putting their money where their mouth  is, these investors should get a piece of the cake (startup equity). It is given to investors  in the form of common stock or preferred stock. The share can also give them a voting right when a decision is to be made in the startup.

Advisors

Some startups typically have some founders in their management board who might not give financial investments. These founders usually offer expertise, a credible name, powerful network or mentorship guidance.

Nevertheless, they might ask for a piece of the startup equity in exchange for what they offer. There is no cast in stone formula as to the amount of equity these people get. Most times, it’s up to the discretion of the founders and what they are willing to offer.

Employees

The employees that begin the startup with the founders and support to scale can also be offered the startup equity. Some founders might also offer these founding employees a stake in the startup if they are not able to pay competitive rates.

If they believe in what the startup is building, then the startup equity could be a fair reward for most employees. The degree of equity offered to employees has to be determined by the founder(s). Also, the employees need to fully understand what the startup is offering to make an appropriate decision.

Final Thoughts

Distributing your startup equity is not something to be done without thorough research and expert advice. Founders should speak with their accountants and lawyers who would help them to accurately do the valuation and equity sharing.