Equity Distribution in Startups

Equity is negotiated on a case-by-case basis, which makes it hard to give any generalizations as to how it should be distributed. Here are, however, some rules of thumb.

Dividing equity among founders

Founders receive equity for what they bring to the table. How much of the company they own as a result of their contribution is up to the group to decide. There are several factors which need to be considered: timing, size and duration of contribution. The earlier, bigger, or longer the contribution to the company, the more equity a founder should receive.

Power. Equity conveys voting power and control over the business. Generally, founders who intend to stay with the business long-term should retain the most control. Partners with equal ownership are great in theory, but in practice they can destroy a company when the partners have no way to resolve fundamental disagreements.

Money. Early money is a contribution for equity. Money has the side-effect of valuing the company. If you give 10% of the company for someone contributing $50,000, it implies a company value of $500,000. If you try to raise money immediately thereafter, that valuation could hurt your negotiating ability. But if substantial infrastructure has been built in the meantime, if customers have been acquired, or if more of a team has been built, then a higher angel/VC valuation is justified.

Kind of contribution. A founder may contribute in many ways. Some bring patents or product ideas. Some bring business expertise and ongoing work to build the business. Some bring capital. Some bring connections. Some may bring big names or reputations which convey credibility with VCs and/or clients. Understand what each founder’s contribution is, and value it appropriately.

We have 5 founders, what do we do?

Having several founders makes it hard to keep everyone adequately compensated. By the time of IPO or acquisition, the founding group can expect to own about 20-30% of the company. With one founder, that can mean riches. With several founders, that may mean splitting the pie into so many pieces that no one is happy with the value of their piece.

In short, fewer major equity holders are better. If you’ve already got several, make sure that you tie each founder’s vesting to the contribution you’re expecting from them.

How much will investors expect to own?

Different investors value companies in different ways. Some look at the quality of the idea, assets, market size, and management team. Some rely on financial projections. Some simply look for “big ideas” and determine their percentage ownership purely through negotiation.

The basic formula is simple: if you need to raise $5 million, and an investor believes the company is worth $15 million, you will have to give them 33% of the company for their money.

What equity should part-time contributors expect?

Not very much. In reality, startups usually require 150% commitment by everyone involved. Venture capitalists require equity in return for ongoing commitment. Even founders who stay with the company have a multi-year vesting schedule. Many VCs will not allow equity to be given to part-time employees or contractors.

There is a one-time contribution for stock that is routinely made: giving capital itself. A cash investment for stock lets the investor own the stock free and clear, with no further contribution required. Having part-time contributors purchase stock outright may be the best way to include them in the deal.

How can we increase the company’s valuation?

From an interview with Ron Conway in Bankrolled by an Angel, part 3, by Lawrence Aragon, Red Herring 12/22/99.

Angel investor Ron Conway says:

To get a $5 million valuation, you need a great market, a great idea, a crisp business summary, a really good elevator pitch, a compelling product prototype of your software or solution, and two or three members of your management team in place. For a $2 million valuation, none of the software for the solution is written yet. It's just a CEO without a proven track record and a market to attack.

Q. Given the number of questions, many entrepreneurs seem to focus too much on valuation. Generally, what do you advise?

A. If you're building a company like Yahoo, Ask Jeeves or eBay, you shouldn't worry about valuation on the front end. If you're worried, then you probably don't have the confidence to build a large, significant company. A CEO who's completely stuck on valuation is a warning sign. That's a CEO who's confused about his role. The bottom line: if the idea is great, you'll end up with a multibillion dollar market cap and everyone will make more money than they can ever spend. Rather than focusing on valuation, focus on execution.

Q. A guy wrote that he's worried about not having a Harvard MBA. How would you rate a college dropout with a brilliant idea, an excellent prototype, but no team? Would you fund him?

A. Yes, but that would definitely be in the $2 million pre-money category. If the prototype is excellent, he might get a valuation of $3 million to $4 million.

What does ownership look like after the first round?

According to Ann Bilyew of Advent International, a typical first round is:

Angel investors-20-30%
Option pool-20%
Venture capitalists-30-40%

What does ownership look like at IPO?

From an article by Anant Raut published on www.techound.com.

A May 1999 study by the William M. Mercer, Inc. consulting group [showed] the Internet companies reserved 15.7 percent of their common shares for compensation, compared with traditional industry's 10.7 percent; after their IPO's, however, traditional industry had 5.3 percent of their reserved shares still available for option grants in the future, while the Internet 32 had only 3.7 percent to offer.

The same study found the following distribution of median equity stakes among members of the executive team (following an IPO):

Founding chairman-20.4%
Non-founding CEO-4%
Other executives-0.79% (0.96% before IPO dilution)

It's hard to quantify percentages that non-executives should expect. Variables include the age of the company, the degree of financing, and the strike price. Kersey Dastur, an independent consultant based in McLean, Virginia, has assisted a number of high tech companies in establishing stock option plans and explains, "If I am a company with no financial backing yet, I will be likely to set aside 10 percent of my company for non-executive employees because they are taking a risk working for me. I may, however, set a high strike price to ensure that the value of the company is not diluted." It is not uncommon for companies with financial backing to offer no more than 2 percent to non-executive employees, because someone else has already assumed the financial risk. Remember, these allocations are spread out across all employees so, unless you have something truly unique to offer, don't expect a large piece of the pie.

Stever Robbins, VentureCoach, Inc.


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