What Founders Need to Know About Startup Equity
Equity is a startup’s lifeblood. And, just as with any other element of building a successful business — putting the right team in place, setting and hitting milestones, and effectively managing cash — developing your capital strategy is an important a piece to get right.
One thing to remember: your equity is precious: don’t be lavish in giving it away. On the other hand, being too stingy will make it hard to attract talent, advisors, and investors.
If you missed this week’s webinar with Peter Stone of Hopkins & Carley and EGFS’ Chief Strategy Officer Glenn McCrae, I’ll recap the main points you need to know. You can also check out the presentation here.
From the outset you’ll need to:
Develop your capital strategy as part of your business plan. That includes answering the questions:
- How much capital do you need?
- What do you need it for?
- Where/who are you going to get it from?
Choose the right business entity. There’s no single best choice in terms of the type of business entity you choose, but there is a best choice for your company based on your goals. If you’re setting your business up as an equity play the structure that will facilitate stakeholders’ participation in stock sales while giving you the most flexibility and predictability from a legal perspective is a Delaware-based C-Corp.
With some key decisions made, it’s time to consider who and what may be part of your capital structure.
The What: Anatomy of a Capital Structure
1. Common stock — May or may not be restricted. Granted to founders and earliest investors.
2. Founders’ Stock — Typically issued at a very low price, this is all about sweat equity. Negotiate the split between founders based on the unique skill sets you each bring and on your respective roles. Other things to decide are whether you want equity to be subject to vesting from day one (recommended). Once you get funded, investors usually require some portion to be vested, though but designationg a portion for pre-vesting in recognition of founders’ initial contributions is reasonable.
3. Preferred stock — Usually sold in series at different stages and with different valuations.. Preferred stock is convertible into common stock and carries a variety of rights. The most important of these is a liquidation preference, or the right to receive a defined amount prior to the common stockholders in a liquidation event.
4. Convertible notes — Short-term debt that converts to Series A equity at a discount (usually 20-30%) as compensation for the risk early stage investors incur. Convertible notes may or may not include a cap on valuation to insure early investors participate in the upside and are guaranteed a minimum percentage of equity.
1. Pre/Seed Stage — The definition varies, but we use it here to refer to the first outside money you receive. At this point, your investors will typically be “friends and family.” They don’t have to literally meet this definition, but they do need to be accredited investors as per state and federal laws. Tread carefully here: there are significant penalties for not verifying that your investors are accredited, such as being forced to buy back stock.
2. Early employees — Here again, the percentage varies, but it’s typical to set aside 20% (on a fully diluted basis) in an employee pool. Standard terms are 4 years vesting (including provisions for partial vesting), with unexercised vested shares going back into the pool. The size of the pool and the distribution of shares among employees is usually decided/negotiated with investors. Dilution will also be an ongoing discussion, especially as it relates to when to increase the option pool (part of the fully diluted number; treated as if all shares have been issued for valuation purposes) as it gets depleted.
3. Advisors — Whether it’s for guidance on marketing strategy or to provide a sanity check on your overall strategy and tactics, a handful of trusted, well-connected, and high profile advisors can really add to your business’ credibility. They can make key introductions to potential team members and funding sources, and they often invest in seed rounds. A grant of .5%, subject to vesting, is typical. When you get to later rounds with institutional money, investors will want to weigh in on composition and set limits on the size of your formal board.
4. Service providers — Many investment banks require some portion of fees to be paid in equity, and some law firms and other service providers will accept equity as payment, in lieu of cash. Equity can also be a tool here to incite performance – and to account for shared risk. But don’t overdo it. The amounts we’re talking about are likely to be about .5%.
5. Series A investors — Investors typically want 50%, with a range of 30%-65%. Your remaining equity stake will be based on a fully-diluted (shares in the option pool, preferred shares, and convertible debt all treated as if they have been issued) number at the closing. One thing to remember: I’ve talked a lot about milestone funding: specifically gearing each stage of your raise to discrete milestones. In addition to preventing you from raising too much (yes, this can be a bad thing!), milestone funding sets you up for higher valuations going into the next round if you’ve reached your milestones.
As you can see, things start to get complicated pretty quickly. But, as long as you know these basics, remember to project the impact of capital structure changes on your equity, and negotiate wherever you can, you’ll be well set up.
Questions about equity or raising investment capital? Tell us about it in the comments section below or contact Early Growth Financial Services for for guidance on financial analysis, forecasting, and more.
David Ehrenberg is the founder and CEO of Early Growth Financial Services, an outsourced financial services firm that provides small to mid-sized companies with day-to-day accounting, strategic finance, CFO, tax, and valuation services and support. He’s a financial expert and startup mentor, whose passion is helping businesses focus on what they do best. Follow David @EarlyGrowthFS.