Entrepreneurs face many challenges when nurturing and launching their ideas into healthy business establishments. In particular, the division and distribution of equity in a startup is a tall order for many firms. How a firm unties this Gordian knot significantly impacts its future course.
Understanding Equity and Equity Distribution
Equity generally refers to the portion of a company's ownership that a shareholder acquires in exchange for their contribution to the business. In a technical sense, equity is the monetary worth of a firm available to its stakeholders after settling its liabilities. The stakeholders generally include founders, investors, employees, and advisors.
Companies in their infancy rarely generate enough income to cover their capital and operating expenditures. In the initial stages of its existence, a startup might need to raise funds from investors. Additionally, it must employ skilled staff to upscale. In such situations, equity is a very good currency that cash-strapped firms can offer their stakeholders. Equity gives the partakers access to the potential future value of the firm. But the division of ownership decreases the founders' share in the firm. This phenomenon is called equity dilution or stock dilution.
The Groundwork for Equity Distribution
There is no hard-and-fast rule governing the distribution of equity in startups. On a broader level, the process follows certain industry precedences. The two fundamental factors affecting the distribution of equity or shares of startups are the funding stage of the firm and the category of stakeholders. The division and allocation of equity take place during different funding stages. Startups must carefully consider the following points during equity distribution:
1. If the firm has multiple founders, divide the equity among them before assigning equity to third parties. This primary division will serve as a basis for subsequent equity distributions.
2. Plan equity distribution based on proper legal consultation and make the contracts legally binding.
3. Understanding the exit options available for each stakeholder will help avoid future hostile takeovers or power struggles.
4. What are you as a founder getting in exchange for equity and is that really the last option available to you?
5. Understanding the rights you are giving away along with equity such as information rights, board rights, etc.
Startup Funding Stages
The distribution pattern of equity differs for each funding round. A startup firm progresses through different funding stages in its development, including:
1. Pre-seed funding stage- The business will be in the ideation phase, with only a limited investment need. Usually, entrepreneurs meet capital requirements using their funds, and this method is called bootstrapping.
2. Seed investment stage- Money raised during this round funds market studies and the development of products or services. Sources of seed capital include self-funding, friends and family, bank loans, angel investors, etc. Depending on the funding method, firms might need to split and share equity in the startup with early investors.
3. Venture Capital (VC) funding stage- Startups move to the Venture Capital stage of funding when their products or services hit the market. Venture capitalists invest money and expertise in exchange for a stake in the company. The founders would have to see to proper equity distribution and management. This phase involves multiple rounds of funding, namely:
1. Series A: The firm will focus on sales growth and finding new markets. Investments are used for marketing activities and creating brand identity.
2. Series B: The product has found a correct market, and the business is growing. Funds received in this round will help hire additional workforce, pay salaries, and develop infrastructure.
3. Series C: A firm opting for round C funding is generally successful. It will need funds to expand to new markets, acquire businesses, or develop new products.
4. Initial Public Offering (IPO)- IPO raises funds from the public by offering company shares to retail and institutional investors through primary markets.
A typical equity dilution at different rounds of startup funding falls within the following ranges:
Allocating Equity to Stakeholders
When distributing equity among stakeholders, it is necessary to consider their time of entry, contribution level, the firm’s valuation at the time of funding, and its business model for a fair division.
1. Founders- The premise of equity division is the assumption that founders own 100% equity in a startup. Dividing the equity among the founders must be fair and proportionate to the assets and resources they bring into the business. At this stage, the founders should conduct candid conversations and reach a consensus regarding splitting ownership. Founders’ share in the business shrinks during each funding round.
2. Investors- Investors include informal entities like friends and family members who provide financial assistance, semi-formal entities such as angel investors, and formal entities such as venture capitalists. Professional investors will negotiate for their share in the equity pie during investment discussions.
3. Employees- Employees bring their unique skill sets and experience that can take the startup to the next level. Startups can offer employees a share in the company as an incentive to join. Startups earmark a portion of their equity for employees, called the option pool. A typical option pool receives an 8%-10% share of the equity.
4. Advisors- Mentors and advisors provide startups with the strategic insights to make progress. They are also valuable resources for establishing connections and networks. Up-and-coming firms generally allocate 1%- 3% of their equity pool to advisors.
Points to Ponder
There is no objective method for dividing and allocating equity in a startup. Since a startup is the brainchild of its founders, the entrepreneurs will seek to protect their interests by maintaining a majority stake in the firm. Therefore, they must rationally and logically identify how much equity they are willing to part with during each funding stage. Founders must also predetermine the size of the firm's option pool. Ultimately, equity distribution should focus on the firm's growth and success.
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