In the early days of creating a startup, cash can be extremely scarce. When you’re starting out and don’t have money to pay employees and investors, offering equity can be an excellent way to provide compensation for supporting your startup.
However, giving away equity does mean that you are in effect, giving away a little bit of your business.
Previously, we were writing about Marketing Requirement Documents and Product Requirement Documents. This time, we’ll be looking at what startup equity is, the pros and cons of giving it away, and how much you should offer in return for helping your startup.
There’ll also be some links to equity calculators and other valuable resources to help you work out the proportion of equity to give to stakeholders.
What is equity?
Concerning a startup, equity refers to the percentage of the startup that you own.
When you start a business, you will have 100% of the equity. However, you may choose to give a proportion of the equity away in exchange for goods, money, or other services.
Think of your equity like a cake or a pie. The more of it you give away, the less you will have for yourself.
Is equity the same as shares?
Not quite. Equity refers to the percentage of the startup that someone owns, while shares refer to the number of units of capital that someone owns.
So far example, an investor could own 2,700 shares, which equates to 25% in equity.
The number of shares available in the business is at the discretion of the founder or co-founders of the startup, while equity will always total 100%.
The pros and cons of giving away equity
The advantage of giving away equity in your business means that you don’t have to put up any money upfront in exchange for financing or expertise. This can be extremely valuable when you are launching your startup and don’t have much capital.
The money someone with equity in your business will receive depends on how well your startup does. This makes it in their best interests to work as hard as they can to help your business grow!
The disadvantage of giving away equity is that you will have to compensate people who have equity in your business when you start making a profit. This means that the money you make as a founder won’t be exclusively yours.
Another disadvantage to think about is that people with equity in your business own a stake in it. If someone has 2% or 3% equity, this won’t impact you too much. However, if someone asks for a more significant percentage (e.g. 40%), they could potentially overturn any decisions that you want to make).
Startup equity by role: who may want equity in a startup?
You can give equity to a wide range of people that are involved in your startup. They include:
- Founders and co-founders. While the startup is growing and developing, it is highly unlikely that founders will be able to take a wage. Their level of equity is their reward in the business when it starts to turn a profit.
- Investors. An investor is someone who invests capital in the business to help it grow. They may also provide support and advice and introduce you to people in their network. An investor will ask for a share of your equity in return for their involvement.
- Accelerators. Startup accelerator programs provide founders with support, training, and advice, as well as an opportunity to meet potential investors. Instead of asking for money for this service, they take payment in the form of equity. Find out more about how startup accelerator programs work.
- Employees. At some point in time, startups will need to hire skilled employees to help their business grow. A startup can either hire someone with equity instead of salary (this is very rare), as part payment, or as an additional benefit of joining the business. Equity can help startups not only get the best talent but foster loyalty in the company too. For example, employees that are given equity work eight hours a week more than those that aren’t.
- Advisors. Advisors can help startups with legal, industry, and technical advice. They are not hired as employees but provide advice and support on an ad hoc basis. They are rewarded for their time and support with equity in the business.
How do I decide how much equity to give away?
There are no hard and fast rules to determining how much equity to give away. However, we would recommend keeping it fair.
Some startups have established methods in place to work out how much equity to give away. For example, some roles and responsibilities may warrant a higher share of equity than others.
Here are some guidelines to help you determine how much equity to split with different groups of people, as well as some calculators and resources that can help you work out who should get what:
Founders and co-founders
The good news is that you can agree with your fellow co-founders on how much equity to keep between yourselves.
If you all have a relatively equal hand in the startup, you may choose to split equity evenly. We’d recommend choosing how much equity that you each get, and then having a ‘pool’ of equity to give to other stakeholders. That way, you’re not giving away your own personal equity to other people as they come on board the business.
You can issue new shares if you need to, but this will dilute the value of any existing equity you own. Find out more about managing equity dilution.
If you’ve all played different parts in the startup, these guidelines will help you work out how much compensation each co-founder should receive.
- How much risk is each founder taking to create the startup? For example, is one quitting their job or moving to another country?
- How much work is each founder putting into the business?
- How much money has each founder invested in the startup?
- Who had the original idea for the startup?
- Who has the most connections within the industry (i.e. who knows the most advisors, investors, and journalists)?
Investors, whether angel investors or venture capitalists are giving their money, time, and resources to help grow your business. This means they will expect a large amount of equity for their support.
It is a good idea to think about how much equity you are willing to give an investor and propose this to them when you pitch for their business. Be prepared to negotiate though, as they may have their own idea of how much your startup is worth!
Consider these pointers when thinking of how much equity to offer:
- How much money is needed?
- How much is your business worth, and how much will this increase in the future? Find out how to put a value on your business.
- What stage is the startup at? A startup at the idea or prototype stage will need less money than one that is ready to launch or needs to scale.
- How much experience does the investor have in your industry?
- How popular is the investor? An investor that is famous or has worked with a lot of well-known startups will probably ask for more equity than one that is more obscure.
A good tip is to go on Crunchbase and see how much your competitors have raised. This can help you put a value on your business and see how much equity you may need to give away.
Most accelerators have a fixed amount of equity you need to give to them to be accepted on the course. This amount is generally not negotiable. For example, Y Combinator asks for 7% equity from all businesses that take part. Smaller and less well-known accelerator programs may ask for less.
Remember that if you accept an investor’s offer while on the accelerator program, you will have to give them equity in your business too.
With employees, we’d recommend determining how much of your equity will be given to staff – this is sometimes called an ‘option pool’. So, for example, you may decide that 15% of your startup’s equity, and no more than that, will be awarded to staff.
You’ll also need to determine when your employees are entitled to their earnings. This is known as a vesting schedule. Some startups use vesting schedules to encourage staff to stay as long as possible; if they leave before the allotted time, then they cannot access their equity.
- How much experience does the employee have?
- When did they join the startup? An employee that was there at the beginning is probably entitled to more equity than one that started later on.
- How senior is the employee?
The Holloway guide to equity compensation is a good document to help you determine how much equity to give to staff.
Generally, with advisors, the amount of equity you will offer is small. 0.1 to 1% of equity is the recommended amount. However, the final number will depend on several factors.
- What skills and experience does the advisor have? A specialist advisor will be worth more than someone with more generalist knowledge.
- How much time are they committing to the business?
- How long-term is their involvement? Will they just be helping as you launch, or will they be around during the lifespan of the business?
How much equity is too much?
When you are the founder or co-founder of a business, you want to make sure that you hold the majority of equity. If you think back to equity being like a cake or pie, you want enough of it to eat yourself!
The founder or co-founders should hold over 51% of the equity in a business. This will give them the final say over how things are managed.
If you want more control over equity, you can put together a shareholder agreement. This document will detail the rights and responsibilities of the people who hold equity in your business. For example, you can state that if someone wants to sell their equity in your business, they must give you first refusal in buying it off them.
In conclusion – do you know to who you are giving your equity?
Equity can be a great way of sourcing capital to help your startup to grow, but it’s not a freeway to getting money.
Think of equity-like using a credit card. You don’t have to spend any money initially, but you will have to pay for it further down the line, often with interest attached.
If you do decide to give away equity in your business, carefully consider who you will give it to, and how much you will provide them with. It’s not a decision that you should make in the heat of the moment, or under pressure from other people. If you give people equity, they will own it for the life of the business, unless they sell or give it back to you.
Remember that you don’t have to give equity away if you don’t need to. If you are a sole investor, bootstrapping your business from scratch and not hiring employees straight away, then you can keep 100% of the equity for yourself!
If you don’t want to give away control of your business but do need financing, there are other options you can consider, such as a bank loan, startup grant, or crowdfunding.
Not sure how much equity to give away and to whom? Give You are launched a call!
You are launched has been working with lean startups since 2014, giving them impartial advice on how to fund their businesses most efficiently