You’re finally putting your ideas down on paper and sharing them with your friends and family. Everything’s coming together, and you get the chance to connect with an expert in the industry. They like your product, and now they want to teach you everything they know. How much startup equity should you offer them?
If you’re like most startups, cash isn’t something you have an abundance of, so it is typical to reward those that helped with its creation with startup equity. However, if your advisors believe in your company and put in the work to make your dream a reality, equity compensation is a must.
So, what is startup equity? Simply put, startup equity is a stake in the company. A stake is just the official term for holding a portion of the company’s stock. Technically, if you own just one stock in the company, you’re considered a stakeholder, though you won’t have the same weight as someone that holds a quantifiable percentage point of stock.
Startup equity is often used as a form of payment for those that helped a startup get off the ground. It’s also referred to as “equity compensation.” Startup equity is often the only bartering tool an entrepreneur has, and knowing how much to offer is essential. You don’t want to give away too much of the pie.
Who Gets Startup Equity?
When considering who gets equity compensation for their contributions to your startup, many things must be considered. How much did they help? What stage of the startup’s development did they join? How much value did they contribute? How much cash do you have on hand? Answering these questions can help you make an educated decision on whether to offer startup equity and how much.
If you genuinely believe in your business and have the cash on hand, this is the best way to compensate those that helped you along the way. Offering equity instead of cash could result in compensation far beyond what would typically be paid for the tasks performed.
Typically, startup equity is reserved for a small group of people. This includes founders, co-founders, employees, advisors, and investors. Offering equity compensation outside this group is not wise, but it’s also not uncommon due to cash on hand being tight.
When Facebook was barely a startup, they requested Graffiti Artist David Choe to paint their first office. David, who absolutely hated Myspace and the concept of social media, was glad to be a part of decorating the startup because the CEO, Sean Parker, was his friend. David Choe had gained some notoriety by then, and his price tag of $60,000 was rather steep.
Sean negotiated with David, and they eventually settled on a payment of equity compensation. David was glad to take startup equity because he believed in Sean and saw the investments already rolling in from wealthy donors. Today, the startup compensation that David received is now worth hundreds of millions of dollars. At the time, equity compensation seemed like the best idea, but was it wise in the long run?
In other words, anyone that helps with any aspect of your startup can receive equity compensation. Not everyone wants it, and not every task is worth it. It would be wise to try and reserve startup equity for those that contribute the most to your company’s launch, like founders, co-founders, advisors, and employees.
What To Consider When Offering Startup Equity
The first thing you need to do when considering offering startup equity as compensation is to look at your company as a pie. A pie has a finite number of times that it can be split, and every time you cut off a slice, the less startup equity there is to go around and less for you in the end.
How do you determine how much common stock your company should authorize? This is actually a relatively straightforward question, and not much thought is required. Ten million shares is the universal startup number that is authorized.
That number seems rather large and arbitrary, but it is a rule of thumb for its simplicity. It’s easily divisible, and you can offer round numbers. I’m sure you can choose another amount but reinventing the wheel when you’re already inventing your startup is an unnecessary task.
After establishing how many shares will exist, you must determine which groups you will want to offer startup equity to and what percentage of the pie you will want to offer to each group in total.
Again, don’t reinvent the wheel. You have too much on your plate to be worrying about the nuances of startup equity. That doesn’t mean equity compensation isn’t an important task. It just means that you can pull from industry standard and call it a day.
Typically, it’s broken down like this:
Founders and Co-founders: 50 to 70 percent
Investors and Advisors: 20 to 30 percent
Options Pool (Employees): 10 to 20 percent
This number should equal 100 percent. Next, when deciding how to divide startup equity, you should break down founders and co-founders and Investors and Advisors into smaller groups to determine how much to offer them individually.
Founders and Co-Founders
A prevalent practice when launching a startup is coming up with an idea with your best friends. You guys come up with a genius startup, and you will share the profit equally amongst partners. While this sounds equal, it is not a wise way to distribute startup equity.
Deciding how much startup equity the founders should get after splitting the 50 to 70 percent amongst themselves involves creating a system where you identify contributions, past and present, and assign a quantifiable value. This will determine how much of the pie each individual gets.
Oh, but you’re friends, and you shouldn’t let things like this be a thing. Just split it up. No! Maybe friend number three was only there initially but had plans to drop out at a certain point. His contributions, in the beginning, were invaluable, but friend number two plans to be around for the lifetime of the startup. To remove any personal feelings on the matter requires a technical approach.
Deciding on startup equity that the co-founders get can also be done at different times. You can get it out of the way right away, or you can wait until the startup is has started to reach maturity. This will give you a more quantifiable metric.
Waiting is always a good idea because the common understanding when dividing startup equity among co-founders is that everyone will be equally unhappy. People feel more entitled to a larger piece of the pie. Making sure each party is equally unhappy removes resentment. This is especially true with a late startup equity distribution.
If you split up startup equity early, the average founder’s unhappiness goes up 2.5 times, leading to a potential company collapse. Being patient will avoid one of the biggest and earliest mistakes most startups make.
There is no universal formula or correct answer for actual percentages of startup equity split among co-founders. The typical startup will look at a few areas of contribution and decide who gets what percent of startup equity.
Now that you’re at the table and deciding how to divide the startup equity, ask yourself a few questions. Is the founder committed or part-time? Are they financing the company? Are they technical or sales-based? Will they be a primary force in driving company success? What stage did they join? How much work did they put in?
Using these questions as a guide point, you’re able to determine how to distribute co-founder startup equity.
Investors and Advisors
Without investors and advisors, your startup likely wouldn’t even exist. Their contribution to your startup requires a sizable equity compensation. But how much startup equity should you distribute?
Based on the 20 to 30 percent margin, the equity compensation split among the two groups should not exceed 30 percent of the company’s value. From there, you must decide how much equity compensation to offer each group.
Investors are both relatively straightforward and challenging at the same time. Due to the risk of being a startup, investors typically want an unreasonable piece of the pie.
Pro Tip: To avoid offering more considerable equity compensation to investors, ensure that you have a large pool of early adopters. This will ensure confidence in the investor, and they won’t ask for a more significant percentage of startup equity. You don’t want to end up pulling from the co-founders cut.
A good rule of thumb for investor equity compensation is to keep it from 10 to 20 percent. This is not easy to do without proof that your product already has a market and early adopters, so make sure to seek out investors when you are prepared.
From there, when negotiating with investors, make sure your pitch deck is solid so that they will accept equity compensation that is agreeable for both parties.
When considering how much startup equity your advisors should get, you get into some really technical territory. There are formulas and equations based on metrics that include the time they started assisting, their industry experience, and the value they offered your startup.
So, what is a startup advisor? In short, a startup advisor is the one that took you under their wing and taught you all that they know about the industry you are joining. They have ample experience and wisdom, and you cannot make it without them. That is why they deserve equity compensation over a cash payout.
A startup advisor has the relevant industry experience and connections in the business. They do networking and leg work that you don’t have the experience or know-how to make happen. Their contributions can make or break your entire startup.
On top of being a wealth of knowledge on the industry your startup is entering, your startup advisor is a soundboard that you can bounces ideas off. When you’re stuck or completely stumped, you can run your thoughts by them, and in their wisdom, they will help you get through that. A valuable advisor is essentially like your closest mentor but in a professional sense, and their equity compensation should reflect their contribution.
Now it’s time to consider the logistics of how much equity compensation you should offer them. At the end of the day, your advisors should be getting somewhere between .25 percent and 1 percent.
These numbers may seem small, but when your company goes public, if your stock valuation is around $10, your advisors earned an equity compensation of $250,000 to $1,000,000. Depending on their level of contribution, that is a decent return.
When deciding how much startup equity you want to offer, you must determine the value they provided the company and which stage they joined. This will allow you to create a quantifiable metric for equity compensation.
First, you want to create a startup equity pool for advisors. Typically, this pool is capped at around five percent. This leaves you 15 to 25 percent for investors.
Then after you create the cap, you identify which stage the advisor joined. This will determine equity compensation. The three stages to look at are the idea stage, the startup stage, and the growth stage.
Once you identify the stage they joined, you want to note how they participated. This is broken down into two groups: Standard (Came to meetings and gave some input), and expert (Masters in the industry. Put in lots of leg work). These two groups will receive different equity compensation.
If you are part of the standard group, your startup equity should fall around .25 percent at the idea stage, .20 percent at the startup stage, and .15 at the growth stage.
The expert group is a little more involved, so their startup equity should fall around 1 percent at the idea stage, .80 percent at the startup stage, and .60 percent at the growth stage.
These numbers are not absolute. Just a starting point. It is also vital to create a vesting schedule with a cliff so that if any of your advisors drop out before creating enough value, their equity will remain in the company.
Knowing how much equity compensation to offer those that helped you take your startup to maturity is crucial in creating a great company.