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:
Founders-20-30%
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%
Founder-9.6%
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.
