What is startup equity?
Startup equity is the amount of ownership in a business that entrepreneurs distribute among founders, investors, advisors and employees in exchange for services or seed money. Because many startups do not have inventory that investors can liquidate if the business fails, they often offer a percentage of shares in their company as an incentive for venture capitalists to risk an investment in their startup.
When you give your startup’s equity to an outside party, you hand over a percentage of your company’s future earnings and growth in exchange for financial support. Investors and employees who accept equity at the ground level do so with the hope that the business will succeed and they will eventually own shares in a highly profitable company.
The details of your investment agreements can vary, but startup equity is relevant to your business far beyond the investment stage. As your business grows, shares usually become more valuable, giving investors a return on their venture. It’s important to be mindful of how much of your company’s equity you are willing to give to others, who the majority shareholder is and how startup equity is distributed among founders. You can also set boundaries that regulate how investors and employees earn and access equity over time in order to protect your business while it grows.
Different types of equity in startups
Equity essentially means ownership, but there are a few different ways people can own part of your business, including:
Common shares, or common stock, represent someone’s initial investment in a startup. Entrepreneurs give common stock to venture capitalists alongside the right to a portion of the company’s assets. People who own common stock are generally more involved in how a business is run and are responsible for determining company policies, appointing board members and other governing tasks as the startup grows.
At the beginning of a startup, the founding members of a business often work for free and retain a high percentage of shares with the hope that they will eventually become profitable. They also offer common shares to employees, usually as an incentive to accept lower pay or benefits for their work. These stocks usually come with restrictions, such as a vesting period, in order to ensure that employees put time and effort into the company instead of collecting free stocks and quitting. Entrepreneurs give restricted stocks to employees for free, compared to stock options that employees purchase.
Related: How to Find Good Employees
Stock options are a popular way to offer equity to employees while your business is still growing. Employers give employees the option to purchase stocks at a predetermined price based on fair market value. Employees can exercise their options after meeting holding requirements, allowing them to profit from growth in a company’s value over time.
Startups can also offer preferred stock, which gives stock owners a share of the company without any of the voting rights that common stock shareholders receive. People who own preferred stock have a higher claim to your startup’s assets than those who own common stock. If you ended up liquidating your company, preferred shareholders would be paid out before common shareholders, giving preferred stocks more financial security in exchange for less control of the business.
Who gets startup equity?
Entrepreneurs can use a variety of strategies to divide their company’s equity between investors, advisors, employees and founders. Some startups don’t take on any investors, allowing co-founders and employees to have a larger share of company equity, while others may not offer equity to their employees at all. The amount of equity you give to each group depends on your company’s valuation and the value of the services or investment you’re asking for.
The entire employee pool usually makes up 10-20% of a company’s equity. Advisors generally receive a fraction of a percentage of the total equity, while investors could range from 1% to a majority share depending on how much they are investing. When deciding how much equity to offer, consider the current value as well as the potential value of your shares. Look at the valuation of other startups to get a good idea of how much your business is worth.
Startup equity packages FAQs
Here are some frequently asked questions about startup equity:
Why offer a startup equity package to employees?
Equity allows you to compensate employees when you don’t have the liquid cash to increase their pay. It also helps them commit to your business because their hard work and success will translate directly into financial growth as their stock shares become more valuable.
What is a vesting schedule for employees?
A vesting schedule is the amount of time an employee must work with a company before they can access their equity benefits. Most vesting schedules have a four-year vesting period with a one-year cliff, meaning that an employee who leaves a company after less than a year will not get any equity benefits. After they are employed for a year, they will own a quarter of their total equity offer. Employers set a monthly or quarterly vesting schedule for the remaining three years, allowing employees to gain equity in increments.
What are treasury stocks?
Treasury stocks or treasury shares are any stocks that a business owner buys back from investors. Treasury stocks usually indicate a decrease in equity and buy back their stock at a higher price than they originally sold it for.