What is equity in a Startup?

new.blicio.us Follow Sep 08, 2021 · 5 mins read
What is equity in a Startup?
Share this

If you have just started a business together with a partner or more people, they will probably be excited and focused on productivity and profits. The latter will have to be shared among all the founders of the company.

The answer is to share the same business plan, have clear rules of the game (partners’ agreement) and a good distribution of equity (ownership of the company).

Is it true that equity sharing causes tensions?

Yes, because the issue can be uncomfortable. The fact of having to divide the property of the company can generate tensions, especially if it is something that is postponed. It’s like a separation of marital property; it may be logical but we find it difficult to put it on the table because it seems to generate mistrust.

Therefore, the healthiest thing to do is to talk about it from the beginning. The objective is to have all the aspects clear in order to focus on the productivity of the business. On the other hand, the inconveniences at the time of dividing the profits equitably can lead to disputes and even to the breakup of the partnership, putting all the work in danger.

To prevent this from happening, let’s see what suggestions we can put into practice.

Let’s start by defining what equity is.

In the startup world it is very common to use English terms. Equity is the shares of a company, i.e. the shares into which the ownership of a business is divided. Therefore, when we talk about the equity distribution of a startup, we are talking about how the ownership of the company is divided among the partners of the company.

Startups combine tangible factors such as money, and intangible factors such as knowledge, working hours, contributed ideas… That is why the job of dividing the shares can be a difficult task.

So, how to divide it up? There is no single formula. But reasonable guidelines and criteria can be taken into consideration to reach a common agreement.

How to divide the pie?

Equity sharing should be a consensual solution. All partners must feel comfortable with the outcome of the distribution and, moreover, it must be the result of shared generosity. Dogmatic positions do not work for this. It is better to be generous among team members and to maintain a good atmosphere for the benefit of the company.

What should we take into account to make the equity allocation?

To achieve this, we can take into account the following:

  • What was our initial contribution? The idea? Initial capital? A patent? It makes sense that the partners who contributed the idea should be rewarded with something else as long as they have contributed to the development of the idea.
  • What can I contribute in the future? This includes customers, contacts, knowledge, experience, among others. It is true that it is difficult to evaluate something that is not yet tangible, but it should still be taken into consideration.
  • What are the merits of the partners and their responsibilities? That is, we must evaluate whether the contribution we are making generates some value to the company. Partners with a key role, to some extent, should have more weight in the shareholding.
  • What decisions do the partners have? This also implies the time they devote to the company, full or partial? The sacrifice that one makes when embarking on a venture is, to a certain extent, the risk that one assumes and it is something that should be reflected in one’s participation.

The roles of the partners. The differences in function and responsibility are susceptible to be covered with equity. They cannot all earn equally, so the distribution of assets will not be equal either.

Do you want to recruit talent to reinforce the team? If our team still needs some profiles to be balanced, it may be necessary to offer equity to this talent to be incorporated (and this must be foreseen).

All of the above makes the distribution of equity something dynamic. And it is beneficial to consider it this way from the beginning because the company will be changing. At the initial stage when all the founders get along well, talking about “sharing the pie” and the partners’ pact is more than opportune and it is worth having this conversation sooner rather than later.

Consequences of a bad equity split.

Clearly, without a business pact, everything that is agreed at the beginning will end up being forgotten.

Another mistake, the result of not having uncomfortable conversations, is that of dedications and contributions. If not all partners are equally dedicated and committed, no matter how close friends they are, they should not be equal partners.

Roles, responsibilities and contributions are vitally important, as it prevents equal sharing between partners who are not equal participants in the effort, time and capital invested in the business.

By the way, in companies with two founding partners, 50% and 50% splits generate quite a lot of noise. Really? Isn’t it the fairest thing to do? It may seem fair but it usually leads to deadlock. Either mechanisms are generated in the partners’ agreement to prevent deadlocks or, then, we will have to think about sharing based on responsibilities and contributions.

Resources for equity distribution.

The equity distribution can be compared with others to obtain references. But, in the end, it is a matter of each company.

Still, it is worth using tools such as Startup Economics or Startup Equity Calculator for comparison. Both tools ask us questions to offer us a possible equity distribution for our company; a result to compare with ours and see if we are “aligned” with the market.

Another very useful tool is CapTable.io because, as with Excel, we can make the equity distribution and then see how it changes with the different rounds of financing the company goes through.

We can also turn to other entrepreneurs and benefit from their experience, or gain knowledge through some books such as Mike Moyer’s Slicing Pie Handbook: Perfectly Fair Equity Splits for Bootstrapped Startups.

As we can see, equity splitting is a complex but very important topic. It is not something to leave on the road and raise later, when the need arises. It is a priority to make things clear from the beginning in order to focus on the goal of any venture: the growth of the startup.

Written by new.blicio.us Follow