The decisions made around allocating equity early on in a startup’s lifecycle will have major effects on its long-term financial well-being. It’s important to make strategic decisions now that will put your company in the best possible position when it comes time to attract key hires, garner investment capital, and scale your teams.
This article addresses the major considerations for allocating equity:
- Getting started with equity allocation
- Founder equity split and compensation
- Tips for managing your cap table
Getting started with equity allocation
To get started in determining sound equity allocation, first consider the purposes, which include:
- Incentivizing contributions to company growth; and
- Promoting long-term commitment.
To ensure that both of these purposes are properly served when allocating equity, always start by asking this question: What will a co-founding team member contribute to the future growth of the business?
Equity allocation to co-founding team members should reflect an appropriate reward for the future value they’re expected to contribute. If the expected contributions are fairly equal, then the initial equity should be allocated relatively equally (e.g., 51% and 49%, etc.) And if the contributions are anticipated to be unequal, then a greater portion of the initial equity granted should be distributed to the founder(s) who will be contributing more value to the company. In addition, the founding team can make adjustments to the proposed equity allocation to account for disproportionate past contributions to the business (such as seed money contributed by co-founding team members, code, generating the idea behind the company, etc.) by increasing the number of shares allocated to those early contributors.
Other considerations include time-based vesting and the equity allocation upon incorporation.
Upon incorporation, the majority of the shares should be allocated to the founders with a small portion going to the option pool. Bearing in mind that being able to offer equity in your company will continue to be a valuable tool, I caution against giving away any large amounts of company stock (e.g. greater than 10%) without due consideration. See below under “Tips for managing your cap table” for an example of how to allocate equity to founders at incorporation.
Impose time-based vesting
Each co-founder should be subject to time-based vesting on their shares. With time-based vesting, if a co-founder leaves the company, they will be entitled to keep only the shares they have vested over time through involvement with the company.
This protects the company and the other co-founders in the event that the founding team’s initial assessment of someone’s future contributions was inaccurate. Co-founders may choose to part ways for any number of reasons. Without vesting, a co-founder could walk away at any time with a large chunk of the company’s shares without needing to contribute anything to the future value of the company.
The time to impose vesting is at the time of incorporation when everyone is amicable and excited to build a company together, not later on when disagreements are more likely to arise.
The usual vesting schedule provides for monthly vesting of shares in equal increments over four years, with a one-year cliff before any shares vest.
Founder equity split and compensation
To review, equity—non-cash compensation that represents partial ownership in a company—is an effective means of attracting talent at an early stage startup. Equity is typically distributed across early founders, financial backers, and employees who join the startup in its earliest stages.
Here are four factors to consider when determining an optimal equity split for founders:
- Salary replacement;
- Idea generation;
- Development stage; and
- Seed capital.
1. Salary replacement
In some cases, co-founders and/or employees will agree to work for low salaries in exchange for ownership in the company. However, companies need to be aware of potential wage law issues when taking this approach.
Payment of employees through stock or stock options can violate both federal and California wage and hour laws. There are certain exemptions but this is a complex area of law so be sure to involve a specialist if unsure of your liability.
2. Idea generation
Whoever proposed the chief value proposition of a company typically receives the greatest percentage of equity ownership. However, the division of equity is not always that simple.
Concrete, measurable contributions in capital and sweat equity might matter more to the success of your startup than a single idea. Therefore, a fair equity split will usually follow a careful analysis of the relative amount of early development work contributed by each co-founder. This is a sort of balancing act where the goal is to fairly reward the early contributors while also leaving enough for others to contribute and move the idea forward.
3. Development stage
Those who join a company in its earliest stages of development, such as before the seed round or Series A funding, often receive a larger piece of equity to recognize the time they invested and the risk they assumed in working for such a young company.
4. Seed capital
If one co-founder provided more seed capital into the business than the other(s) he or she will often be rewarded for that through equity.
Tips for managing your cap table
A capitalization table, cap table for short, is key to any startup. It is a record of the pro-rata stock ownership of the company’s founders and shareholders and should be well maintained to ensure that stock is thoughtfully distributed.
Setting the option pool
When you’ve determined how you plan to allocate equity to the co-founding team, it’s time to focus on determining the size of your option pool. Typically among startups, an option pool will range from 10-20% of the total equity. The optimal option pool size will depend on how much hiring you intend to do before the company’s first round of equity financing, at the time of a Series A raise, for example.
Authorizing shares of common stock
When incorporating a new Delaware corporation, a good starting point for founding teams is to authorize 15,000,000 shares of common stock. Of the 15,000,000 authorized shares, the co-founders should allocate only 10,000,000 shares among themselves and the option pool. If the co-founders think they will have greater hiring needs, then they can increase the size of the pool and reduce the allocations to themselves.
Typically stock allocated to C-level executives (e.g., CEO, COO, etc) ranges from 2-10%, and other employees from 0.2-1%.
Purchasing founder shares
Once the co-founders have decided on their share allocations, an attorney can help them document and make their share purchases and any recommended tax filings like their 83(b) elections. When the purchases are completed, the co-founders then hold issued and outstanding shares. The shares in the option pool do not become issued and outstanding until the company grants options as approved by the board of directors and those options are vested and exercised by the recipient of the stock option grant.
Centralize the data
Centralize and share your company’s capitalization data with your accountant and lawyer, rather than keeping multiple spreadsheets and managing all of the data across them. You may have started with Excel spreadsheets, but there are dozens of templates available on the Internet that it’s worth transitioning the numbers to so that when the time comes to hand it over to your financial and legal providers you’ll waste less time on document clean up.
Review your cap table regularly
Review your cap table with your attorney anytime an event occurs. Anytime you make a change, hire a new employee, issue a round of funding, etc., you will need to review the equity plan and update the capitalization table. Just as you would check in with your accountant quarterly, you’ll also want to review your cap table on the same schedule at a minimum. As a business owner, it’s important to understand how much of the company everyone who’s invested in it owns.
To recap, when getting started with equity allocation, remember to think back to the purpose of allocating equity: to incentivize future contributions and instill long-term commitment. The goal is to balance allocating equity among co-founders while leaving enough available to sustain continual growth and hiring. Be strategic. Don’t make concessions now that you can’t live with in the future.
For more context and brief examples of the topics above, listen to the webinar I hosted on Determining (co)Founder Equity and Compensation.