A Complete Guide to Equity

RochelleBailis by Rochelle Bailis on June 25, 2014
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You’ve started a new company, and now it’s time to decide how you’ll split up ownership of the business between you, your co-founders and—let’s hope—your future employees.

The basic idea of startup equity is rather simple: In their early years, young companies don’t have the capital to pay employees a competitive salary that’s made up entirely of cash, so the companies compensate them in part with stock in the company, or equity. The arrangement incentivizes employees to work extra hard and in the best interest of the business because if the value of the company grows, so does the value of their equity.

But in practice, issuing startup equity is anything but simple. There’s dilution, vesting, capital contributions from investors and many other things you need to know about before doling out stakes in your company.

First, let’s define “vesting,” a crucial concept for founders and employees to understand. Vesting is the technique that allows employees to earn their equity over time. At startups, equity typically vests over four years, meaning employees must stick around for four years in order to own all their equity. If employees leave the company before the four-year period is up, they only receive a percentage of their stock based on the terms of the vesting schedule.

Industry standard for vesting schedules, according to Brad Feld, a Boulder-based venture capitalist, is a one-year “cliff” and monthly thereafter for a total of four years.

“This means if you leave [the company] before the first year is up,” Feld writes, “you don’t vest any of your stock. After a year, you have 25% (that’s the ‘cliff’). Then—you begin vesting monthly (or quarterly or annually) over the remaining period. So—if you have a monthly vest with a one-year cliff and you leave the company after 18 months, you’ll have vested 37.25% of your stock.”

But not all equity is created equal. Here are the four most common types of equity issued by startup companies:

1. Founder Stock

  • This is the stock that founders issue to themselves when the company is created. It is typically subject to vesting provisions that ensure a founder doesn’t jump ship early on and still retain all their stock. Those provisions typically extend to outside investors in the company.

2. Restricted Stock

  • This stock is commonly issued to employees or top executives when the company is founded, or shortly thereafter, and the stock value is very low. Holders of restricted stock own the shares from the day of their issuance and typically receive preferable tax treatment from the sale of the stock if it is held for at least one year. (Making an 83b election is recommended for maximum tax savings in the instance of a rising company valuation.)

3. Options

  • Stock options, the most common form of equity compensation, give employees the right to purchase common stock in the company at some point in the future at a set price, also known as the “strike price.” A low strike price can be worth a lot of money in a company where the value is climbing quickly.

4. Restricted Stock Units

  • These are a relatively new form of equity compensation that is subject to vesting provisions and generally becomes actual, tradable stock only after a large infusion of outside capital, such as from an initial public offering (IPO) or from the sale of the company.

Once you have a solid grasp on the different types of equity that can be issued, it’s time to answer the million-dollar question: How do I allocate equity in a fair way?

While it’s easy to get caught up in sophisticated spreadsheets, Joel Spolsky, cofounder and CEO of Stack Exchange, has a relatively straightforward way of answering that question.

As companies grow, Spolsky writes, they tend to add people in “layers.” By the time they’re big enough to sell or go public, he notes, they probably have about 6 layers: the founders and roughly five layers of employees.

According to Spolsky, “The founders should end up with about 50% of the company, total. Each of the next five layers should end up with about 10% of the company, split equally among everyone in the layer.”

For example, Spolsky explains:

  • “Two founders start the company. They each take 2500 shares. There are 5000 shares outstanding, so each founder owns half.
  • “They hire four employees in year one. These four employees each take 250 shares. There are 6000 shares outstanding.”

(Go read Joel’s post to understand how he sets up additional employee layers.)

As new employees join your company and investors contribute capital, they’ll receive shares in exchange. This increases the total number of your company’s shares and thereby decreases the value of existing shares, also known as “diluting” shareholders.

Sticking with Spolsky’s example above, imagine two founders give themselves 2,500 shares each so that they each own 50% of a company when it’s created. Then an investor comes along and offers money in exchange for one-third of the firm. The founders could then dilute their holdings by creating another 2,500 shares and giving them to the investor so that the investor and the two founders each own 2,500 shares, or what is now one-third of the company.

Given all the occurrences that can complicate startup equity, Chris Dixon, a San Francisco-based entrepreneur-turned-venture-capitalist, urges startups to keep things simple.

“The one number you should know,” he writes, is “the percent of the company you are being granted (in options, shares, whatever—it doesn’t matter—just the [percent] matters).” Everything else, Dixon adds, including the number and price of shares, is “meaningless.”

RochelleBailis

Rochelle is an experienced business writer, marketer and researcher. She is currently the Senior Editor and Content Producer at Intuit.

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