The process of a getting a start-up off the ground is overwhelming. One of the critical steps to solidify a start-up and its foundation is nailing down the number of co-founders that the start-up needs, and what benefits those people will receive. Equity allocation is key, and your founders will be inquiring about this. If the stock is high, it is only fair to make the proper delegations. Why is this important? If you are the only founder, it’s not. But, if you are a team of two or more, then this issue is critical.
Typically, in the early stages, start-ups sometimes do not have enough revenue to pay salaries. One of the most popular ways to inspire and support co-founders is a start-up equity allocation. During this time, you typically also will not have enough information to predict founders’ contributions and added value. You won’t have any data that would be telling in accurately predicting the company’s potential. This means that the equity agreement will be an estimation based on best guesses.
Why Should You Allocate Equity Among Start-Up Co-Founders?
Many founder teams give too much credit and a large amount of the company’s equity to the person who came up with the idea for the company. Ideas are obviously very important, but they have no real-world value in the long run. Value is created when the whole team works together to execute on an idea. It should be highly discouraged to give a higher amount of stock to the founder who came up with the idea. Investors pay a lot of attention to these proportions. For example, if a founder owns 80% of startup shares, and the other two people only own 10%, the investor will likely have high doubts of the team.
When a start-up incorporates, a certain number of shares are authorized. Start-ups typically authorize 10,000,000 shares of common stock. This amount is easily dividable and will enable you to distribute round numbers of shares. It is important to allocate these shares evenly because it will motivate the co-founder and ignite excitement and determination while also showing the founders gratitude and respect towards them.
Who Gets Start-up Equity?
This question is quite simple. Anyone who is involved with the start-up should be involved in the equity allocation process. This can be investors, employees, or advisors that help get the start-up off the ground. Co-founders will be prioritized, then the investors are next. After all, they are the ones funding the dream and vision of the company because they believe in it.
Typically, independent start-up advisors get %5 of shares or no equity at all. Investors take about 20-30% of start-up shares, and founder receive 60% or more. 10% should be allocated to employees and an option pool. Start-ups should be thinking long term, and it is important during this process to strictly determine responsibilities within the team. When deciding a founder’s value, it can be divided in 5 categories: idea, commitment and risk, business plan development, domain expertise, and responsibilities. You can assign a value between 0 and 10, and then multiply by the founder’s score to determine a weighted score.
Vesting schedules determine when an individual may exercise his or her stock options. They are time-based and will vary depending on the start-up. The most seen vesting schedules include:
- A four-year vesting schedule
- A one-year cliff
- Single-trigger acceleration
Start-ups usually utilize a vesting schedule, which help to steer people away from leaving the start-up and reduce the risk of equity dilution.
It is important to note that dedicated employees can also receive equity shares, which are known as the employee stock option. Employee stock options are a type of equity compensation granted by companies to their employees and executives. Rather than granting shares of stock directly, the company gives derivative options on the stock instead. Start-ups use stock options frequently to reward their key employees at 10%. Employee stock options typically fall into two categories: outright award and performance-based award.
If you need assistance with understanding how to allocate shares or stock options within your start-up, NOW CFO can help. Our consultants have years of expertise working with start-ups and setting them up for success.