Equity Allocation in an Early-Stage Startup

Equity Allocation in an Early-Stage Startup

Startups are different from small businesses. Startups are generally technology-based, expect to raise capital from investors, plan to scale at a high velocity, and expect to reach an exit event whether an IPO or an acquisition within 10-15 years. So why do startup founders behave like a small business when splitting the equity pie? Many startups spend at most 30 minutes dividing the pie among founders. Equity is often evenly divided and granted outright. Without the correct paperwork, equity is not vested; the IP is likely owned by five different people or more, only a couple of whom are the founders; and one of the founders has bailed with half of the equity. This is a common scenario. (Remember Facebook and the Winklevoss twins?) If the company becomes successful like Facebook, lawsuits will fly back and forth. But even early-stage startups face lawsuits. The only difference is that an early-stage startup could be killed by a real or perceived lawsuit, while Facebook can manage the blow. The key takeaway for startups is that no investor will want to work with a startup where one of the founders has jumped ship with a significant amount of equity (a wayward founder, if you will).

Standard Vesting Terms

Imagine you are the founder of a startup. You bring to the table the innovation that will change the world (hopefully for the better). You also bring technical skills. On top of that, you just quit your high paying job to pursue this crazy idea of yours! If you were to ask the average person on the street how much of the company this founder should own, the layperson would likely say 100%. They wouldn’t be wrong, or would they?

Not this kind of “vest”ing.

(Not this kind of "vest"ing.)

We call this subsection “Standard Vesting Terms” because vesting has become just that-standard. For the most part, a founder will own 0% equity in her own company in her first year. Quite a far cry from what common sense tells us—that the founder should own 100% of the company.

Realistically, the founder will never own 100% of the company. Why? Because the startup wants investors. Investors want equity, which results in the inevitable dilution. Startups also want employees who are invested in the company and are willing to put in long hours for below market compensation for the chance at a potentially lucrative future payoff. Startups want employees who have skin in the game. Once again, this results in dilution.

Going back to the standard vesting terms, the first year when the founder or the employee or consultant owns 0% equity is called a “cliff.” Once the individual demonstrates her initial commitment, 25% of her equity will vest upon the one year anniversary of the hire date. This generally applies equally to founders. After the first 25% vests, the remaining equity will vest monthly on a pro rata basis for the next 3 years.

Acceleration

Sometimes equity/employment agreements will discuss acceleration. For example, what happens if a founder gets kicked out of the team or by the board for no reason? If the founder pre-negotiated his termination terms, he may be able to accelerate his vesting by 3-6 months. From a startup’s perspective, if the founder is terminated for cause, he may not be entitled to any further compensation.

Single Trigger Acceleration

If the company is acquired before all of an equity holder’s stock has vested, sometimes the equity holder will get single trigger acceleration. Single trigger acceleration means that most or all of the equity holder’s stock will vest upon the acquisition/exit event. But remember that this must be pre-negotiated.

Double Trigger Acceleration

Investors and acquirers may prefer to see double trigger acceleration, however. Double trigger acceleration is like single trigger acceleration in that the equity will vest immediately. But the triggering event in this instance is not the acquisition itself, but an involuntary termination upon the acquisition. For example, let’s say that the acquiring company wants to replace the CFO once the acquiring company is in control of the startup. If the CFO pre-negotiated a double trigger acceleration, the CFO would vest all of her shares upon the termination.

Developing an Equity Grant System

It’s a good idea for founders to consider developing a system for granting equity. This will prevent making decisions on the fly when hiring.

One method of determining how much equity to grant is by thinking of your equity in layers. The first 75% may be allocated to the founding members and investors. The next 10% may be allocated to the first 3-5 members of the founding team. The next 10% may be allocated to the next 10 to 20 early employees. The last 5% may be allocated to the next 20-100 employees. At this point, you are no longer an early-stage startup and your hiring needs go beyond the scope of this article.

A second method of determining equity allocation is the market value method. This method examines the difference between the market rate an established company will pay for a comparable employee and what the startup has available in funds to pay the employee. The difference will be the value of equity that is granted to the employee. This method requires some more research into market rate salaries, which can be done using AngelList and Glassdoor and understanding the valuation of your company.

As an example, let’s say the market rate for someone you want to hire is $120,000. Your company can only afford to pay $100,000. The difference of $20,000 multiplied by the number of years the employee will be paid below market rates will be made up with the equivalent in equity. If your company expects to bridge the gap in salary within 1.5 years, then multiply $20,000 by 1.5 and you arrive at the deficit of $30,000. If the company’s most recent valuation was $1,500,000, then divide $30,000 by $1,500,000 to arrive at a 2% grant for this employee.

So how does a startup and a founding team split the pie?

Splitting the pie is not an exact science, but years of experience and data show us some patterns that have emerged among successful startups. And just as with any successful process, others follow suit and emulate them. Here, we will discuss very general ranges of equity allocated to founders, investors, employees, board members, consultants, and advisors.

Splitting the pie

Founders’ Equity

Before calculating founders’ equity, startups are often advised to consider setting aside 10-25% of the pie as an option pool for employees. After that, deduct another 20% for investors in a future round. You might be left with about 65% to allocate to founders.

Investors

On average, investors take 20% per round, starting with the Series A round. Investors also like to see an option pool set aside for employees.

Founding Team – the first hires of a company

The Lead Engineer may receive 1-3% equity. The Senior Engineer may receive .33-2% equity. The Product Manager may receive .1-1% equity.

Early Employees

A Developer may receive .025-1.5% equity. A Marketing Manager may receive .025-.5% equity. A Designer may receive .01-.5% equity.

Advisors, Board Members, and Consultants

These are people who are not involved in the day-to-day operations of the business. They are brought in for their industry expertise or to accomplish a specific task. They tend to receive between .25-1% equity.

Parting Words

Every startup is unique. There is a unique number of founders with a unique set of skills who are selling a unique set of goods or services and who have a unique vision. Startups are synonymous with breaking rules, challenging existing systems, and innovation. Granting equity does not have to look cookie cutter. But sometimes, learning from someone else’s past mistakes can make all the difference to the success of your startup.

Disclaimer: This article is provided for educational and informational purposes only. An attorney-client relationship is not formed by visiting this website, commenting on this post, or submitting information through the Contact Us form. The information provided here is not intended to, and should not replace, advice from a licensed attorney in your state. Kimberly Shin Law Firm PLLC disclaims all liability with regard to any and all actions taken or not taken as a result of information contained here.