What is startup equity?

Startup equity represents the ownership stake that founders, employees, and investors hold in a startup company. It is typically in the form of shares or stock options, entitling the holder to a portion of the company's assets and future profits.

Equity serves as a key motivator, aligning the interests of stakeholders towards the long-term success of the startup.

How do startups typically split up founder equity between co-founders?

Splitting up equity within founders mostly depends on certain key factors like:

• The level of skill
• Experience
• Level of commitment to the startup
• Responsibilities of the founder
• Whether the founder is bringing in source of funding or not
• What part of the startup the founder will be focusing on
• Depending on these, you can select the amount of equity to provide to founders.

Usually, in the early stages when starting the startup it’s not decided by these factors.

If you have a good relationship with your founders, maybe they are friends, or colleagues that you have worked with that you can trust and know how they work and know the amount of skill/experience they have and can bring — then these are what will decide how much equity you will divide among yourself.

A common pattern is equal division of equity, but it can differ based on each startup and the founders’ responsibilities.

How do founders typically acquire startup equity?

Founders acquire startup equity through the issuance of founder's shares, which are common shares distributed among the initial founding team. These shares are often granted at the inception of the company and represent the founders' ownership stake.

Additionally, founders may receive equity through incentive stock options or restricted stock units (RSUs) as the company grows and attracts investment.

What is the importance of startup equity for founders?

By holding equity, founders have a vested interest in driving the growth and profitability of the startup. Moreover, equity serves as a valuable tool for attracting top talent, incentivizing employees, and securing funding from investors.

What is vesting?

Vesting refers to the process by which ownership of startup equity becomes earned over time, typically contingent upon the individual's continued involvement with the company. When equity vests, it means that the holder gains full rights to the shares or options granted to them, allowing them to exercise control over their ownership stake.

Key Elements of Vesting:

• Vesting Schedule: A vesting schedule outlines the timeline over which equity vests.

• Cliff Period: The cliff period represents the initial period during which no equity vests.

• Acceleration: In certain circumstances, such as a change in control (e.g., acquisition) or termination without cause, equity vesting may accelerate, allowing the individual to gain immediate ownership of a portion or all of their equity.

Learn in-depth about Vesting: What are Vesting Schedules? Explained

Why is vesting important for startup equity for founders?

Vesting is crucial as it ensures that founders remain committed to the startup's long-term success. By earning equity gradually over a predetermined period, founders are incentivized to stay with the company and contribute their skills and expertise.

What happens to the shares of a co-founder who leaves before the company goes public?

Shares within a startup have vesting schedules. Meaning that over a period of time, the shares grow to take up their full amount. So when the company goes public and the co-founder leaves, depending on the terms in the founders agreement, the founder can retain this shares or may split up shares within the company to other founders and investors.

And, based on whether the shares would be vested or not, the founder will be able to financially benefit from the company going public based on the number of shares that have been vested.

Should co-founders in a startup vest their equity or get it all from the start?

The main reason for vesting the equity is that vesting your equity shows to other potential stakeholders like, investors, that you believe in the startup and are willing to work on it for the long term.

Vesting can also involve performance elements which will motivate the founders to work more harder on achieving them which is great for the business and financially beneficial for the founders, as compared to just getting all equity up-front. This is not the same in every startup, but in terms of equity, this is the best way to get better performance for the startup.

And especially if you are bringing in co-founders that you don’t know much personally, but are highly skilled and experienced, it’s in the best interest for you to vest their equity, as it shows that they can work long term and believe in the startup.

It also mainly shows investors that the founders believe in the startup, long term… So, do vest equity for both founders and early employees you give equity to, or anyone you give equity to.

Quick note:

We have already written a post on Equity compensation which goes into the basics of using equity as a form of compensation for employees, investors etc. This blog post aims to answer all the questions about Startup Equity and help founders fully understand what Startup Equity means and the full guide to get started with it.

What is Equity Dilution?

Equity dilution refers to the reduction in the percentage ownership of existing shareholders, including founders, when additional shares are issued or allocated. This reduction occurs because the total number of shares outstanding increases, thereby spreading the ownership among a larger pool of shareholders.

Causes of Equity Dilution:

• Fundraising Rounds: When new investors inject capital into the company, they typically receive shares in exchange, which dilutes the ownership percentage of existing shareholders.

• Employee Stock Option Plans (ESOPs): When these Stock options are exercised, new shares are issued, leading to dilution for existing shareholders.

• Convertible Securities: Convertible instruments such as convertible notes and convertible preferred stock may convert into equity upon certain trigger events, such as a future financing round. When conversion occurs, additional shares are issued, diluting the ownership of existing shareholders.

How does equity dilution affect the founders?

Equity dilution occurs when new shares are issued, leading to a reduction in the percentage ownership of existing shareholders, including founders.

While dilution is a natural part of the startup journey, founders should be aware of its impact on their ownership stake and take measures to mitigate dilution through careful negotiation and strategic decision-making.

Does a startup co-founder necessarily have to own 50% of the equity?

Owning more than 50% equity or more equity than other shareholders gives the founders more power in terms of running the company and making the decisions. But most of the time, when raising investments and hiring employees, the equity may get diluted to a lower amount.

But it’s not a must for the co-founder to have 50% equity, it would be highly beneficial both financially and in terms of making decisions, but depends on the situation of the startup, when they have to raise money, hire employees which may reduce the equity percentage overall.

How much equity does the first engineer at a startup who has secured the pre-seed round, usually get?

When raising pre-seed rounds, you maybe a early-stage startup.

Early stage startups mostly provide anywhere between 0.5% - 2% of equity in the startup.

If the first engineer is the only technical person in the startup and without a CTO, and the first engineer has a lot of the responsibilities of bring the first versions of the product, iterating it, bringing in and training the upcoming engineers into the startup, then these factors may push to a slightly higher equity, somewhere around 1.5%-2% would be ideal.

But if you do have a CTO who overlooks the technical things, and you are hiring your first engineer to help out, then this can be 0.5%-1%, but after all you are hiring your first engineer in your startup, so you can provide anywhere from 0.5–2% depending on the responsibilities and the situation in your startup.

What’s the standard equity stake for an advisor of a pre-funded startup?

In pre-funded startups, advisors often play critical roles in shaping the company's direction and strategy. While they may not contribute capital directly, their mentorship and connections can be instrumental in navigating the challenges of early-stage growth.

The standard equity stake for advisors in pre-funded startups typically ranges from 0.25% to 2% of the company.

However, this percentage can vary based on several factors, including the advisor's level of involvement, expertise, industry reputation, and the specific needs of the startup.

What is the % of equity startup companies usually give to the seed investors?

Seed investors usually receive equity stakes ranging from 10% to 25% of the companythough this can vary based on several factors.

These factors include the stage of the company, the amount of funding required, the perceived value of the company's potential, and the bargaining power of both parties.

The specific percentage of equity allocated to seed investors is typically determined through negotiation and agreement between the founders and the investors. Both parties must carefully consider their respective objectives and the long-term implications of equity allocation.

What are the different types of startup equity funding?

Startup equity funding can come from various sources, including angel investors, venture capitalists (VCs), crowdfunding platforms, and corporate investors.

Angel investors are typically wealthy individuals who provide capital in exchange for equity. Venture capitalists are professional investors who invest larger sums of money in exchange for equity and often play an active role in guiding the startup's growth.

Crowdfunding platforms allow startups to raise funds from a large number of individuals in exchange for equity or rewards. Corporate investors are established companies that invest in startups in strategic industries or sectors.

How much equity should a founding team member receive?

Ideally startups provide equal distribution of equity. For example, if there are 3 co-founders if your startup, then each co-founder gets 33.3% of equity in the startup.

But, as mentioned above, this depends on various factors.

Do startup employees get stock options if the company gets acquired by another bigger company?

If your question is whether the startup employees get stock options in the ‘acquiring company’ when the startup is acquired, it totally depends on the terms of the agreement.

There are different ways the stock options can go when the startup is acquired.

The acquiring company may fully vest your shares, meaning that all your shares will be vested and now you can either exercise them or sell them to profit from the acquisition.

The company may choose to purchase your shares, in exchange for their company shares or money.

So, in all sides, you can financially profit the acquisition, but whether you will receive shares of the acquiring company depends on the terms of the acquisition.

What happens if a founder wants to take back their equity?

This will involve negotiating with your shareholders (investors or early employees who have equity) on how the process should work, how the equity should be transferred, valuation of the company, price of the share and other legal requirements depending on where you are registered.

Or if there is a buyout agreement in place, the founder can act according to the terms of that agreement, buyback the shares at a given price on the agreement etc…

Taking back equity also means significant changes in distribution of equity in the company, therefore, it can impact decision making, leadership, the culture of the company, what the company works on, etc..

What are the tax implications of startup equity for founders?

Startup equity may have tax implications for founders, depending on factors such as the type of equity compensation, the timing of its issuance and sale, and applicable tax laws.

• Tax at Acquisition: When founders receive equity in a startup, they typically don't owe any taxes right away. The IRS doesn't consider equity as income until it's "realized," meaning until you sell or transfer the shares.

• Vesting and Taxes: If your equity vests over time (meaning you gradually gain ownership), you might face taxes as each portion vests. This is because the IRS sees the vested equity as income at the time of vesting. However, if you have stock options, you're not taxed until you exercise them (buy the shares at the predetermined price).

• Tax Treatment of Stock Options: When you exercise stock options, the difference between the fair market value of the stock and the exercise price (known as the "spread") is subject to taxation as ordinary income.

  If you hold the shares for a year or more before selling, any additional profit is taxed at the long-term capital gains rate, which is typically lower than the ordinary income tax rate.

• Tax Upon Sale: When you eventually sell your shares, you'll face capital gains tax on any profit you've made. The tax rate depends on how long you've held the shares. If you've held them for more than a year, you'll pay the long-term capital gains tax rate, which is lower than the short-term capital gains tax rate for shares held for a year or less.

• Qualified Small Business Stock (QSBS) Exemption: Under certain conditions, founders may be eligible for the QSBS exemption, which allows them to exclude a portion of their capital gains from the sale of qualified small business stock from federal taxation.

• Alternative Minimum Tax (AMT): Founders who exercise stock options may be subject to the alternative minimum tax (AMT), which is a separate tax system that ensures high-income earners pay a minimum amount of tax. The spread on exercised options can trigger the AMT, so it's crucial to understand and plan for this potential tax liability.

How can founders negotiate fair equity compensation?

Founders can negotiate fair equity compensation by understanding their contributions to the company, conducting market research on typical equity grants for founders in similar startups.

It's essential for founders to communicate their interests while also considering the needs of other stakeholders, such as employees and investors, to maintain a balanced and mutually beneficial relationship.

What rights do founders typically have with startup equity?

Founders' rights with startup equity may include voting rights, information rights, and rights to participate in future funding rounds. These rights are often outlined in the company's shareholder agreement and corporate bylaws.

Founders should familiarize themselves with their rights and responsibilities as equity holders to exercise effective corporate governance and protect their interests.

What happens to founder equity in the event of a startup's acquisition or IPO?

In the event of a startup's acquisition or initial public offering (IPO), founder equity may be converted into shares of the acquiring company or publicly traded shares, depending on the terms negotiated as part of the transaction.

Founders should carefully review the terms of the acquisition or IPO agreement to understand the implications for their equity holdings and seek legal and financial advice to maximize their value.

Have any more questions? Ask us.

These are the questions that we were able to gather, if you have a question that is yet unanswered, then please email to team@useairstrip.com and we will add your question and the answer to this blog post to help other founders as well.