How Startup Equity Works

Welcome to Phase Two of a four-part Splitting Equity Series. If you missed it, start your journey here: Introduction - Early Startup Equity — Getting it Right before continuing on if you haven’t already, and go in order from there.

Phase One - Startup Equity - Avoiding Early Mistakes 

Phase Two - Part 1 - How Startup Equity Works ( ←YOU ARE HERE 😀)

• Part 2 - Startup Stock Options

• Part 3 -Startup Stock Vesting

Phase Three - How to Split Equity

Phase Four - Equity Management

Let's continue!

Startup companies have been wrestling with how to structure stock ownership forever. As private companies we have major decisions to make, from raising venture capital to awarding key employees with equity to just splitting equity among co-founders — we need a structure that makes sense (and scales!)

Startup founders have a handful of directions they can take to divide their startup's equity. We'll explain the most popular approaches toward dividing ownership interest in early-stage startups while weighing the pros and cons of each.

Warning: Be Careful before you Grant any Startup Equity!

Here's how most new founders approach their cap tables: they want to get their startup company up and running quickly so they spend 5 seconds determining how much equity to dole out.

Perhaps they give huge equity packages to early key employees who never pan out. Or they divide their capitalization table among the founders 33/33/33 before they realize one Founder won't make it past Year 1. This happens all the time!

We're going to walk through a process for determining which startup equity approach makes sense for your situation.

How to Approach Startup Equity among Co-Founders

We don’t necessarily need to agree to all of these items right now, but it does help to at least try to focus on some of these issues so that we can get some cycles as a team in coming to a consensus.

These are decisions that shouldn’t affect any one member individually. We’ve deliberately separated this from the discussions around individual equity stakes and the conditions of managing someone’s equity so that we can isolate those discussions when the time comes.

Said differently: if we can’t agree on the basic stuff... we’ve got bigger problems.

Many ways to Accomplish our Goals

Not all stock is created equal.  When it comes to determining how our stock structure works, we have a handful of different ways in which we can hand out our stock.

For example, we can give members 100% equity ownership in our company or we can just give them the option to buy equity at some later date (stock option). We can even create something called “phantom equity” that provides a financial benefit like stock but isn’t actual equity in the company. 

It’s worth at least having a basic understanding of the 3 most popular types of stock we can issue even if we just arrive at the default decision of “just give everyone regular equity.” There are some important nuances in how we might want to structure our stock so that we aren’t giving away ownership or controls that we don’t need to. Most people don’t realize this is even an option, so it’s worth knowing about.

3 Methods of Startup Equity Distribution

By default, the startup founders of private companies have "Regular Equity" — we own actual shares of the company's stock. This is the same equity startup investors like angel investors or venture capitalists would get in a priced equity round.

That's not necessarily the same structure that our employees who receive an equity grant or incentive stock options would get. Once we set up lots of people for a liquidity event, how we structure that deal for them really matters. This is where the 3 stock structures come into play.

3 ways to Grant Employees Stock:

Let's first take a look at how the three methods of distributing stock and then we'll dig into the Pros and Cons of each. It's worth noting that there could be a combination of offers as well. For example, the co-founders, angel investors, and venture capital investors will all get equity, but employees, formal advisors, and some third-party sources may get stock options.

1 - Regular Equity

Employees can be offered equity at a fair market value just like we have. They can be put on a vesting schedule which is typical in the startup world and earn their equity over time. This can sometimes create a situation where they have to pay taxes on company shares even before they have a liquidity event. This is often how any startup founder will divide equity among their fellow co-founders.

2 - Stock Options

Early-stage employees can be granted stock options to buy stock in the company at a later date.  That means right now they don’t “own” anything, but in the event the company is sold or goes public, they can “exercise” the option to buy their shareholder's percentage at any time.

3 - Phantom Equity

Phantom Equity ownership is a lesser-known variant that provides employees the cash benefit of equity (getting a cash payout upon a liquidity event) without having to own actual equity (which could force them to pay taxes early). This works more like a company bonus structure, whereby if the company hits certain milestones (typically a sale) the team gets a percentage of the proceeds.  

Let's start with Regular Equity Ownership

Similar to startup investing, there are pros and cons to how startups approach giving and getting equity. Mind you, most of our focus here won’t be on what type of stock the Founders get in the company — we’re focused on what everyone else gets.  Chances are the startup founders are getting regular ol’ equity. 

We're going to break this lesson into 2 parts. The rest of this lesson will cover "Regular Equity Ownership" and the next lesson will cover "Stock Options" and "Phantom Equity" in detail.

Regular Equity Ownership

The most basic form of offering equity is just to offer an ownership stake in our company. If we award a member a share, it’s theirs and that’s all there is to it. Sounds simple, right?  

For the most part, it is. If you and I split our equity 50/50 and we both own half of the company, that’s easy to understand. And millions of companies have been founded with exactly that structure in place, so while it doesn’t solve every problem, it definitely has a strong track record.

What is often lost in that translation is how equity is distributed. Simply slicing up the pie amongst a handful of co-founders is one thing, but once we start to hand equity out to a larger group of people, particularly employees, things start to get way more complicated.  

When to use Regular Startup Equity

When we want to divide the company amongst a small number of active members who will all share the responsibility of managing the company long term. While that sounds like something reserved for small-cap tables with a small number of people, we're really talking about where it starts.

Every cap table begins with a small number of participants and therefore we tend to distribute equity first. Soon thereafter as we grow, we will likely look to offer additional participants (employees, etc.) a stock option instead.

Benefits

• Easy to understand for a small number of participants

• Very common method used by millions of startups since the dawn of time

Drawbacks

• Potential control issues with adding more members

• May not be financially able to buy it back

• Will likely have tax consequences for the recipient

• May add members who cannot financially support the business

• May accumulate dormant equity holders 

There are some meaningful drawbacks to just handing out equity and that’s really the heart of the discussion.

First off, we have to make sure that handing out equity is the best way to accomplish our goals. If our goals are to reward talent with compensation in the event we sell or want to distribute profits, we don’t need to give regular equity to do it. We can, but it’s not necessarily our best or only option.

Second, we need to understand the challenges around just handing out straight equity because that is really what may drive our decision to use Stock Options or Phantom Equity to accomplish our goals.

More on the Drawbacks of Regular Startup Equity

Most Founders have no idea why using regular equity would have any downside because, frankly, most people have never done this before (why would we have?). Let’s look at the main costs and challenges we may face by handing out regular equity:

1. We introduce control issues. When someone owns a legal share of a company, they often have specific rights ranging from voting options to complicated fiduciary rights. If our goal is to create cash incentives on the upside, we don’t necessarily have to introduce complex control issues as well.

2. We may not be able to afford to buy it back. If we want to buy back a share of actual equity, there is likely a fair market cost to do so. The problem is that we probably won’t have a bunch of cash sitting around waiting to “buy someone out” and therefore we may be stuck.

3. It may have tax consequences. Fun fact — if we get handed a share of equity, and that equity has marketable value, the IRS may tax us on the value, regardless of whether we have any actual cash to show for it. That could be a massive problem for anyone that just got granted equity. This is a complicated legal and tax matter that we’ll definitely want to discuss with our advisors.

4. Recipients can’t financially contribute. Technically, every shareholder in the business is responsible for the same liabilities of the business including paying taxes and absorbing additional costs. Do our employees intend on putting money back into the company as their share of ownership? Probably not. They want the upside, not the downside.

5. May accumulate dormant equity. If we can’t buy back the equity from folks who have left, over time we may find ourselves with swaths of equity holders who aren’t contributing any ongoing value (they left years ago) yet are still eating up valuable equity that could be used for raising venture capital or awarding current employees. Not to mention working for people who don’t work there anymore is a bit disheartening.

After reading all of those potential challenges we may say “Woah! That’s bananas. Let’s definitely not give away regular equity!” And we may be right, but let’s use these challenges as the backdrop to understand why startups consider Stock Options and Phantom Equity as alternatives to some of these challenges.

Key Equity Compensation Terms

Before we get into the weeds on some structural decisions, let’s make sure we’re good on some key terms that will come up over and over. Key terms are super boring to read, so let's keep our attention on the absolute most important moving parts. These are the pieces that you absolutely need to know if you're going to do even a basic equity split.

Cap Table 

A spreadsheet that lists how many shares each person or entity has in the company. If we own 10,000 shares and the company has a total of 100,000 shares, we "own 10% of the cap table."  

Option Pool 

This is a portion of the Cap Table that's set aside for future employees. Instead of diluting all of the members every single time we hire a new employee with stock, we do one "round of dilution" that affects everyone in order to set aside a "Stock Option Pool" from which smaller grants are distributed. If there are unused Options when the company sells, the unused parts typically go back to the original holders.

Dilution 

Whenever the amount of shares we hold is reduced ("diluted"), typically when we add more members to the Cap Table like investors or employees.

Equity 

Equity is an actual ownership stake in the company. It's often confused with "stock" which isn't always ownership in the company (because it's often conflated with the term "stock option").

Stock Option 

Stock "options" are an agreement that we have the "option" to purchase stock in the company at a predetermined amount.  

Strike Price

The price at which a single share in the company will be made available to purchase. If we had 100 Stock Options and the Strike Price was $5, that means it would cost us $500 to "exercise our option" to buy the stock. We'd only do that if the stock were worth more than $500.

Valuation 

The value of the company either now or in the future. While this value is often speculative, it provides a very real determination of how much stock a particular investment will yield in the company. If the company has a $1 million valuation, and someone invests $100k, they will own 10% of the company.

Vesting 

Instead of awarding all of our stock at once to a member (including Founders), we set up a schedule to “vest” the stock so that a member earns it over a fixed period of time, similar to the way they earn a paycheck throughout the year. 

Next Up - Stock Options and Phantom Equity

Now that we have a full handle on how regular equity works let's do a deep dive into the other two variants - Stock Options and Phantom Equity. We'll also compare the Pros and Cons of these options so that we can make a solid, informed decision on how to structure our stock.

Be patient here! There's very little reason you should understand the nuances of all of these structures your first time out (or your third, or your fourth!)

The most important thing right now is to absorb all of the options, ask tons of questions, and get a feel for where things might work best for you.