Equity Management Guide

According to Paul Graham, co-founder of Y Combinator (YC), approximately 20% of YC startups resulted in a founder leaving. Frequently, the conflict arises from equity splits. Research by Harvard Business Review indicates that the percentage of founders dissatisfied with their equity split increases by 2.5x as their startups mature.

Equity split refers to how ownership shares are divided among co-founders, investors, and employees. Overtime, founders may feel dissatisfied from the initial division of ownership between them or the resulting share they retain after considering investors' and employees' stakes. 

A lot of these issues surrounding equity can be solved through effective equity management.

What is equity management?

Equity management involves overseeing the distribution and administration of a company’s ownership among its stakeholders. It determines how much equity each party receives, implements vesting schedules, handles stock option grants, and ensures compliance with legal and financial regulations.

Equity management can be broadly divided into three categories:

1. Cap table management

‍To manage equity effectively, start with a well-organized cap table. It is a digital record that acts as the single source of truth for your ownership structure. You can use our cap table management software to maintain this transparently.

 A cap table tracks:

a. Shareholder information: Names, addresses, contact details, and the number of shares held by each investor.

b. Ownership percentages: The proportional stake each shareholder holds in the company.

c. Investment details: It records investment amounts, types of equity issued (common stock, preferred stock, etc.), and any vesting schedules for stock ownership plans.‍

d. Transaction history: A cap table also maintains a record of changes in ownership caused by the issuance of new shares, repurchases by the company, and transfers between shareholders.

Read our cap table management guide to know more.

2. Equity administration

This is an important part of equity management as it ensures storage and convenient access to all relevant information like: 

a. Shareholder agreements: These are legal documents outlining the rights and obligations of each share class.

b. Employee stock ownership grants : Data of stock options granted to employees, including vesting schedules and exercise prices.

c. Dividend payment records: It maintains historical data on dividend payouts to shareholders.

d. Meeting minutes and resolutions: It details key decisions made regarding equity, such as stock splits or issuance of new shares.

e. Board communication: Company performance, upcoming votes on important decisions, and any changes to ownership terms are mentioned here.

f. Company valuations: Keeps track of all your past valuations and Fair Market Values (FMVs).

3. Compliance

Compliance is a non-negotiable part of equity management. It makes sure you adhere to the legal and regulatory requirements by:

a. Understanding securities laws:  Depending on your location and the types of equity you offer, you might need to comply with specific securities laws governing how these instruments are issued, traded, and reported.

b. Following regulations: Stay informed about relevant shareholder communication protocols, proxy voting procedures, and reporting requirements specific to your company type (public or private) and geographic location.

Types of equity

Knowing the different forms of equity that exist is useful when structuring your own equity plan. Not all ownership is created equal. Equity comes in various forms, each offering distinct advantages and considerations:

1. Common stock

Common stock represents the most basic form of ownership in a company. It is typically held by founders and employees. Owners of common stock have voting rights in corporate decisions and may receive dividends when the company distributes profits. 

However, in the event of liquidation, common stockholders are paid last, after creditors and preferred stockholders.

‍2. Preferred stock

Preferred stock is a type of equity that has certain advantages over common stock. 

Unlike common stockholders, preferred stockholders usually do not have voting rights (except in some cases) in corporate decisions. However, they often receive dividends that are paid out before common stockholders. They also get preference in the event of liquidation, providing them with greater security.

3. Employee ownership and incentives

Employee equity is a part of common stock but it is structured differently than founder’s equity. Company’s can either have one or a combination of the following plans.

a. Employee Stock Ownership Plan (ESOPs): They are a type of incentive compensation that grants employees the right, though not the obligation, to purchase company stock at a predetermined price, known as the strike price, within a specified period, called the exercise window. ESOPs also have a vesting schedule and a cliff period to encourage employees to stay longer with the company.

Read more about ESOPs.

‍b. Restricted Stock Units (RSUs): RSUs represent a promise to give actual company stock to the recipient after they meet certain conditions.These conditions typically involve time, such as vesting over a set period, but they can also be based on performance metrics.

Read more about RSUs.

‍c. Stock Appreciation Rights (SARs): This offers recipients a cash bonus tied to the company's stock price growth, without giving actual ownership (shares). This alignment of incentives ensures that employees benefit from an increase in the stock price while the founders maintain ownership without dilution.

Read more about SARs.

4. Advanced equity structures

These are instruments through which companies can raise capital from investors, they usually convert to preferred stock.

a. Convertible notes: Convertible notes are a common form of debt financing used by startups to raise capital. Unlike traditional loans, convertible notes can convert into equity in a future financing round.

The key feature of convertible notes is that they usually convert at a discount to the valuation determined in the subsequent equity financing round, or with a valuation cap to protect investors from excessive dilution. They also typically include provisions for interest payments and maturity dates.

‍b. SAFEs: Simple Agreements for Future Equity (SAFEs), allow investors to invest capital in a startup in exchange for the right to receive equity in the company at a future financing round.

Unlike traditional equity financing, SAFEs do not specify a valuation of the company at the time of investment or an immediate equity stake. Instead, they leave it for a future date.

SAFEs are not debt instruments. 

‍c. Warrants:  These are contracts that give the investor the right to purchase shares of the company at a predetermined price and exercise window in the future. They function similar to stock options but are issued to investors instead of employees. Warrants are often used alongside convertible notes, with the note converting upon specific conditions, and the warrants providing an additional potential upside for the investor.

Equity split

Now this is the most critical part of equity management and also the primary reason for discontentment between stakeholders.

Founders initially own 100% of the company's equity. However, as the company grows, seeks to raise capital, and attracts talent, they begin to allocate a percentage of ownership to others. With each new investor joining the mix, the portion held by existing stakeholders shrinks.

But, a big challenge here is figuring out just how much equity each stakeholder should get.

Equity split between founders

Contrary to popular belief, a 50/50 equity split between co-founders isn't the best choice. Antler reports that start ups with equal founder equity splits were 3x more likely to face team dissatisfaction. Despite this an equal equity split among founders remains the most common type of arrangement. 

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An equal split may seem fair initially but it does not accurately reflect the value each founder brings to the company. In many cases, founders have different skill sets, experiences, networks, and levels of commitment. Therefore, an equal split may not appropriately recognize the varying levels of investment and effort put forth by each founder. Allocating equity based on individual contributions allows for a more equitable and balanced distribution of ownership.

The CEO premium

When deciding the equity split, founders should also be mindful of the ‘CEO premium’. The CEO is a strategic thinker in the business, setting the company's direction, and leading the team towards its goals. As the company expands, the CEO's role and impact often grow disproportionately compared to other founders. Thereby demanding a larger share of the equity.

Take Uber for example. It all started when Garrett Camp began developing an app for hailing cars using smartphones. But when Uber went public, Camp held a 4.6% ownership stake, while Travis Kalanick, who served as CEO until 2017, owned 6.7 %.

At the same time, a very skewed equity split such as 80-20 is also not ideal. It reflects poorly on the perceived value that founders assign to each other.

Co-founders must have an open dialogue about the equity split, however difficult it may be. Ignoring this crucial conversation early on can lead to even bigger problems down the road. Consider seeking advice from external experts or utilizing simple tools like questionnaires to facilitate the process.

Equity split for employees

Having a great team is crucial for success. However, competing for talent with large corporations that offer high salaries and perks can be challenging. Nonetheless, startups have a significant advantage in their ability to offer generous stock options. The potential for equity upside in smaller companies can be far greater than what established tech giants can offer.

But how much equity should you give to employees?

Typically, during the seed stage, an ESOP pool size accounts for about 10% of the total company equity. This is supported by both Index Ventures and Balderton Capital also agree with this.

Beyond the benchmarks, the size of your ESOP pool depends on several factors, including:

• The need for multiple key hires.
• Outsourcing early development versus hiring in-house engineers.
• The size of the ESOP pool of your competition.
• The level of competition for the specific talent you are seeking.

Companies over time also  top up their initial ESOP pool. 

In the US, ESOP pools typically increase from 10% at seed to 15% at Series A, and continue growing with each subsequent funding round. By Series D, the pool may reach 20% or even 25% as noted by Index Ventures. 

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Equity split for Investors

Investors usually take up the biggest piece of the pie.

Usually, businesses that stay in the game go through 3-4 rounds of equity funding in their lifetime, giving up almost 55-70% ownership, mentioned Fred Wilson, a VC since 1986 in one of his newsletter editions.

However, it's important to note that these figures are not set in stone. They are estimates derived from data collected from numerous startups. Your specific situation may or may not align with these estimates.

Calculate cost of equity

When giving away equity, you should have some sense of its potential worth. This ensures you don’t dilute too much for too little.

To understand this, you can check for startups in a similar niche that have gone public. While you may not find detailed information about each investor’s contribution in each funding round, analyzing their ownership structure and total funds raised can give you a sense of the overall cost of equity if your startup becomes successful.

For instance, Tableau, founded in 2003, raised a total of $15 million before going public in 2013. Its Series A and B investor, who invested $5 million and $10 million in 2004 and 2008 respectively, ended up with 38% ownership and 20 million shares at the time of the IPO.

Tableau's IPO price was $31 per share, which meant the investors made $620 million, a whopping 40X return!

Common equity management mistakes to avoid

Now let’s look at some popular equity management mistakes people make.

‍1. Lack of strategic planning

Without strategic planning, a startup risks diluting ownership, misaligning incentives, and encountering challenges in raising additional capital.

Consider a scenario: a startup allocates equity to employees without a defined growth plan. This oversight may lead to premature distribution of excessive equity, diluting the ownership shares of founders and initial investors. Subsequently, attracting top talent becomes challenging due to over-distribution of equity. As the company expands, this oversight could impede its ability to secure additional funding rounds.

‍2. Failure to seek expert advice

Seek guidance from experienced professionals to make informed decisions on equity issuance, valuation, and structuring. Failing to do so could result in over-dilution of ownership, misallocation of equity incentives, and potential legal or regulatory compliance issues.

For instance, a startup might forgo legal counsel when drafting complex equity agreements. This could result in ambiguous contracts that overlook crucial matters such as vesting schedules and anti-dilution provisions, ultimately leading to disputes among stakeholders in the future.

3. Communication complexity

Complexity in equity management arises when stakeholders struggle to effectively communicate and understand equity-related matters. This may be due to the use of jargon or unclear communication channels. To tackle this challenge, promote open dialogue and ensure everyone comprehends equity-related topics clearly.‍

4. Rigidity in approach

Rigidity can manifest in various ways, including adherence to outdated practices, reluctance to adapt to changing market conditions, or resistance to innovative equity models. When a company adopts an overly rigid approach, it can hinder its ability to capitalize on emerging opportunities and respond effectively to market dynamics.

For example newer equity compensation plans, which offer increased flexibility compared to traditional models. These plans allow for customization, such as early exercise options and the opportunity for employees to buy additional stock via employee stock purchase plans (ESPPs). Failing to adopt these flexible approaches may hinder a company's ability to attract talent, especially if their competitors offer these options.

‍5. Neglecting technology

Equity management software is essential for streamlining equity-related processes, guaranteeing accuracy, and improving transparency. Neglecting to utilize such software for tasks like cap table management, equity tracking, and compliance monitoring can result in inefficiencies, errors, and compliance risks. Additionally, relying on outdated manual methods can cause delays in granting equity, calculating vesting schedules, and issuing employee stock options.

Equity management software or spreadsheets?

Spreadsheets aren’t ideal for comprehensively managing equity. While it can be used for cap table management to a certain extent, other critical functions like drafting and storing shareholder agreements, issuing ESOP grants, sharing investor updates, and recording meeting minutes need to be handled separately.

In contrast, an equity management software streamlines these processes into a unified platform. With just a few clicks, you can access and manage all your shareholder agreements, ESOP grants, and other vital documents. Additionally, it also automates vesting schedules.

While spreadsheets may suffice for small companies with simple ownership structures, their upkeep can be cumbersome and prone to data loss. We advocate for the adoption of equity management software, which provides automation, data security, comprehensive reporting, and scalability to streamline your equity management process. 

Consider it an investment that not only saves time and reduces errors but also enables informed decision-making for your company's future.