Startup founders come up with inventions and innovations. However, they need to raise funds to establish and grow their businesses. To do this, they develop a financing structure and identify potential investors to fund their idea.
Ideal investors who believe in the startup idea give out equity in order to propel its success. In very basic terms, as many of the best books on private equity will explain; equity refers to the company ownership rights that startup founders give investors in exchange for funding or team member benefits.
During the early stages, startup founders may give up significant equity to investors to match the risk they take in funding the startup. The percentage of equity changes as the startup increases value and investors agree to less equity or decide to pay more.
Challenges in handling equity
But even as entrepreneurs raise equity from investors and build strong teams to establish startups, they can experience difficulties keeping tabs on equity or understanding ownership structures due to work demands.
Also, first-time entrepreneurs aren’t knowledgeable about stock options for team members and how financing rounds can affect their dilution over time. These issues keep them from paying attention to details until a problem arises.
To avoid such problems, startup founders can use equity management software such as Cake to handle equity data from the onset. If you’re planning to issue equity in your company, here are some valuable tips to help you handle it correctly:
1. Practise founder share vesting
Vesting of founder shares is an essential practice in handling startup equity. Essentially, vesting means startup founders retain all stock shares or a percentage of shares in their name for a specific period or after quitting the company.
Vesting enables startup founders to leverage their sweat equity and remain committed to the business for several years. The company may purchase unvested shares at a lower price than the open market rate.
2. Manage your startup’s cap table
Proper management of cap tables is one of the critical aspects of handling startup equity. Startups use cap tables to manage company ownership. Ideally, startups list their company’s securities, including preferred shares, common shares, warrants, who owns those shares, and the prices paid for each security.
Furthermore, the cap table shows the percentage of equity for each investor, the value of the securities, and how they dilate over time. The content of cap tables informs founders’ financial decisions about market value, market capitalization, and equity ownership.
Cap tables are often prepared before other startup documents. Although they may be simple at this stage, they become complex after several funding rounds as details of potential funders, mergers, initial public offers, and acquisitions are added.
Due to the critical information that your company’s cap table carries, failure to update them or committing data entry errors can compromise a startup.
You can manage your startup’s cap tables better by ensuring you know your founders, reviewing the tables regularly, and centralizing equity data. Avoid taking more than you can handle. Ensure you get enough information about equity shareholders and keep away from improper agreements.
3. Opt for fair equity splits
In a startup, partial ownership can be distributed evenly or fairly between investors and founders. And, in some instances, it includes employees where founders decide to reward talented staff with ownership shares.
Founders are motivated to give equity shares to employees to compensate for the large salaries they can earn elsewhere and reward them for agreeing to work in the startup’s uncertain environment.
Splitting equity evenly among the three groups means each receives an equal percentage of equity. On the other hand, a fair equity split means distributing equity based on contributions made. Although a fair equity split can be daunting, considering factors like ideation, salary replacement, startup onboarding stage, and seed capital contribution should make this exercise a dodl.
Under ideation, consideration is given to the individual or teams that crafted the main value proposition for the startup. Salary replacement involves considering founders and employees who accepted lower pay because they believed in the startup’s future value.
On the other hand, the startup onboarding stage begins when founders or employees join the company, while seed capital evaluates the investment amount of a startup’s valuation.
4. Final thoughts
Equity plays a vital role in enabling startups to raise the much-needed capital to establish the business. However, companies in the startup stage have to deal with risks associated with allocating equity to other parties or onboarding new investors.
To manage those risks well, founders must structure equity appropriately and manage it well. If you’re considering issuing equity shares for your startup, applying the four tips discussed above can help you handle it better and minimize its long-term impacts.