A straight-talking deep dive into the equity terms that matter for founders
Welcome back to Keeping your Slice of the Pie - The Startup Founder's Guide to Equity. This is a 3 part guide covering the basics of equity for founders or soon-to-be-founders.
In this second installment, we’re going to dive into the different types of equity your company grants to founders, investors, and employees. After you read this article, you will understand how equity works for each group so you can:
(a) Maximize your return at an exit - how to set up your founder shares correctly
(b) Better negotiate with investors - what terms matter beyond the valuation, and
(c) Hire talented employees - how to create a fair compensation plan.
This installment is a fair jump in complexity from the first. If you haven’t read our first installment which explains exactly what equity is, we recommend you start there.
And don't worry if this sounds complicated. You can use this article as a reference. You don't need to understand or even read everything today. Come back and reference the relevant section as you hire and fundraise.
Founders get equity by buying shares from the company. Founder shares are not automatically gifted to founders at incorporation (read more about company structure in our first Femstreet post here). Beyond the number of shares you receive, there are two key terms you should know when creating founder shares: vesting and acceleration.
What is acceleration (unique to founders)?
Acceleration means that all of your shares vest immediately if your company exits (i.e. if you get acquired). This is a founder-friendly term most investors accept. Acceleration helps protect against the downside scenario. You can sell your company and disagree on the product direction with the acquirer and get fired. With acceleration, you still receive the financial upside of all your shares vesting.
What is vesting (standard for founders AND employees)?
Vesting means that you don't own all of your company's stock today. Rather, you will receive your shares over a period of time called the vesting schedule. The standard vesting schedule is four years with a 1-year cliff. A four-year term means you receive all of your shares after working at the company for four years. The 1-year cliff means that you do not receive any shares until you work at the company for at least one year. The cliff protects against the case that the founder leaves after six months without contributing anything - it takes time to build a successful company.
Investors want to see vesting because the success of the company is closely tied to the founder. Startup investors take a risk and bet on people and ideas. They want to see vesting included in founder shares to make sure all founders have the motivation to stick around for the long term.
Vesting and acceleration are standard causes included in most founder share issuances. If you handle your founder shares with services like Atlas, Clerky, or a law firm familiar with startups, you don't need to worry about the details.
Investors Equity - Lesser-known terms you can negotiate
Most founders understand valuation when fundraising. But there are two terms that matter just as much for your company's future that are often missed: liquidation preferences and pro-rata.
To start, let's go back to basics. There are two types of shares that companies give away - common and preferred. Investors buy preferred shares during financing rounds. Employees and founders receive common shares. Investors purchase preferred shares and they come with certain rights that make them "better" than common shares. These rights are liquidation preferences and pro-rata. Both terms can have a huge impact on your future fundraising and your payout on an exit.
What are liquidation preferences?
Liquidation preferences give investors and other preferred shareholders the right to get their investment back before any common shareholder when a company is sold. They substantially reduce the risk for investors.
Liquidation preferences are marked as multiples. A 1x liquidation preference means the investor gets back their original investment. A 2x liquidation preference means the investor gets back double (or 2x) what they invested before anyone else. Once an investor's liquidation preferences are satisfied, cash is split based on ownership percentages.
Liquidation preferences matter when the business is not doing well. Let's walk through an example. Dwight Schrute invests $10 million on a $100 valuation in Acme Paper Company. Dwight negotiates a 1x liquidation preference and his investment gives him a 10% share in Acme. Pam Beesly is the founder and owns the remaining 90% of the company.
Unfortunately for Acme, Covid has decimated the industry. The paper industry tanks because no one is going into the office and printing documents. Everything is electronic. Pam sells the company in a fire sale for $10m.
Without a liquidation preference, Pam would earn $9m from owning 90% of the company. With the liquidation preference, Dwight is protected and makes back his original $10m investment. Unfortunately for Pam, she walks away with nothing.
What are pro-rata rights?
Pro-rata gives investors the right to invest in future rounds and is most common at the seed stage. Founders are often caught by surprise when they find they are required to allocate a portion of the round to an earlier investor.
In practice, this means that early-stage investors can keep buying into successful companies at later stages - which could mean a limited pie for new investors you want to involve with the company.
What are the standards around pro-rata and liquidation preferences?
For benchmarks, no liquidation or a max of 1x liquidation preference is common in today's funding climate. Institutions may ask for pro-rata rights if they're investing early. This term can be harder to negotiate. Angel investors are often more flexible. But again, in this funding climate, founders have the leverage to negotiate away pro-rata if your company is doing well.
Having investors you trust on your cap table matters more than the specific terms. Founder-friendly investors often do not take their full pro-rata in future fundraising rounds to make room for strategic investors to help founders. Your investor is a partner in your company. Optimize for people you trust rather than the terms alone.
Remember, your investors are also taking a huge risk when they invest in you. Angel investors and pre-seed funds bet on companies when they are laughably early. They take a chance when banks and traditional investors often won't. Early-stage investors allow entrepreneurs to get paid to carry out their mad, audacious ideas and should be rewarded for taking a gamble. Pro-rata rights and liquidation preferences reduce the risk for investors so they can raise more funding and invest in more crazy ideas, from founders just like you.
Equity is a great way for startups to recruit the best and most talented. It's tough for startups to compete on cash compensation against Google or Facebook. With equity, candidates can give up cash compensation today for the chance to own a small piece of a company that could become the next unicorn. Equity also aligns incentives - it focuses everyone on the north star of making the company more successful.
There are three types of equity employees receive:
- Restricted stock awards (RSAs) - granted at very early stage startups pre-funding.
- Restricted stock units (called RSUs) - granted at late-stage companies pre-IPO
- Stock options - an option is simply the right to buy shares in a startup at a pre-determined price in the future. Buying your options to receive shares is called exercising. If the startup does well, employees can exercise their options at a lower price.
This section focuses on options because it is by far the most common form of equity. We'll cover what you need to know to give options to employees.
What are options?
There are a series of steps to follow to issue options correctly. Founders sometimes skip these steps and it leads to all sorts of problems down the road - including disputes with employees, due diligence scrutiny during fundraising, tax consequences, and more. Here is what you should know to issue equity correctly.
Step one: Create an employee option pool
Employees receive equity from an option pool. The option pool fixes the percentage of the company's shares that is dedicated to employees. Having a pool makes it easier to grant equity because all of your employees receive the same paperwork and abide by the same rules when receiving equity. Without the pool, you would need board approvals for every equity grant - an administrative nightmare that can be costly.
The size of the option pool depends on your business and your hiring needs. The standard size of an option pool for a seed-stage startup is ~10% to 15% of your company's total shares. You can increase your option pool as needed. For companies that need to hire executives who demand more equity, a bigger pool closer to 20% may make sense. For companies that have a large group of co-founders, a smaller pool of 5-8% could also work.
Setting your option pool comes standard through most incorporation services. If you don't have an employee option pool, set one up today to prepare for future grants.
Step two: Get a 409A valuation to price your options
A 409A valuation is an independent appraisal of your company's common shares. Remember that preferred shares for investors are different than common shares. It is required to issue options to employees. The valuation determines the price your employee can buy options (aka the 'strike price'). The 409A valuation needs to be refreshed yearly to make sure your employees don't face adverse tax consequences. Startups must receive an up-to-date 409A valuation from a trusted third party. 409A valuations are available from tools like Pulley, accounting firms, or you can ask for references from your lawyer.
Step three: Create a compensation plan
Create a compensation philosophy for your company and stick to it. Without a compensation philosophy, the best negotiators will be the best paid. This approach is a disadvantage for women and minorities.
To determine your company's compensation philosophy, start with a benchmarking tool like Option Impact to determine what's normal for equity in your market and at your stage. If you're a fully remote team, you can layer on geography considerations - an engineer in SF will cost more than an engineer in Alabama - in both equity and cash comp. Your compensation philosophy will certainly change as you grow. Candidates want to know their compensation is fair and having a compensation philosophy forces you to answer these tough questions in advance.
Finally, leave room for additional grants based on performance. Top performers contribute more to the company's growth and should be rewarded. Don't be shy about giving stellar employees more equity as they hit key targets.
Understanding equity is like understanding your runway. You should understand the basics because equity is the unit that measures your upside. The third and final installment will cover practical tips on managing your company's equity. When should you hire a lawyer? What parts of your equity can you handle yourself?
I also want to hear from you! Post your comments below or find me on Twitter @yinyinywu. Let me know what questions you want to be addressed on equity or starting a company for our last post.