How equity gets divided initially and at harvest
One of the most common questions I get is about how equity should be distributed. I’ll warn you in advance: there are no hard and fast rules. Equity is negotiated on a case-by-case basis, which makes it hard to give any generalizations. I’ll try to give some thoughts on what to consider when you give out equity.
- How should we divide equity among the founders?
- We have 5 founders. What should we do?
- How much of the company will the investors need to own?
- What equity should part-time contributors expect?
- How can we increase the valuation of the company?
- What does ownership look like after the first round?
- What does the ownership look like at IPO? How much does the CEO have, etc.?
Founders receive equity for what they bring to the table. How much of the company they own as a result of their contribution is purely up to the group to decide. There are several factors which need to be considered, however.
Timing, size and duration of contribution. The earlier, bigger, or longer the contribution to the company, the more equity a founder should receive.
Power.Equity conveys voting power and control over the business. Generally, founders who intend to stay with the business long-term should retain the most control. I have heard it recommended that one individual own at least a 51% of the company, to provide consistent decision making when resolution is needed. Equal partners, while great in theory, can destroy a company when the partners don’t agree and have no way to resolve fundamental disagreements.
Money. Early money is a contribution for equity. Money has the side-effect of valuing the company. If you give 10% of the company for someone contributing $50,000, it implies a company value of $500,000. If you try to raise money immediately thereafter, that valuation could hurt your negotiating ability. But if substantial infrastructure has been built in the meantime, if customers have been acquired, or if more of a team has been built, then a higher angel/VC valuation is justified.
Kind of contribution. A founder may contribute in many ways. Some bring patents or product ideas. Some bring business expertise and ongoing work to build the business. Some bring capital. Some bring connections. Some may bring big names or reputations which convey credibility with VCs and/or clients. One big name that provides instant credibility may, in fact, be worth more to the company than a founder who actually puts in the work to build the business. Make sure to understand what each founder’s contribution is, and value it appropriately.
Negotiate, big-time. Too many founders can be a big problem. As the company reaches for outside funding, you make many decisions about equity, contribution, and dilution. The more equity-holders, the more negotiation has to enter into each of these decision.
Having several founders makes it hard to keep everyone adequately compensated. By the time of harvest (IPO or acquisition), the founding group can expect to own about 20-30% of the company. With one founder, that can mean riches. With several founders, that may mean splitting the pie into so many pieces that no one is happy with the value of their piece.
In short, fewer major equity holders are better. If you’ve already got several, make sure that you tie each founder’s vesting to the contribution you’re expecting from them.
The basic formula is simple: if you need to raise $5 million, and an investor believes the company is worth $15 million, you will have to give them 33% of the company for their money.
Different investors value companies in different ways. Some look at the quality of the idea, assets, market size, and management team. Some rely on financial projections. Some simply look for “big ideas” and determine their percentage ownership purely through negotiation.
I asked a couple VCs, some entrepreneurs who recently received funding, and an angel investor how much of a company is typically given up in the first round. While one VC has seen investments as low as 5%, the majority thought that first round investors will usually take from 25-45% of the equity.
One entrepreneur remarked,
The better thing to ask is: how much should management and founders try to hold onto before the IPO. Answer: as much as possible, but no less than 25%.
The entrepreneur has an important point. If it comes down to the money (as it often seems to, these days), what matters in percentage ownership at harvest multiplied by the valuation at harvest. Owning 1% of a company with a billion dollar valuation is still more interesting than owning 10% of a company with a fifty million dollar valuation.
Not very much. The reality of the situation is that startups usually require 150% commitment by everyone involved. Venture capitalists insist equity be given in return for ongoing commitment. Even founders who stay with the company have a multi-year vesting schedule. Many VCs will not allow equity to be given to part-time employees or contractors.
There is a one-time contribution for stock that is routinely made: giving capital itself. A cash investment for stock lets the investor own the stock free and clear, with no further contribution required. Having part-time contributors purchase stock outright may be the best way to include them in the deal.
Angel investor Ron Conway says:
To get a $5 million valuation, you need a great market, a great idea, a crisp business summary, a really good elevator pitch, a compelling product prototype of your software or solution, and two or three members of your management team in place. For a $2 million valuation, none of the software for the solution is written yet. It’s just a CEO without a proven track record and a market to attack.
Q. Given the number of questions, many entrepreneurs seem to focus too much on valuation. Generally, what do you advise?
A. If you’re building a company like Yahoo (NASDAQ: YHOO), Ask Jeeves (NASDAQ: ASKJ), or eBay (NASDAQ: EBAY), you shouldn’t worry about valuation on the front end. If you’re worried, then you probably don’t have the confidence to build a large, significant company. A CEO who’s completely stuck on valuation is a warning sign. That’s a CEO who’s confused about his role. The bottom line: if the idea is great, you’ll end up with a multibillion dollar market cap and everyone will make more money than they can ever spend.
Rather than focusing on valuation, focus on execution.
Q. A guy wrote that he’s worried about not having a Harvard MBA. How would you rate a college dropout with a brilliant idea, an excellent prototype, but no team? Would you fund him?
A. Yes, but that would definitely be in the $2 million pre-money category. If the prototype is excellent, he might get a valuation of $3 million to $4 million.
According to Ann Bilyew of Advent International, a typical first round is:
- Angel investors-20-30%
- Option pool-20%
- Venture capitalists-30-40%
From an article by Anant Raut published on www.techound.com.I do not have the exact URL.
A May 1999 study by the William M. Mercer, Inc. consulting group [showed] the Internet companies reserved 15.7 percent of their common shares for compensation, compared with traditional industry’s 10.7 percent; after their IPO’s, however, traditional industry had 5.3 percent of their reserved shares still available for option grants in the future, while the Internet 32 had only 3.7 percent to offer.
The same study found the following distribution of median equity stakes among members of the executive team (following an IPO):
- Founding chairman-20.4%
- Non-founding CEO-4%
- Other executives-0.79% (0.96% before IPO dilution)
It’s hard to quantify percentages that non-executives should expect. Variables include the age of the company, the degree of financing, and the strike price. Kersey Dastur, an independent consultant based in McLean, Virginia, has assisted a number of high tech companies in establishing stock option plans and explains, "If I am a company with no financial backing yet, I will be likely to set aside 10 percent of my company for non-executive employees because they are taking a risk working for me. I may, however, set a high strike price to ensure that the value of the company is not diluted." It is not uncommon for companies with financial backing to offer no more than 2 percent to non-executive employees, because someone else has already assumed the financial risk. Remember, these allocations are spread out across all employees so, unless you have something truly unique to offer, don’t expect a large piece of the pie.