The external measure of raising money is often the focus of attention when it comes to the financial aspect of startups. Before this, an entrepreneur must consider many factors to set their business up for success.
This article outlines eight important considerations for equity, budget, and valuation of a new startup.
This makes you appear credible to investors and increases your success rate in raising funds. Many investors will ask for much of the information below.
You’ll be set up for financial success. Don’t become one of the ” 75 percent founders” who lose money when they sell their business.
You can use it to make your own decisions based on logical, quantifiable guidelines. Should you, for example, pursue your startup or continue working full-time? What amount of funding will you need?
First, you must understand the mechanics of equity for startup founders
As a founder of a startup, one of the most important financial decisions is how much equity you and your other stakeholders have and when. Equity is important because it provides financial rewards and motivates co-founders and employees. It also gives advisors and service providers a reason to work. Equity determines the decision rights and control over the company.
If you get this wrong, not only could it lead to underperformance and resentment from stakeholders, but your termination or dilution into an insignificant position.
How do I split equity among co-founders?
You will most likely start your journey with another cofounder or hire one soon after. Decide on the equity share as soon as you can.
There are several articles on the subject and online calculators that can help you calculate the exact amount. The main factors that should determine the split are:
Idea: Who is the inventor of the concept, and who owns the intellectual property? The initial idea may be important, but the execution is what will make a business last.
Contribution: Take into account the role and responsibilities each employee has, the relative value of their job to the business, and the importance that investors have indicated. If anyone is part-time, the commitment level will be vital.
Opportunity Costs: What would each cofounder earn if they found a job on the open market today?
Stages of the company: What is the date the cofounder joined? The earlier you do it, the more risky your company is and, therefore, deserves more equity.
Remember that whatever model you choose, the split should be “future-oriented” in the sense that it should reflect what the company is worth.
In my case, I made a mistake in basing the entire split calculation of my startup on a method that looked backward. “How much has been accomplished to date?” This model, in my case, gave a cofounder, who was working only part-time as a CTO, a much larger equity stake than mine (>60%) when compared to a typical IP licensing agreement of 5- 10% equity. I created the business plan and pitched for funding successfully. I also worked as CEO full-time. This decision did not reflect the risk and contribution elements that were considered in advance.
Another approach is to wait and see. Startups and personal situations can change quickly. You can leave 15 of your founders’ equity for the future and decide when you reach a significant milestone, such as the MVP or the first investment.
As CEO, you must have a majority (>50%) equity in order to control your business and make crucial decisions.
To be considered a “cofounder” and have a significant amount of “skin in game,” you must hold >25% equity.
Prepare for your cofounder’s departure and have a plan B in place to keep your business going. For example, you could set up a vesting schedule for equity or include clauses that force cofounders who quit to give a certain percentage of their shares to a new co-founder.
Even if the cofounders are “waiting and seeing” for the final amount to be paid, it is important to have an early discussion and to have them sign a “cofounder contract.” No matter how prepared and committed people may think they are, they will always change their minds until they mark something (even if it’s non-binding). It was a similar experience when my cofounder quit after working with me for months.
Do I need to allocate shares to non-co-founders of my company?
As you expand your team, you’ll need to reward employees with shares. Most VCs also require you to create an employee share option pool (ESOP) and then add to it over time. In Series A, investors will typically ask you to contribute 10% of the employee share option pool. Investors may ask you to increase it to 15-20% in the subsequent rounds.
What to give and when depends on the age of the company, the level of the employee, and the tenure of the company. The common practices are:
Engineers~0.5% Assume that you will earn a salary of at least $100k. If you live in Silicon Valley, the monthly cost for a good engineer is about $15,000. The higher the equity, the lower the salary. This tool can be used to determine employee equity compensation.
Service Providers0.1% (10k in services for a post-money valuation of $10m) Convertible notes are a way that some lawyers offer their services in exchange for equity.
Vesting is Insurance: Use it as a carrot on a stick.
The vesting schedules protect the other shareholders from early departures and free riders. If you are a cofounder and do not have a milestone-based vesting plan amongst the founding team, then the normal vesting schedule will be four years with one-year cliffs at 25%, as well as 1/36 of the total shares earned every month for the following three years. This term can be referred to as accelerated vesting or vesting cliffs.