Startup Equity 101

Alan Mcgee , HEAD OF PRODUCT , GUST INC.

5 Apr 2017

A critical decision in the early days of your startup is the equity split. You may have co-founders, or you may be on your own, but these early decisions have downstream consequences on things like hiring, taxes, and legal complexity.

Establishing ownership is also necessary to complete company formation, so you’ll face this soon after you incorporate. If you avoid this, your corporate formation will not be complete. There is no one right approach to dividing the ownership of your company, and every case is different. But the factors that might go into your decision are quite common.

As a former founder, I’ve been through this myself and have been a part of many new founder’s learning curves as they navigate these tough decisions. Before Gust, I co-founded a startup called Sharewave (now Gust Equity Management), which powers the cap table and modeling within Gust Launch. It’s not all that difficult once you learn the basics, but you want to get things right from the start.

Below I’ll outline a few things that you may want to consider as you decide how many shares to distribute from the perspective of a Delaware C-Corporation. Before we get started, there’s some basic vocabulary we’ll need to know:

• Equity: a corporation is divided into shares, which represent a slice of both the company itself and the value the company creates. These shares, once distributed, represent the company ownership (a word commonly interchanged with equity).
• Authorized Shares: the maximum number of shares that your company is authorized to issue, governed by your Board of Directors. Any increases or decreases to this number require amending and restating your Certificate of Incorporation in Delaware, so it’s in your best interest to keep things simple early and work with the initial amount of authorized shares. Gust Launch starts each company with 10 million authorized shares—a very common number to begin with.
• Issued Shares: the total number of shares that have been granted by the company and purchased by a shareholder. These are also commonly referred to as Issued and Outstanding Shares.
• Unissued Shares: the total number of shares that are authorized to issue, but have not yet been issued to shareholders. Mathematically, this is the difference between your Authorized Shares and Issued Shares, and are also commonly referred to as Authorized Unissued Shares.
• Fully Diluted Shares: all stock (common and preferred) and issued options (or warrants) as if converted to common stock. This is less relevant in the early days, but it’s a representation that investors care about as it most accurately reflects preferences, rights, and decisions made during a liquidity event (e.g. an acquisition or IPO).
• Options: a different way of distributing ownership—options are the right to buy shares based on a set of conditions. When an option is “exercised,” the option to buy stock is used and the result is issued shares. They’re typically used as part of a compensation package in the form of an incentive to employees, directors, advisors, and other people key to the company’s success.
• Vesting: vesting is a concept applicable to both stock and options, which prevents the recipient from owning all stock or options outright and instead earn them over time. For stock, vesting typically refers to stock that’s earned over time and, therefore, not re-purchasable by the company. For options, vesting indicates the number of options that become exercisable.
• Option Pool: an allocation of shares specifically reserved to be granted as options, specified in your company’s Equity Incentive Plan (also known as a stock option plan). You can also issue other derivatives from this reserved pool (e.g. warrants, RSAs, RSUs, etc) but that’s a topic for another post.
• Cap Table: also called the capitalization table, is a record of all securities and their shareholders commonly displayed in a fully diluted view.

With that, let’s talk about a few considerations you can make when establishing ownership.

Equity splits in a typical startup

As hinted in the authorized shares definition, incorporation determines the number of authorized shares (for startups incorporated through Gust Launch, it’s 10 million). After formation, the founding team can split these shares amongst themselves, but should be sure to leave enough unissued for later. How much should be leftover? There’s no right answer, but the more you allocate upfront the less room you’ll have to work with down the line. Some of the remaining portion of unissued shares will likely become the option plan, which is dispensed among key early employees, advisors, and directors. It’s common to keep the pool somewhere between 10-15% of fully diluted shares.

Many founders’ first inclination is to split equity evenly, or close to it—often times this comes out to simple splits like 50/50, 33/33/34, or 51/49. This topic is widely written about, but modern wisdom is that even splits are not ideal and that co-founders should divide equity according to the value they’ll create for the startup. For an in-depth discussion of this topic, my colleague Keyvan Firouzi has written “Co-Founder Equity Split: A New Framework to Objectively Divide Startup Ownership and Get Back to Building a Business,” which explains the logic behind equity splits. You can apply this logic easily to your own situation with Gust’s free Co-Founder Equity Split tool.

The point is that every startup is different, and there’s no catch-all plan. Just be thoughtful about how you split equity, and leave enough unissued shares reserved for key hires.

Tracking ownership gets complicated

A common misconception of ownership is that shares are explicitly worth a percentage of the company. In reality, ownership is only ever calculable at a specific point in time. The fully diluted calculation is also an approximation based on assumed shareholder decisions, so that’s commonly used.

To illustrate this, let’s start with the simplest scenario, a brand new company with two co-founders:

This company has one class of common stock and there is not yet an option pool. The total number of issued shares represents all the ownership of the company: there are 10,000,000 authorized shares, two co-founders each have 2,500,000 issued shares, and 5,000,000 authorized shares are left unissued. In this case, because the co-founders have equal amounts that together account for all issued shares, each co-founder owns 50% of the company, and together they own 100%:

Co-founder A: 2,500,000 / 5,000,000 = 50% Co-founder B: 2,500,000 / 5,000,000 = 50%

Now let’s say that the co-founders create an option plan with 1,000,000 shares. Before they actually issue these options, do they have 100% of the company? In theory, yes, because there is no option holder who is capable of exercising an option for common stock. But until that happens, looking at the fully diluted share count would still show a 50/50 split as the unissued options would vanish at an exit event.

After creating this option plan, the co-founders find and hire a talented sales leader to build their sales funnel and strategy. They decide to give her 100,000 options. What percentage of the company is that? In the fully-diluted share count, it’s 100,000/5,100,000 or 1.96% of the company:

Co-founder A: 2,500,000 / 5,100,000 = 49.02% Co-founder B: 2,500,000 / 5,100,000 = 49.02% Sales Leader: 100,000 / 5,100,000 = 1.96%

This adjustment to each co-founder’s percentage is called dilution, and they equitably made room for the options represented by the sales leader. What’s important to understand is that the representation is based on the option grant number and not percentage, but if you offered her 1.96% of the company, the next hire you make will equitably dilute all three of you and she’ll no longer have 1.96% of the company.

Options come into play in fundraising

A major area of confusion among founders is the strategy behind option pool sizing. Most people operate on the received wisdom that the option pool should amount to 10-15% of fully diluted shares, more or less because that represents a reasonable slice of the company to incentivize key hires. In reality, there are some very good reasons to pay more attention to this issue.

We touched on this above, but options have a specific and concrete use: they give your employees an incentive to become an owner of the company in exchange for their hard work. Stock options also include a strike price (i.e. the price at which those shares can be purchased) set at the grant date, so even if the company share price has grown substantially the employee can still buy shares at the original strike price. Most option grants will be subject to vesting, which requires that employees stick around for a given time period to be able to exercise the entire grant amount. In other words, they’re a form of compensation that entices early employees to do their best to increase the value of the company and stay the course, because they’ll own a percentage of a valuable company on an exit event. Because it’s compensation, it’s in the company’s (and the other stakeholders’) interest to keep each employee’s ownership to a reasonable amount in proportion to the value they’ll create for company so the incentive remains.

Second, the timing of option pool sizing is critical. When investors are considering providing capital to your company in exchange for equity, they also want that 10-15% option pool available for key hires. It’s often written directly into term sheets, with a distinction between pre-money and post-money. Let’s explore that.

Let’s say investors want an option pool representing 15% of fully diluted shares, assuming all options would be distributed. Investor preference will often be to carve out the option pool before the investment takes place (“pre-money”), so that the 15% is still available after their investment (commonly called the “post-money” option pool). In that case, everyone on the cap table is diluted by the pre-money creation of an option pool larger than 15%, and when the investor money comes in, that pool is diluted down to 15% along with all existing shareholders. Founders would prefer the option pool is carved out after the investor’s shares are issued to minimize the impact on their and existing shareholders’ dilution, so the point of dilution in the term sheet is often the subject of negotiation. The takeaway here is to pay attention to how large your post-money pool will be and when it will be created, because if you reserve too many shares for equity incentives then you’re taking on that burden upfront instead of sharing it with future investors when the time is right.

Because of these considerations, your startup should strive to develop a hiring plan that takes into account who you’ll need to hire, how important they’ll be to the company’s future, and where you want to be before you take your next round of investment. Then, create an option plan that covers this hiring plan while minimizing an excess of reserved shares.

All these numbers are flexible

The reality is that all of this is customizable, but you don’t need to make this too hard on yourself. Future events will continue to govern these decisions, and the more you can surround yourself with strong advisors and board members the simpler this becomes. Just remember the basics, and know that dilution plays a critical role in what the numbers look like today vs. tomorrow.

Is there a ballpark number that can be used? Sure, but please make the decision on your own. You and your co-founders will want to grant yourselves a large chunk of authorized shares, typically around 4 million or more shares split amongst the founding team. The larger number issued will also decrease your franchise tax bill with Delaware. Avoid issuing all 10 million shares, so that you can allocate them in the future without having to incur a legal bill to authorize more shares. Avoid creating an option pool larger than 15% for now, which you can adjust later. And finally, find someone to support you who knows your startup’s unique circumstances along with the details of startup equity, like your startup’s lawyer.

Check out the Co-founder Equity Split tool:

SEE YOUR SPLIT