How startup equity works

One of the most frequent conversations I have with entrepreneurs and employees alike is how equity works in a startup, so it seems like a good place to start these musings.

My goal here is to write something that will help entrepreneurs with their thinking as they seek investment and allocate equity to employees, as well as help employees think about equity when they’re evaluating offers from a startup.

The basics

OK, let’s start from first principles. Equity in this context almost always means shares in a company. In the US that company will usually be a C-Corp, and of course internationally there are many different structures. Almost all of them work the same way, though the tax implications of owning equity can differ wildly in different countries. Always, always check out your tax implications. In the US and elsewhere you can easily end up incurring tens of thousands in taxes unnecessarily on a $100,000 equity grant.

Public and private

Companies can be public, which means they have greater reporting requirements and may be (but not necessarily are) traded on a stock exchange, or private, which means they have no public reporting requirements and their equity is usually held by a smaller number of people. The overhead means you need a really compelling reason to be public, so the vast majority of companies stay private.

How many shares?

When a company is incorporated, the initial shareholders will decide how many shares they want to issue. 10,000,000 is often cited as a good number, because it allows for a great amount of flexibility when it comes to allocating shares amongst multiple shareholders both now and in the future.

Par value

Par value of a share, sometimes called face value, is the value at which it was created. It’s not particularly important for shares, though it is for bonds and other instruments that have a maturity date. When created, most companies set a negligible par value, $0.01 or even zero if the jurisdiction allows it, so that there aren’t any tax implications to assigning initial equity.

Share Classes

Shares in a company can be of a certain class. Some companies only have one class of share, usually called common stock, while others have several classes.

Share classes exist to give different rights to different shareholders. These rights are limited only by your imagination and the law, but a couple of common ones include:

· preference shares: holders of these shares are entitled to preferential treatment upon a liquidity event (such as a sale or a winding up). A 1x preference means they get a minimum of their share’s acquisition cost (usually the amount of capital invested to receive these shares) back, a 2x preference means they get twice the acquisition cost of their shares back, and so on. A participating preference means they get this value back before any other calculations are made, and then get to participate pro-rata in the dividing up of the rest of the proceeds as well. Participating preferences and multiple preferences are less common these days, as investors, entrepreneurs, and employees come to see each other as equally necessary parts of the process.

· Voting shares, or management shares: each of these shares counts for more than one share of common stock when it comes to voting rights. This is a mechanism often used to ensure that founders retain control of a company even when they don’t own a majority of shares.

The company’s articles of association (or sometimes the shareholder agreement, the document differs in different jurisdictions) will spell out the rights and obligations of each class of shares. Read them carefully!

The corollary is, don’t accept a share if you aren’t allowed to see the shareholder agreement! If you don’t know what rights attach to it, it could effectively be worthless.

Shareholder Agreement

Being a shareholder, you’ll be bound by the shareholder agreement. This will usually happen by you signing a document (sometimes called a Deed of Accession, sometimes the shareholder agreement itself) when you accept the shares.

There are as many different shareholder agreements as there are companies. Don’t be concerned if you don’t understand it, but do get someone who does to walk you through it. If your shares are potentially worth a bit of money, think about that someone being your lawyer.

Outstanding Shares

A company will have a certain number of shares of each class. When it raises more money, or allocates shares to new hires, it will create new shares of the appropriate class to give to these new shareholders. The list of all shareholders, the number of shares, and the type of shares they own is called a cap table (short for capitalization table).

As the company grows, new shares will be issued, increasing that number, and share splits may occur, in which each share is exchanged for two or more shares that in total equal the same value as the original share.

Dilution

That means that you (and usually every other existing shareholder) will be diluted — the number of shares you hold will decrease relative to the total number of shares.

This is a big deal if you’re a founder, and not a big deal if you’re an employee.

As a founder, your equity is both a means to earn a return should things go well, and a means to exercise control over the company. Your company articles or shareholder agreement will usually spell out the limits of that control — what percentages are required to do what sort of things, and if you have investors they are likely to be given specific veto powers — but the simplified version is that shareholders get to vote on important things like what the company actually does, and they also get to appoint people to the company’s board, which in turn decides on other important things like who gets to be the CEO.

There are lots of ways to maintain control regardless of your percentage ownership of the company, but the most common, used by Facebook and Uber amongst others, is probably the class of shares that has greater voting power mentioned above.

It’s a truism though that while you’re doing well, investors are happy to leave you in control. It’s usually only when that stops happening that they’ll start to exercise their rights.

Even as a founder, dilution is almost inevitable. Raising capital will dilute you even if you’re doing well, and it’s not unusual for founders to own a relatively small part of the company by the time of exit, even if it’s been very successful. At the time of writing, Mark Zuckerberg owns less than 20% of Facebook (though a good chunk of that is in a class of shares with extra voting power), and Travis Kalanick owns a little over 10% of Uber (also including shares with extra voting power).

As an employee, dilution is nothing to be worried about. It’s hard to extract any meaningful information from your percentage, because it will likely change many times before an exit happens, so it doesn’t have any real relationship to what you might make if the company gets acquired. If you know you have 10,000 shares that you earned at $4 per share though, you know that an acquisition at $50 per share will make you $460,000 in profit.

The share price will grow from round to round, and keeping track of it will give you a good sense of how the value of your equity is growing (or not!). Of course, it’s not always as easy to keep track of the share price as it is to understand a valuation. Everyone talks about raising $4m at $20m pre-money or a $100m acquisition, but your founders or your CFO will always know the share price and the number of shares outstanding, and good companies will be happy to share them.

Options

Frequently, employee equity is granted via an option scheme, where you’re given the right to buy shares at a particular price. If you get 10,000 options at a strike price of $4 with a 10-year exercise window, that means you’re entitled to buy 10,000 shares at a price of $4 within 10 years. Options are often given with other conditions too, such as only being exercisable if the share price exceeds a certain amount (this one is frequently found in public companies), or if an offer is made to acquire the company. Worth noting that those conditions are likely to change when you stop being an employee — in particular exercise windows often become much shorter.

Taking up options

You’ll usually need to notify the company to exercise your options, but the exact mechanism will be spelled out in your options document. Exercising your 10,000 options with a strike price of $4 means you have to spend $40,000 to actually buy the options though. Sometimes this isn’t a big deal, but sometimes shelling out a big chunk of cash can be a challenge for employees, even if the options are going to be sold immediately for a profit.

There are a few ways around this, most involving borrowing the money. Sometimes the company will lend employees the capital in an arrangement which doesn’t actually involve any cash changing hands, but if that isn’t an option it’s often possible to borrow money from traditional sources under a loan arrangement that will require you to sell the shares immediately.

ESOP

An Employee Stock Ownership Plan is simply the arrangement that covers how employees in a company receive their shares and options. It will usually be a separate agreement to the company articles or shareholder agreement, and will specify a number of shares that will be put aside for employees. It’s often put in place early in a startup’s life, sometimes at the insistence of investors, and expanded as it goes through rounds of funding.

You might see the phrase “fully diluted” in respect of an ESOP. That means to act as if all shares in the ESOP have been allocated, even if some have yet to actually be given out. In practice, this means you’ll get a little more dilution in the short term, but it’ll even out over time.

Grants

It’s common for employees to receive shares or options when they’re hired, but it’s also common for additional amounts to be given out upon contract renewals or other milestones. These grants are usually, but not always, part of the ESOP, and each may have different strike prices and other terms. In the US it’s sometimes called getting a refresh.

Vesting

One of the main reasons companies give employees shares is to give them an incentive to stick around, so it makes sense for those shares to be allocated over time. Vesting is the process by which that allocation happens, and just means to regularly give out a part of a predefined number of shares over a certain period of time. Common terms today are monthly allocations over 4 years, but quarterly and 3 years isn’t unusual.

Companies don’t want employees who only stuck around for a short time, for whatever reason, on their share register (partly because each shareholder takes a little bit of effort to manage, and lots of them can mean lots of effort), so there’s almost always a 12 month cliff period at the start of any vesting allocation, which means that the first 12 months’ worth of equity gets allocated all at once at the 12 month mark.

There can be tax implications of receiving shares or options like this, so a process sometimes called reverse vesting is sometimes used. In reverse vesting, all equity is allocated immediately, but the company retains the right to buy it back at the price it was issued at. That right diminishes at the rate of the vesting schedule — on a 4-year vesting schedule, after 1 year the company would only be able to buy back three-quarters of the total allocation, after 2 years half, and so on.

Participation rights

Most purchased equity, that is, equity that comes as a result of an investment, comes with participation rights. Participation rights allow the owner of the equity to participate in future rounds of funding, at the percentage of shares that they own. So, if you own 10% of a company, and you have full participation rights, you can take up to 10% of the next round of funding. This is commonly referred to as a pro rata, because you’re getting the right to participate pro rata to your equity.

Of course, if you don’t take up your rights, the round will dilute you, and you’ll only have participation rights for a smaller percentage of the next round.

Participation rights can be very important, they’re one of the main ways that investors maintain their level of equity in a startup. It’s not uncommon for larger funds to invest broadly in early stage startups primarily for the participation rights. If the company goes well, they’ve cheaply purchased the opportunity to invest in later rounds.

Employee shares sometimes don’t come with participation rights, because it can be a pain to organize a lot of small shareholders during a raise, and not many employees would take them up anyway.

Issuing new shares

Issuing new shares becomes a bigger deal the further along a company is. It usually requires the consent of at least a supermajority of shareholders (or a particular class of shareholders), and usually the process implicitly sets a value for the company as a whole.

SAFEs and convertible notes

SAFE agreements and convertible notes are worth a post on their own. They aren’t actually equity, though they usually convert into equity, and they come with only the rights the note documentation grants (plus the usual rights associated with loans and similar agreements in your jurisdiction). Those rights might or might not be similar to the rights that shareholders have, but are usually not as broad.

Notes (I’ll call a SAFE a note for convenience here, though technically it’s a warrant. The difference is mostly semantic — warrants typically have no intrinsic value, while a convertible note is technically debt, even if there are no terms under which it would be paid back) convert to equity at the price defined in the agreement, after all discounts, caps, and other mechanisms are taken account of. This can often be a quite different price than a casual reading of the note would suggest, so it’s worth reading these in detail, and getting professional advice if you aren’t sure.

When a lot of notes convert at once they’ll likely have a large effect on the cap table. If you’ve done several notes at different valuations with different discounts and caps, that effect can require a bit of work to predict. It’s worth doing that work, and then checking it twice, because it can mean a difference of millions of dollars in your pocket.

Number of shareholder restrictions

Most jurisdictions have various restrictions on the number and type of shareholders that different types of companies can have. Go beyond these limits and you’re likely to be treated similarly to a public company — though not one traded on a stock exchange, that’s a different process — with a whole host of accounting and other requirements you must abide by.

One of the advantages to being a C-Corp in the US is that they don’t have hard shareholder limits. They do have a soft limit though, in that once you have more than $10m in assets and 2,000 shareholders who are accredited investors (or 500 shareholders who aren’t accredited investors) you are required to register with the SEC and file financial documents similar to those required of public companies.

Notably, employees who received their equity as part of an employee compensation plan aren’t counted towards that 2,000 limit.

This is one of those areas where you want legal advice, because there are many nuances that can be difficult to navigate, and not meeting your obligations can be time-consuming and expensive to fix.

Conclusion

Like most things investment-related, this stuff can be complex. Employees can afford to skip the details as long as they’re willing to relegate their equity to a nice surprise that might appear long after it’s forgotten, but founders without a good understanding of how it all works run the risk of losing out significantly.

Remember, there are no stupid questions, and your advisers are there to help.

Thanks to Kim Heras and Chris Thurston for feedback on early drafts of this article.