The 5 Golden Rules of Issuing Your Startup’s Shares
Besides picking a company name, distributing shares is commonly an early task that most teams must do. It’s a tricky conversation that many first-time entrepreneurs tend to avoid, or worse, just split equally (continue reading to learn why). The conversation is especially uncomfortable because the project hasn’t started yet, and everyone wants to remain cordial. Adding this talk about ownership into the mix can change the atmosphere. Though, the fact is that the conversation is important because it brings you back to the reality of running a startup, where you have a long road ahead of making tough decisions.
This one is your first test. It’s an easy test because there is a right way and wrong way to do it. If you do it the wrong way, the bad news is that it will cause you lots of problems in the future that won’t be so easily resolved and may even require costly lawyers.
Fortunately, following these five rules will set you on the path to issuing shares the right way. By having this talk with your founding team early, bringing a plan to the table, and explaining why that plan is in the best interest of the company, you will steer the conversation in a way that doesn’t just make sense for everyone listening but also saves everyone headaches down the line.
1. Don’t offer even splits
Remember, in high school or college, when you had team assignments? Most of us have experienced situations in those moments where team members don’t all pull equal weight; in fact, it rarely ever happens. When building a startup, you may also experience that. No one enjoys the feeling of putting in twice the effort and receiving the same return.
Furthermore, a company needs one leader. Sure, you could point to NetFlix, which recently appointed Ted Sarandos as Co-CEO, as a beacon of hope for this type of leadership approach. The reality, though, is that you aren’t NetFlix — at least, not yet. You are a scrappy startup without the number of employees that would require two leaders to manage. More importantly, you need to move fast. If you and your co-founders all have equal shares (and therefore say) in company decisions, your competition will likely outpace you because of your own analysis paralysis.
Maybe you’re a super early startup, and you think you’re different. You and your cofounders get along; you all could’ve been best friends in another life. Good for you, but startups are a roller coaster, and you haven’t even buckled up for the ride yet. Disagreements will arise, decisions will need to be made, people may call each other names, and some may even leave. Giving everyone equal shares is a naive move that will result in unfortunate headaches for the company as it tries to scale.
Speaking of scaling, investors won’t like it. First and foremost, it shows that you and your team aren’t mature enough to handle tough conversations. Also, investors may ask you to decide which person takes the most shares. They need to know that their money is safe and the company can grow quickly, so it’s a reasonable ask. At that point, the conversation between you and your co-founder(s) will be even harder because you’re close to getting investment. In the startup rollercoaster illustration, you’re sitting at the top at that moment — the founders are excited and can see the beautiful views. No one will want to give away anything.
2. Don’t issue direct shares; issue options
Options contracts give people the option to buy shares of a company. This is preferable over just directly issuing shares for reasons regarding quitting and firing.
For example, at some point, maybe one of your cofounders doesn’t want to work on the company anymore. They may choose to quit at that point. If they were already issued shares, then they take a good chunk of the company with them when they leave. They will eventually reap the upside of the company’s success without having to do any work. Similarly, if you have to do the tough job of firing a founder or early employee, the options contract protects the company from losing a significant portion of its shares.
3. Vest any issuance of options
Whether you decide to issue shares or options, never give it all away at once. A common practice is to vest the shares — vesting means that shares or options to buy shares are unlocked over time. Vesting shares is analogous to receiving a salary. If an employee earns $50,000 per year, the company doesn’t just pay that employee $50,000 every January. If they did that, the employee could just quit the next day, never having contributed anything to the company. Vesting prevents that type of action for company shares.
For example, if you issue options to an early employee to buy a total of 2% of shares over a vesting period of 4 years, then that employee can purchase 0.5% after the first year, 0.5% after the second year, 0.5% after the third year, and the final 0.5% after the fourth year. By vesting, you further mitigate the risk of unnecessarily losing company shares. Typically, vesting periods range from three to four years at startups. I’ve rarely seen it under three.
4. Never give options to contractors/part-time
Any activity regarding shares implies a founders’ belief in the company. The more you hand them out, the less you think they’re worth. Many first-time entrepreneurs make the rookie mistake of offering to pay with shares rather than money. That is an unsustainable practice at best. The reality, though, is that shares are never equal value to money. On the one hand, if the company goes under, then shares are worth nothing. On the other hand, if the company succeeds, then the shares are worth much more than what you would have spent to get your MVP, prototype, or other services from contractors in the early days. In other words, using shares to pay contractors is either unfair to the contractor or unfair to the business.
Giving away shares to contractors also means that you now have uncommitted people that own a piece of your company at an early stage. The 2% you gave to a contractor (who are we kidding? It was probably more like 10%) could have been used to hire one of your first full-time, committed employees. Instead, you’ll be left having to explain to potential investors why you thought having some developer from Fiverr on your cap table was a good idea. Those investors will be left thinking the same thing: you don’t believe enough in your company's value and would rather pay in shares than dollars.
5. Never give options to early customers
When I’ve discussed go-to-market strategies with founders, some of them have thrown out the idea of giving a small number of shares to early adopters to incentivize them. That is a bad, bad idea. Foremost, it is a bad idea for the reasons I mentioned above — giving away shares implies your belief in the company. The companies will also hold a disproportionate amount of shares for the amount of work they need to put in to get the company off the ground.
Even worse, the moment you make the mistake of giving shares to a company, you are associating your business — its current and future state — with that company. Let’s say you somehow manage to convince a VP of Marketing at McDonald’s to take some of your company’s shares (this is a contrived, hypothetical example — read the next paragraph to understand why this would never happen) in return for using your product. Now you are partly owned by McDonald’s. What happens when Burger King or Wendy’s is interested but then finds out that McDonald’s is a shareholder? Your chances of winning the business are affected.
As a bigger-picture comment, giving shares to a company is a bad idea simply because large companies don’t care about it. The only group in the company that may care for it is the strategic investment or innovation arm, but you are unlikely to sell to them. The person you’re selling to wouldn’t even know what to do with those shares. You can’t give them the shares to personally hold, either, because that would create a conflict of interest.
Your shares are the most valuable thing that you own — treat it like gold. If you don’t believe that, then you don’t believe enough in your business. Don’t make rookie mistakes because they will come back to bite you, and by that time, not only will it impact the founding team, but also your investors and employees.
Take the time to have an uncomfortable conversation, and come to a conclusion that is in the best interest of moving your business forward.