Keeping to the fundamentals can be tough.
As an overtasked and overwhelmed startup founder, it’s tempting to look for DIY stop-gap solutions for equity issues with a mantra of “we can deal with this later.” It’s like going after that vending machine Snickers bar (or two!!) when your stomach is grumbling and you still have an afternoon packed full of meetings.
But early mistakes in allocating equity almost always catch up with you. And they’re not quite as easy to remedy as the consequences of an errant candy bar or two.
Short-sighted equity arrangements are costly to remedy, if they can be remedied at all, and may even spell the death of a long-fought for venture. That’s a hard lesson for a founder who’s poured his or her all into the undertaking.
As an advisor to life sciences and technology companies for over three decades, I’ve seen plenty of these types of mistakes made by eager and ill-prepared entrepreneurs. I don’t want YOU to repeat them.
So here are some practical insights you can avoid making these same mistakes.
Who gets equity and how much?
One of the most common questions that I hear from founders and entrepreneurs is “who should get equity and how much?”
Here’s a helpful breakdown and some important considerations to keep in mind.
Founders-Founders are the brain AND the brawn behind a startup venture’s early growth. It goes without saying that they deserve to be rewarded for both their hard work and the risks that they shoulder in that endeavor. This is almost always accomplished by giving founders the majority of equity in the enterprise in the form of shares, or the units of ownership accorded to a business that will eventually produce a financial return in proportion to the founders’ relative number of shares.
Altogether, founders and co-founders will typically hold around 70-80% of a startup’s initial shares, with the rest reserved for early advisors, investors and employee stock options. But deciding how many shares each founder should get vis-a-vis the others can be a tricky proposition. Many times, co-founders will take what seems like the easy option-an equal proportion to each founder-but when done without much thought, this can lead to unfavorable consequences, which we discuss further below.
Advisors: Advisors can be extremely helpful early on in filling in knowledge gaps, providing contacts and credibility, and providing deep industry knowledge and subject matter expertise. They typically consult one-on-one with founders and executives in areas involving hiring, sales, establishing partnerships, dealing with financings or tackling specific challenges in the business.
In exchange for their advisory role, each advisor typically receives between 0.25% to 1% of the company’s shares, depending on the nature of his or her advisory position and the stage in which the startup finds itself. The overall percentage of shares accorded to advisors is usually relatively small; typically, less than 5%.
Investors: Needless to say, lines of credit, personal loans, mortgage refinancings and credit cards aren’t enough to keep a startup afloat in the long run. When seed stage funding becomes necessary, usually through an infusion of cash from venture capital and angel investors, founders can expect to hand away 20-30% of their startup’s total equity, sometimes more.
While a successful fundraising round can be cause for celebration, it also comes at the expense of potentially losing control and being beholden to investors who may not always see eye-to-eye with the founders. Before saying “yes” to any investor, it’s important to carefully consider how much money you really need, whether the person is the “right” investor and structure your deal terms to adequately balance everyone’s interests.
I can’t over-emphasize the need to perform “due diligence” on your potential investors – they are not all equal – or equally easy to deal with once they’re aboard.
Employees: It’s the prospect of large capital gains-and tax advantages- that drive people to consider the world of entrepreneurship rather than taking a position with a larger and more stable company. That’s why in allocating early equity, it’s important to also preserve a percentage for employees in the form of stock options, or the right to purchase shares at an agreed-upon price at a specific time in the future.
Most startups reserve around 5-15% of equity for employee stock option pools and, in some cases, restrict these shares as non-voting common stock. This way employees receive the potential for financial gains but without the voting rights accorded to other shareholders. Another common financial instrument used to compensate employees is stock appreciation rights, or contractual rights that help a company compensate their employees in cash where they don’t want to give up equity in the company per se.
How to avoid the 5 most common startup equity mistakes
Now that we have a foundational understanding of how and with whom equity is split in an early entrepreneurial venture, we can take a closer look at the most common startup equity mistakes and how you can avoid them.
1. Giving inadequate thought to the founder equity split
A lot of startup founders opt to split equity equally among the founders because it’s easy, seems relatively equitable and avoids conflict. While this might work in some cases (although there have been relatively few in which it does in my experience) there are two important issues that can arise with this approach.
One is that some roles may be more important or more time-consuming than others. Later on, tensions can arise among the founders when one person ends up doing most of the work while everyone shares equally in the rewards. To avoid this situation, some things to consider relative to each founder’s split include their:
- Experience, network and expertise
- Time and commitment to the startup enterprise
- Investment of personal capital in the venture
- Relative risk and responsibilities.
Another unanticipated but very important consequence of making a proportional equity split among founders is that it can negatively impact future fundraising. Interestingly, HBR research shows that companies with equal founder splits have a harder time raising venture capital.
That’s because early in a venture, investors have few guarantees for their investment, other than that the terms of the initial equity arrangement are calculated to ensure the founders will give the venture adequate time, attention and follow through. An equity split that seems miscalculated to each founder’s relative contribution to the enterprise is unlikely to instill confidence in potential investors. Likewise, avoiding the discussions and negotiations that accompany a more thoughtful split can signal to investors that founders lack the experience and know-how to have hard discussions and negotiate with others-skills that are important to any startup’s success.
2. Getting vesting wrong
Vesting is a restriction placed on equity shares that requires the holder of that equity to work for the company for a specific period of time or to hit certain milestones to “earn” that equity.
Vesting arrangements are typically time or performance-based or some combination of the two.
These are memorialized in a “vesting schedule” that details how much equity is earned at specific milestones and the conditions that must be satisfied for the equity to actually vest.
As the name implies, time-based investing is premised on equity vesting over a period of time, with specific percentages being earned at specific time-based milestones. Cliff vesting is one common time-based vesting arrangement-employees must work for six months or a year until part of their equity vests, with the remaining equity vesting in equal monthly installments over the remaining period of time, usually two or three years. Alternatively, milestone vesting is an arrangement that predicates equity earnings upon hitting a specific target or milestone, like sales revenues, product development or marketing targets.
Ideally, a well-designed vesting schedule ensures that founders, employees and other stakeholders are equitably rewarded for their contributions to the business over time. And it also incentivizes them to stay the course rather than cut ties early in the enterprise. But one mistake that startups sometimes make is using a vesting schedule or mechanisms that are poorly aligned to the position or tasks at hand.
For example, using milestone vesting as a large portion of an executive or advisor’s compensation can be problematic. The rapid need to pivot early in a startup’s trajectory can make it nearly impossible to set meaningful milestones or result in targets that quickly become obsolete.
Milestone-based vesting tends to work best for objectives that are relatively short-term, predictable and extremely clear. If you do use milestone-based vesting in your equity compensation scheme, it’s important that both the employment contract and vesting instruments are unambiguous about what needs to happen for that equity to be earned.
3. Giving up too much to investors too early
There’s a common saying in the startup world that early money is often the most expensive. It can seem flattering and a great relief to have an angel investor offer you $4 million for a 40 percent equity stake in your company that isn’t yet making any money. Until you again run out of money and need to give up even more of your precious equity to keep the lights on.
Equity dilution can pose a serious threat to your startup for a few key reasons. One is that you give up your management rights in the process. When initial investors have veto power over essential business activities-incurring debt, issuing new stock, making acquisitions etc.- the founders can find themselves hamstrung in running the business. Likewise, conservative investors may not see the benefits of seizing opportunities and entering new markets.
Another problem is that restrictions tend to grow over time with subsequent financings. So, a restriction given to early investors is likely to be demanded by subsequent investors as well. Finally, handing away a large chunk of equity to investors early on in your enterprise can also signal to other investors that your business model is flawed and not self-sustaining.
It’s important to carefully forecast and understand your initial cash requirements and bootstrap as much as possible in the early stages. When it is time to take on investors, many savvy founders raise only what they need for a set period, e.g., 18 months of capital to get the venture to the next reasonable financing point. They also work hard to obtain equity terms that adequately balance the investors’ rights with the long-term interests of founders and employees in the growth of the business.
4. Choosing the wrong investors
In startup economics, if early money is the most expensive, then we might also add that not every dollar is created equal. Some investors are more willing than others to take up the “oars” on your entrepreneurial boat and row with you, as opposed to others who act more like anchors. Indeed, part of the entrepreneur’s job is to find the “right” investors-and to have the patience to continue to work to find them even when ready money appears available.
Once an investor is “in”, he or she will be around for a while. So, as you engage with potential investors, it’s important to uncover whether they’re willing and able to help your “boat” stay afloat. Questions to consider include “what has been the investor’s management or oversight style and what types of provisions does the investor typically require?” If your answers to these questions don’t seem to align well with your venture, it may be best to pass – if you can – and look for an investor who is a better fit.
5. Not understanding the tax implications of equity arrangements
Entrepreneurs are sometimes surprised to learn that receiving stock in an existing venture can create taxable income-even if the technology entrepreneur doesn’t receive cash with which to pay the taxes! And if the venture increases in value between the time of the grant of stock and the vesting of the stock, an entrepreneur can find himself or herself in the uncomfortable position of having non-cash taxable income and not enough cash from other sources to pay his or her taxes. A very uncomfortable position indeed!
You may think of this as “phantom income” – but the IRS and your State tax authorities don’t think so!
Fortunately, this problem can be helped by making an election under Section 83(b) of the Internal Revenue Code which permits the stockholder to take the income value of the stock up front. It permits a recipient of stock subject to a substantial risk of forfeiture (e.g., losing stock by leaving a company before a vesting period is complete) to choose to be taxed on the value when the stock is granted (presumably at a low price or nominal value) and avoid taxation on the value when the risk of forfeiture lapses.
Another tax saving provision is available under Section 1202 of the Internal Revenue Code, but applies only to actual stock, not stock options. Individuals who receive stock directly from a Qualified Small Business-a small company under $50 million in assets-and hold on to that stock for five years can receive a federal tax exemption of up to $10 million in capital gains. This is an obvious boon to investors who invest in and stick with young companies, as it is to founders.
It’s not how much money you make that’s important. It’s how much money you keep after taxes. So, it’s crucial that early on, founders integrate an intelligent tax strategy with the help of trusted legal and tax advisors to ensure that both the venture and the founders meet all the qualifications for favorable tax treatment to maximize the value received from their efforts.
Talent is one of the most important resources to any startup venture. A well-designed equity arrangement is the key to attracting and maintaining that talent, and ensuring that your company makes it to a successful exit.
Crowley Law can help you in navigating this vital aspect of your life sciences or technology venture. We have years of experience providing full-service representation exclusively to emerging life-sciences and tech companies and their founders. You can learn more about our services here.
The Crowley Law team provides ongoing proactive legal counseling to help start-ups identify and mitigate risk at every stage of your journey. If you need assistance drafting or reviewing your organization’s NDA or have other questions regarding how best to protect your intellectual property, contact us today.