How startup equity works
Startup equity is a complex but essential topic for first-time entrepreneurs to understand. Here’s a detailed breakdown:
1. What is Startup Equity?
- Equity represents ownership in a startup. As an owner, you have a stake in the company, which means you share in the company’s successes (and failures).
2. Why is Equity Important?
- Equity can be used to attract and retain key personnel, including co-founders, early employees, advisors, and others.
- It aligns interests among team members, ensuring everyone is working toward the same goal: increasing the company’s value.
3. Different Types of Equity Instruments:
- Common Stock: This is the most basic form of equity, usually held by founders and employees. Holders of common stock have voting rights but are last in line to receive any remaining assets if the company is liquidated.
- Preferred Stock: Often held by investors. It comes with special rights, like priority in receiving dividends or assets if the company is sold or liquidated.
- Stock Options: The right to buy shares at a predetermined price. Often given to employees as part of their compensation package.
- Restricted Stock Units (RSUs): These represent a promise to grant a set number of shares after a certain vesting period.
- Vesting means that even though you’ve been granted equity, you earn it over time. A common vesting schedule is over four years with a one-year “cliff.” This means that if an employee leaves before one year, they get no equity, but after one year, they get 25% (and then vest monthly or quarterly thereafter).
5. How is Equity Determined and Distributed?
- Valuation: Before equity is distributed, a startup valuation must be done. This establishes how much each share of the company is worth.
- Founders’ Equity: Founders typically start with 100% equity, which gets diluted as more investors and employees come in.
- Employee Equity: Employees are often given equity as part of their compensation, known as an “equity package.” This can range from less than 1% for later hires to larger percentages for very early employees.
- Investors: When startups raise money, they give away a portion of equity to investors in exchange for capital.
- As more equity is given out (e.g., during funding rounds), the percentage of the company that each stakeholder owns will decrease. However, the hope is that the company’s overall value increases, so the smaller percentage is worth more in absolute terms.
7. Exit Scenarios:
- Acquisition: If another company buys the startup, equity holders will get paid based on the terms of the sale and the type of equity they hold.
- Initial Public Offering (IPO): If a startup goes public, shares can be sold on the open market.
- Shutdown: If the company closes without being acquired or going public, assets are sold off, and proceeds go to pay off debts first. Equity holders might get nothing if there’s nothing left after debts are settled.
8. Important Considerations:
- Equity vs. Salary: In the early days, startups might offer more equity and a lower salary. It’s a trade-off.
- Terms and Conditions: Always read and understand the terms associated with your equity. This includes understanding any vesting schedules, rights, or other conditions.
- Valuation: Just because a startup says it’s worth a certain amount doesn’t mean it’s accurate. It’s essential to do due diligence.
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