How Does Equity Work in a Startup?
The most widely known concept in all of finance that’s gotten as much shine in the past few decades is equity. This is largely due to the boom in tech startups since the start of the dot com era. Never before in history have such small percentages of equity created the foundation for big empires in such a short amount of time.
At face value, startup equity is really a rather simple concept. However, the fine details can get quite complicated. This leads to many misconceptions for new business owners, particularly about equity structure and distribution in start-ups.
In this article, we’ll give a basic primer on startup equity, some of the common misconceptions, as well as crucial sub-points that are important to understand. This is by no means a thorough explanation of how equity at startups works.
With a deeper understanding of equity and simplifying tools like our Mata, start-up executives can stop worrying about getting lost in logistics and instead get lost in their creative work.
In basic terms, equity at a company represents a percentage ownership of a company. Whether you’re a creator or an investor, it’s important to know that this represents financial ownership as opposed to creative ownership. Equity is the percentage of a company’s private stock you own.
This brings us to one of the first critical misconceptions about startup equity—your equity is a percentage ownership of shares, not of the company’s decision making.
For example, Travis Kalanick owns 9% of Uber. However, this doesn’t mean he can exert a 9% influence on Uber’s management decisions.
Put simply, shareholders vote and elect on a board of directors. The board of directors vote and elect a Chief Executive Officer – who ultimately makes the decisions at the company. So while Kalanick’s 9% vote is certainly significant in the event of board personnel decisions, his direct impact on day-to-day decisions made by Uber CEO Dara Khosrowshahi are limited.
Now this (as with almost every other thing we describe in this article) is the standard process, but it can and does often get altered. Different companies may extend added voting rights and privileges to different classes of shareholders. This is, however, the exception and not the rule.
Keeping in mind that start-ups are all about new ideas, you can use the “Creator” version of Mata to maintain creative ownership. By keeping tabs on ideas and projects, and closely monitoring funding rounds, creators can avoid getting bogged down by having to satisfy too many opposing voices and keep the product’s integrity.
So, if equity doesn’t necessarily mean voting rights, what’s it worth?
In extremely simple terms, your equity is worth whatever someone is willing to pay you for it.
In certain situations, like when a company does an IPO and goes public, calculations of shares can be very easy. Your equity simply translates to the percentage of shares of that company on the market, and the value of that equity is whatever the market is paying for it. In other words, you can sell your equity to the highest bidder and cash out whenever you want.
This is generally the route most equity-holders capitalize on their equity. In the event of an acquisition, a foreign company may offer to buy your company out entirely, and your equity is sold to the bidding company, with the money being returned to you. In that event, of course, you are returned your equity % of the acquisition value.
For investors looking to find promising start-ups, Mata for backers is an easy way to invest and keep track of expenditures and growth in real-time. It also helps them to sell their shares.
The Mathematics of Risk
In a new startup, of course, neither of these options is really feasible. In a private company with private shares, there is a lot of regulation that dictates the movement of shares. You can’t simply sell it off to anyone you choose. Until your company is sold or hits the public stock market, your equity is nothing more than a percent sign on paper.
And therein lies the crux of what startup equity is—the buying and selling of risk.
As a co-founder, your equity value should be a representation of the amount of risk you’re taking on. By joining a very early venture (which is inherently risky) you are risking your personal well being on the venture’s success. High equity, then, is a monetary representation of your risk with the promise of a future reward. This is why it rarely makes sense for one cofounder to get significantly more equity than another. Collaborators can utilize Mata to help build these ventures while maintaining transparency throughout the process.
When later employees or investors come on board, they’re taking on far less risk – the business has established itself by this point and has proven its ability to generate revenue. Therefore, the likelihood of equity materializing is much higher. They are then rewarded with a lower potential share of the company, to compensate for the lower risk being assumed.
Startup equity is your chips on the table. It’s the bet you’re making on the future financial success of the company.
Common vs. Preferred Shares
A discussion of startup equity would not be complete without a note on one of the single most common pitfalls that early startup employees face: a down round or a poor exit.
Let’s say you’re Employee #5 at a roaring new startup. The company just raised a big seed round at a $100m valuation. (Side note: “valuation” is simply the estimated market value of your company. If investors offer $10million to buy 10% equity in the company, they are valuing it arbitrarily at $100m.)
After raising the round, you are hired and given 0.5% equity in the company. Now, let’s say things don’t go so well, and in a few years the company ends up selling for much less than it was valued at – $15million dollars.
Now, you’re probably thinking, “Hey, I’m still walking away with $750,000… not bad, right?”
Not quite. Equity is typically separated into two groups – common and preferred shares. Preferred shares (typically given to investors) don’t carry any voting rights but do offer the privilege of getting first dibs in the event of a stock buyback. In startups, preferred shareholders also typically get certain protections. For instance, in the event of a liquidation, preferred shareholders often have the right to pay back as much of their capital investment as possible, before a dime is sent to common shareholders.
In other words, your 0.5% of equity doesn’t necessarily mean 0.5% of a liquidation event – it all depends on the terms and clauses and different types of shares defined by the company.
Ultimately, all of these discussions go back to an earlier point – it depends. While broad stroke generalizations can be helpful for understanding equity, in a nutshell, it’s essential to take a deep dive and possibly hire outside help when negotiating startup equity.
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