Equity is a critical concept for startup founders to understand. The amount of equity founders have can significantly impact their financial success, so it is essential to get it right.
What is Equity?
Equity is simply a share of ownership in a company. It is typically expressed as a percentage and can be divided among multiple owners, such as founders, investors, and employees. The more equity a person owns, the greater their share of the company’s profits and assets.
How Co-Founders Change the Equity-Sharing Math
When there are multiple founders, the equity-sharing math gets more complicated. Founders must understand how equity will be shared before starting their company. This will help avoid conflict and ensure everyone is on the same page.
Generally, the more work and expertise each founder contributes, the more equity they should receive. With more co-founders, however, there is less equity, so each founder typically gets a smaller percentage of the company. This is why co-founders must clearly understand how equity will be shared before starting their company.
Co-founders should consider a few factors when determining how to share equity. These include:
- The amount of work and expertise each founder contributes.
- Each founder’s financial investment.
- Each founder’s role in the company.
- Each founder’s risk tolerance.
Equity can be diluted over time as the company raises money from investors. This means the founders’ ownership stake in the company will decrease as more investors are brought on board.
In other words, the more co-founders you have, the less equity is available for investors to fund a startup’s building efforts.
Here are some additional considerations to keep in mind about how the number of co-founders can affect equity-sharing:
- In general, it is best to have a small number of co-founders. This will help avoid conflict and ensure everyone is on the same page.
- If there are multiple co-founders, it is vital to have a transparent and fair equity agreement in place. This agreement should document how equity will be shared and how it can be diluted over time.
- It is also essential to revisit the equity agreement regularly as the company grows and changes. This will help ensure that the agreement is still fair and equitable to all co-founders.
By carefully considering these factors, co-founders can help ensure they have a fair stake in the startup’s success.
How Investment Further Dilutes Equity
The company’s total equity is diluted as a startup grows and raises money from investors. This is because each new investor will receive a share of the company, which will reduce the ownership stake of the founders and existing investors.
The dilution will depend on the size of the investment round and the number of new investors. For example, suppose a startup raises $1 million in a Series A round with 10 new investors. In that case, the founders’ equity will be diluted by 10%.
Remember that investors typically demand a larger equity stake for larger investment amounts. For example, an investor might be willing to accept a 10% equity stake for a $1 million investment. They might ask for a 20% equity stake in exchange for a $5 million investment. This is because the investor is taking on more risk by investing more money.
The number of new investors can also affect the amount of dilution. The more new investors there are, the more the founders’ equity will be diluted. This is because the pie is being divided into more slices.
The type of investor can also affect the amount of dilution. Venture capitalists (VCs) typically demand a larger equity stake than angel investors. This is because VCs are more sophisticated investors willing to take on more risk.
The stage of the company can also affect the amount of dilution. Startups further along in their development typically have to give up less equity than startups just getting started. This is because the later-stage startups have a higher valuation and are less risky.
In addition to these factors, a few other realities can affect the equity dilution that founders experience. These include:
- The company’s financial performance. If the company is doing well, it will be better positioned to negotiate a better deal with investors.
- The founders’ negotiating skills. Founders who are good at negotiating can often get a better deal.
- The terms of the investment agreement. The investment agreement will specify how much equity the investors will receive and how the equity can be diluted over time.
Founders should consider all these factors when deciding how much equity to give investors. By doing so, they can help protect their ownership stake in the company and ensure that they are fairly compensated for their hard work and contributions.
Recommendations on How to Manage Equity
Equity can be a powerful tool for motivating and retaining employees, as well as for attracting investors. However, founders need to remember that:
- Equity is not liquid. This means that it must be converted into cash first.
- Equity is subject to risk. If the company fails, the founders may lose their entire equity stake.
So, what should founders remember when managing their startup’s equity?
- Have a frank discussion with your co-founders about how equity will be shared.
- Be prepared for dilution when you raise money from investors.
- Get everything in writing, including the terms of your equity agreement. The investment agreement should be clear and concise, and it should be signed by all parties involved.
- Be prepared to negotiate. Don’t hesitate to negotiate with investors to get the best possible deal for yourself.
- Get independent advice. Get independent legal and financial advice before signing any investment agreements.
- Review your equity agreement regularly. As your company grows and changes, you may need to revisit your equity agreement to ensure it is fair and equitable.
Founders must understand how dilution affects their equity stake when making equity decisions. These recommendations help founders ensure a fair and equitable ownership stake in their company.
This knowledge can help you know when to raise money and how much equity to give up. More knowledgeable founders can help ensure their company is well-positioned for success.
Consider joining an entrepreneurial community that can help support your personal development goals for you, your team, and your startup. Geekdom’s membership options in downtown San Antonio cater to professionals seeking a collaborative and supportive work environment.
The featured photo shows a hand holding up hundred-dollar bills. Photo by Jp Valery on Unsplash..