Key Considerations When Dividing Equity in Your Startup
The Harvard Business Review, identifies equity division as one of the most common pitfalls founders make when launching their startups. Equity refers to the percentage of ownership founders or employees have in a startup. In the early days, founders will naturally own most of the equity. Later equity it is often distributed to investors and talented team members to scale the startup or as part of a compensation package to promote loyalty and staff retention.
Dividing equity fairly between all parties, including founders, investors, and employees, can be challenging. There is no definitive model that will accurately determine how your equity should be parcelled out. Ultimately, deciding on how your startup will divide its’ equity will come down to what is best for your startup. It is about finding the right balance that suits the needs and goals of your venture whilst ensuring that everyone feels valued and that they are being treated fairly.
There Are a Few Key Considerations…
There is no blanket formula when it comes to dividing equity in your startup. The division of equity will depend on your individual business structure, goals, and needs. Some startups decide to distribute their equity upfront, some wait to get to know each other, and some go through a careful negotiation process. Whichever course of action you have or intend to take, there are a few key considerations you should make when dividing equity.
Implement Legal Agreements ASAP
Quick ‘handshake’ agreements seldom work. In the early stages of your venture, it can be difficult to predict how your startup will mature and whether each founder will contribute to the venture equally. At Allied Legal, we recommend taking the time to go through the terms of your startup’s equity distribution rather than rush into a decision. Once the equity division has been agreed upon, binding contracts such as shareholders agreements, vesting deeds and subscription agreements will cement the process. A commercial lawyer will be able to draft thorough agreements specifying how the startup will be owned and managed and how the rights of each shareholder will be protected during exit or IPO.
Shares or Options?
Equity compensation usually comes in either shares or options. Shares are owned by shareholders, who (typically) have a financial stake or founding role in the startup. Often founders choose to offer their employees stock options by way of an ESOP. With options, team members own the right to buy shares at a set price or ‘strike price’ at a future date, meaning that they are not shareholders until they pay the fixed price.
Vesting or Reverse Vesting
Vesting is a process often employed by startups to establish how people will receive their shares. Vesting allows stakeholders in a startup to acquire a vested interest or a stock option over a period of time. Through various structures like time-based, milestone-based and hybrid vesting, founders or employees must earn their equity stake by remaining involved in the venture. You will also need to decide when your employees can access their equity. The most common timeline is a four-year vesting schedule with a one-year cliff, meaning a stakeholder's equity begins vesting their equity after a year of being at your startup, and finishes vesting after 4 years. At Allied Legal, we recommend consulting a commercial lawyer to design the terms of your vesting arrangement as the process can be both taxing and difficult to navigate.
Need Help? Contact Us
At Allied Legal, we recommend seeking the advice of a commercial lawyer before dividing equity in your startup as the process can be complex and time consuming. You can connect with one of our expert commercial lawyers by calling us on 03 8638 0888 or sending us an email at firstname.lastname@example.org.