This is a syndicated post originally written for Xcelerate Financial, a fully outsourced CFO and accounting firm for tech startups and one of my clients. Enjoy!
A startup company’s equity can often be its most powerful asset. With equity, business owners can incentivize employees, entice investors, hire co-founders, increase synergistic partnerships, and earn a payout in an exit event.
However, while startup equity is powerful, it typically causes early stage companies a lot of problems. This is because a lot of companies give out equity in the wrong way. Rather than finding the best ROI for their equity, founders too often give away equity to friends and family and use it to raise funds from minority investors.
But this squanders the power of startup equity. You only get one chance to divide your startup company. If you give too much – or too little – to such things as employee pools and investors, you might constrict your company to the point that it suffocates.
To help, we’ve written an article that outlines the rules of thumb for equity distribution, how to value potential equity partners, as well as how to avoid dead equity.
Typical Startup Equity Distribution
As a startup founder, the first thing you should be concerned with is remaining in control of your company. It’s common for business owners to give away too much equity to the point where they can’t make decisions on their own. Instead, they give away flexibility and control, often times for a quick buck.
Startup companies typically start out with 2 – 3 co-founders owning 100% of the company. Any more cofounders than 3 and you probably have too many cooks in the kitchen. That, and the fact that you’ll reduce your potential reward for exiting.
When deciding on equity ownership between co-founders, remember that on average, startup founders own around 30% of their company at the time of an exit event (IPO or sale). This percentage takes into account average dilution and equity given to employees, investors, and partners.
So, when dividing equity amongst founders, make sure you keep enough equity in the beginning so that when you dilute and give away options, the startup’s founders still retain 30% in case of a liquidation event.
When it comes to investors, you want to make sure that you give them enough to want to help you, but not enough to the point where they assume control. During an Angel round, startups typically give away between 10% – 20% of the company. During VC rounds, such as a series-A round, it’s not uncommon to give away between 20% – 30% of the company.
Of course, investor percentages are based on many things, but these numbers are good rules of thumb.
For employees and third-party partners, startups typically create a pool of about 15% equity. This pool is used to create synergistic business deals and to incentivize employees.
How to Value Partners and Your Equity
Ok, so you now know the general equity distribution of a standard startup. However, that still doesn’t tell you if an investor, partner, or employee is valuable enough to give them a piece of the pie.
To help, Paul Graham, co-founder of Y-Combinator, created a simple equity equation. This equation will help you determine the value ROI of the equity you give away. The equation is a breakeven and is as follows:
- Startup Equity ROI = 1 / (1 – n) – 1
“N” represents the percentage of equity you give away. It’s really as simple as that. Let’s try it with real numbers.
Let’s say, for example, that you’re determining whether or not an investor will provide enough value to warrant an equity distribution. Sure, the investor is offering cash, but what’s the long-term value of the partnership? Is it worth giving up a piece of your company?
The investor in this example is offering to buy 5% of your company’s equity. To determine whether or not the partnership is valuable, you can use the equity equation to get:
- 1 / (1 – 0.05) – 1 = 0.0526
This is the “value breakeven.” Paul Graham refers to this number as the amount that someone can improve your chance of success. So, if you believe that this investor improves your chances by more than 5.26%, then giving up 5% equity is a good idea. If you think the value is less than a 5.26% increase in your probability of success, it’s a bad idea.
Like I said, it’s as simple as that.
How to Avoid Dead Equity
“Dead equity” refers to passive equity ownership in a company. For example, the small percentages that you give away to passive investors is considered dead equity. You’re not receiving any value from the partnership other than the cash made selling your equity.
While this isn’t a huge factor for venture capitalists, too much dead equity is a bad sign for later-stage investors. Further, dead equity can sometimes hurt your company because you’ve given away some of your leverage and power for a one-time transaction. There are no recurring benefits.
Remember that dead equity in of itself isn’t necessarily bad. You might need cash from an Angel investor and not need their expertise. However, too much of it is definitely not good.
This is why you need to mind the rules of thumb for equity distribution. You never want to give away too much equity to passive partners who won’t help you grow.
Further, this is also why you need to stay true to Paul Graham’s equity equation. Passive equity partners rarely pass the breakeven analysis unless you’re in dire need of cash.
Instead of dead equity, look for long-term partners who have skills that benefit your chances of success. Over time you can distribute your equity in such a way that you have a strong network of eclectic people who know how to scale a business.
Overall, make sure that the people who own chunks of your company care about its success. Equity is a great leverage point. However, the more dead equity you have the lower your chances of continued success.
To help, assess your equity decisions using the equity equation. This way you’ll always know that the people with ownership in your company are increasing its chances of survival.