Part I: What is Equity, and Why does it Matter? The Startup Founder's Guide to Equity
May 5, 2023
You started a hot new company and have just received a term sheet for your next round of funding. Everything is on fire - there are TechCrunch articles and glowing LinkedIn posts. All of the hours, years that you’ve put in have finally paid off. Your lawyer creates a spreadsheet to calculate how many shares the new investor will receive to close the round. You look at the spreadsheet and are shocked.
You only own 10% of your company. You don't control your own company, and even if you sold, you will receive a small slice of the upside.
How did you get to this point?
If you’re a founder or an employee at a startup putting off learning the intricacies of equity, we don’t blame you. It can feel overwhelming to decipher the legalese on the internet.
Founders receive the most dilution in the early stages of funding. Seed stage dilution > Series A > Series C + etc. You take the greatest dilution because your business is most risky and unproven.
You should never be surprised by how much of your company you own. Understanding how equity works prevent this exact sort of unpleasant surprise. And the earlier you understand how equity works- before your startup even has funding- the better your position will be in ensuring you still own a slice of your own pie.
What is equity and why does it matter?
Equity is the unit of ownership of your company. It has two features:
Economics - what is your upside? This is the financial benefit you receive from the company doing well.
Control - who decides the future of your company?
This part of equity most people understand. If your company were to ‘exit’ (i.e. acquisition or an IPO), you’ll receive the percentage ownership of what your company was valued for at that time. For example, if you own 10% of your company, and you sell it for $100 million, you'll receive either $10 million in cash or the equivalent equity in the acquirer.
When you start your company, you and your cofounder own 100% of your company. Things start getting complicated as you grow and bring onboard employees and investors. If you raise funding, you need to give your investors equity in return. As you grow the team, you need to give equity to employees. Equity, however, is a fixed pie. So although you and your cofounders may have owned 100% of the company at the beginning, each time you give equity away to these people you’ll whittle away at your own share as well.
The economics of equity is all about motivation. People like to know they own a part of what they’re building, and it’s a great way to bring and keep talented people on the team. You shouldn’t focus on keeping all the pie to yourself. Focus on making the pie so large that there’s more than enough for everyone to enjoy.
All we’re saying is, is that those pie slices you’re giving are going to come from somewhere, and that will be from the equity you own as a founder.
You might think you control a company if you are the founder and CEO. Unfortunately, this is not correct.
A company is controlled by stockholders who vote on a board of directors. This board of directors then chooses a CEO and other leaders to manage the company- who may or may not be you.
If you’re a newly formed startup, this is not a concern. If you own 100% of your company, your company will select you as director, and then appoint you as CEO because you hold the puppet strings. Although you may think of your company as ‘yours’, it is a separate legal entity.
But if you raise money and invite investors into the fold, they will occupy board seats and comprise an increasingly greater percentage of the stockholders. And if this is the case, you no longer have complete say on who controls the company.
There are absolutely benefits to having experienced advisors and investors on your board. They can help you hire executives, think through your strategy, introduce you to customers, and help you grow your business. But if things are not going well, your board also has the power to fire you. This happened to Travis at Uber and Steph at Away.
If you're going to hire and raise funding, you will need to give away equity. You will not own 51% of the shares forever and maintain control. However, there are strategies you can leverage to control your board and your company for longer:
Super voting - Successful founders have been able to maintain control by giving themselves "super voting" shares, which is basically stock that gives you more votes than you'd get with regular stock. Mark Zuckerberg and Evan Spiegel have used this to maintain control long after their companies have gone public even when they are no longer majority shareholders.
Raise funding smartly - Manage your runway and reduce your need for outside capital. The better your company is doing, the higher your valuation when you fundraise. When you raise your Seed or Series A, don't give away too much of your company, because you will need to raise more capital in the future. We see 10-20% sold to investors at each financing as the norm. That means you have 3-5 financing rounds before you aren't the majority stockholder.
If you’ve read through this article - congratulations! You officially know all about the building blocks of how equity works and why it matters.
Stay tuned for our next installment. We’re going to be diving into the different types of equity, and who gets what depending on your role in the company (investors vs founders vs employees). Understand the terms that matter so you can negotiate to your advantage.
As originally seen in Femstreet: https://femstreet.substack.com/p/keepingyoursliceofthepiepart1
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