By Omoruyi Edoigiawerie, Esq
Last week, I started a twin series on understanding Start-up Equity and its dynamics, this week I wrote the concluding part of the article focused on the types of Start-up Equity.
Understanding the nuances that surround start-up equity entails recognizing its multidimensional nature, encompassing various forms each with distinct purposes.
As I said last week, start-up equity describes ownership of a company, typically expressed as a percentage of shares or stock. The term “stock” refers to ownership or equity in a start-up.
There are two types of equity: common stock and preferred stock.
1. Common Stock
Common stock is a type of security that represents ownership of equity in a company and encompasses the remaining value of all shares. Holders of common stock possess voting rights and are entitled to dividends and residual assets upon liquidation. It also comes with increased risk compared to preferred stockholders.
2. Preferred Stock
Preferred stockholders have a higher claim to dividends or asset distribution than common stockholders. Preferred stockholders enjoy specific rights and preferences over common stockholders, including priority in receiving dividends, protection during liquidation, and conversion privileges into common stock. They have the right to claim income from the company’s operations.
*Stock options
Stock options are probably the most well-known form of equity compensation. A stock option is the right to buy a specific number of shares of company stock at a pre-set price, known as the “exercise” or “strike price.” You take actual ownership of granted options over a fixed period called the “vesting period.” When options vest, it means it has been “earned”, though the shares will still need to be purchased.
*Restricted Stock Units (RSUs)
Restricted Stock Units (RSUs) are a form of employee compensation that grants shares of a company’s stock to employees. They may be granted to employees as a reward for performance, length of service, or some other reason, or simply as an incentive to remain with the company. RSUs provide employees with the opportunity to benefit if the company performs well and the stock price increases. Following vesting, employees acquire ownership rights, enabling them to sell these shares.
*Understanding the role of equity in raising capital
A start-up typically will have several rounds of equity financing as it evolves. Since a start-up typically attracts different types of investors at various stages of its evolution, it may use other equity instruments for its financing needs. Start-up equity plays a pivotal role in the capital-raising process, particularly for early-stage ventures where traditional financing avenues may be limited.
Equity financing mechanisms include:
1. Seed Funding: Initiated by raising capital from angel investors, friends, family, bootstrapping, or crowdfunding campaigns in exchange for common or preferred shares.
2. Venture Capital (VC): As start-ups scale, they seek funding from venture capitalists, who acquire preferred stock with specific rights and protections.
3. Convertible Debt: Start-ups issue convertible notes or preferred stock to early investors, delaying valuation until a predetermined date.
4. Initial Public Offering (IPO): Mature start-ups offer shares to the public, raising substantial funding and providing liquidity to equity holders.
5. Equity Crowdfunding: Some start-ups leverage equity crowdfunding platforms to raise funds from collective investors in exchange for equity shares.
*Managing equity when scaling
As start-ups evolve, managing equity becomes increasingly complex, necessitating careful planning and communication.
Key considerations to put in perspective include:
1. Establishing an Equity Pool for Future Hires: Allocate ownership stakes for successive team members as part of their compensation package, ensuring alignment with hiring needs and talent retention strategies.
2. Minimizing Dilution Risks: Negotiate terms in investment agreements, such as pro-rata rights, and explore alternative funding sources to mitigate the impact of equity dilution.
3. Addressing Legal and Tax Implications: Consult legal and tax professionals to ensure compliance with regulations and optimize equity plans for tax efficiency.
4. Arranging Prospective Exit Events: Define clear exit strategies and prioritize equity pay-outs for stakeholders, facilitating a seamless exit process.
5. Educating Employees on Long-Term Equity Gains: Provide resources and workshops to enhance employees’ understanding of equity options and their long-term value.
6. Regularly Reviewing and Adjusting Equity Strategy: Adapt equity plans to align with changing goals, stakeholder expectations, and market conditions, supporting the start-up’s growth trajectory.
*Equity financing – Pros and cons
Equity financing eliminates the need for repayment of debt and serves as a viable alternative when traditional loan avenues are inaccessible. It is perceived as a lower-risk option, as investors seek returns on their investment rather than loan repayment. Moreover, investors often exhibit a genuine interest in the success of the business, offering valuable expertise and networks.
However, the flip side is that equity financing entails relinquishing ownership stakes, leading to reduced profits for business owners and potential loss of control over company decisions.
The most important benefit of equity financing is that the money does not need to be repaid. However, the cost of equity is often higher than the cost of debt.
So, the bottom line is that start-ups often require external investment to maintain their operations and invest in future growth. Any smart business strategy will include a consideration of the balance of debt and equity financing that is the most cost-effective.
*Conclusion
Equity financing can come from various sources. Regardless of the source, the greatest advantage of equity financing is that it carries no repayment obligation and provides extra capital that a company can use to expand its operations, but this comes at a price and founders must not be oblivious of this price.
Equity is a powerful motivator for investors, as it means they have a vested interest in seeing the start-up succeed. When it is given, the value of their ownership reaches new heights. However, for founders, there’s a trade-off to consider. With each round of financing, where the start-up gets more money from investors, the founders’ ownership of the company shrinks. This dilution if not handled intentionally, can see the founders’ loose grip of their start-up, eroding their ownership rights.
Omoruyi Edoigiawerie is the Founder and Lead Partner at Edoigiawerie & Company LP, a full-service law firm offering bespoke legal services with a focus on start-ups, established businesses, and upscale private clients in Nigeria. The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances. His firm can be reached by email at hello@uyilaw.com.
