By Omoruyi Edoigiawerie, Esq
This week I start a twin series on understanding start-up equity and its dynamics, this decision is borne out of the avalanche of requests that I get from founders who have a difficult time understanding the nuances of their start-up’s equity.
When embarking on a new business endeavour, clarity is essential across all fronts. Founders often wrestle with fluid concepts like start-up equity as they advance their venture. Without a clear understanding, they risk over-distributing equity, struggle with ownership allocation, and hastily promise shares in hopes of gaining investments.
Most start-ups typically operate with finite resources and require effective tactics to draw in top talent, secure investment, and cultivate community backing. Therefore, comprehending the mechanics of start-up equity isn’t just vital for founders; it’s equally important for co-founders, staff, professionals/advisors, and investors. In this two-part article, we’ll explore the nuances of start-up equity, addressing everything from its definition to strategies for scaling the start-up while managing it effectively.
*Equity explained
Equity is a common term amongst start-ups, it refers to ownership interest or rights in a company and it denotes the ownership interest held by individuals or entities in the company. Start-up equity refers to the ownership of a start-up, typically expressed as a percentage of shares in the start-up
Equity plays multiple roles, it helps to attract talent (employees, consultants, and professional service providers), secure funding from private and venture capital investors, and align the objectives of various stakeholders towards shared objectives.
By distributing start-up equity among partners or employees with a range of skills, you can bolster the business’s capacity for growth. A carefully assembled team can harness its expertise to drive the company forward, potentially bolstering its valuation. Strategic equity allocation becomes essential in enabling the start-up to reach its goals effectively.
*Who should be allocated equity?
Many founders have fallen into the trap of offering excessive equity to attract partners, investors, or when hiring start-up developers or other top talent only to realize later that the returns fall short of initial expectations, and they can eventually lose their companies to strangers. Founders must keep in mind that a consistent approach to managing and distributing start-up equity is very important. They must therefore always check their excitement and desperation before making commitments and resisting the urge of oversharing equity. One efficient solution is to ensure that as a Founder, you or your co-founders cumulatively hold more equity shares that outweigh all other investors or stakeholders combined.
*Who then are the stakeholders?
The key stakeholders who typically receive startup equity include:
• Co-founders;
• High-level employees – (c-suite);
• Professionals; and
• Investors.
So let me point out here that not every startup will allocate equity across all four categories. The distribution of start-up equity differs from one business to another and from one co-founder to another. There is also no universal approach when distributing equity to employees, professionals, or other external stakeholders. Regardless of your startup’s stage of development, understanding how to establish a fair structure for distributing shares to various parties is essential.
*Here are a few tips:
Co-Founders
In start-ups with co-founders, it’s wise to have open discussions and documentation regarding equity distribution early on. Discussing equity with co-founders is vital for establishing transparency, alignment, and trust within the founding team. Open communication about equity ensures that everyone has a clear understanding of each member’s contributions, responsibilities, and ownership stakes in the company. This transparency fosters a sense of fairness and equity, reducing the likelihood of conflicts or misunderstandings down the road. This is even more important since they invest their time, expertise, and personal finances to kick-start the company.
Typically, co-founders are granted a significant portion of the initial equity, reflecting their early involvement and commitment to shared objectives. The distribution of equity among co-founders can vary depending on factors such as their roles, responsibilities, and contributions.
With equity in the bag, co-founders can align their long-term goals and aspirations for the business, ensuring that everyone is working towards a shared vision.
*Employees
Employees are an invaluable asset to any growing company, contributing their skills and knowledge to fuel its growth and this is even truer when you talk of start-ups. To attract and retain top talent, start-ups often offer competitive compensation packages. However, if initial compensation is below the market rate, offering start-up equity can serve as an additional incentive. Equity allocation to employees is usually based on factors such as their role, seniority level, and salary. This equity can take various forms, including stock options, restricted stock units (RSUs), or direct ownership of equity shares. However, careful consideration must be had in taking this decision, as there are far-reaching implications when scaling the start-up team.
*Consultants/Professional Advisors
Start-up founders often seek support from the ecosystem to bridge their knowledge gaps and help with areas of technical deficit. These advisors play a crucial role in guiding teams, offering expertise, industry insights, and valuable connections. In exchange for their contributions, they may receive equity in the start-up at a pre-negotiated ratio. The equity allocated to advisors can be project-based or integrated into a long-term advisory collaboration. It’s essential to align expectations regarding equity distribution with advisors, ensuring clear terms and specifying the scope of advisory services in exchange for equity compensation.
*Investors
Allocating equity to investors is a strategic decision that can nurture an alignment of interests and provide vital financial support for start-ups. By offering equity stakes to investors, start-ups attract funding that is necessary for growth and expansion while aligning investor interests with company success. This not only provides investors with a stake in the company’s performance but also incentivizes them to actively support its growth and development. Sharing equity with investors can strengthen relationships, as both parties are invested in the long-term success of the venture. However, it’s crucial for start-ups to carefully consider the terms of equity agreements to ensure that they maintain control and ownership over their vision and operations.
Investor equity is typically acquired through the purchase of shares in the start-up, with investment terms predefined in the term sheets and investment agreements. These agreements also outline any rights or preferences associated with the issued equity shares.
*Conclusion
Understanding the intricacies of start-up equity distribution is essential for founders, co-founders, employees, advisors, and investors alike. Equity serves as a multidimensional tool, attracting talent, securing funding, and aligning interests among stakeholders. Through thoughtful allocation and strategic distribution, start-ups cannot only empower their teams, but they can also drive growth, and ultimately realize their innovation-driven objectives. It is, therefore, a must that they have a holistic picture of the nuances of equity and its implications, armed with this information, they can navigate the complexities of building a successful start-up with confidence and clarity.
Next week, we will explore the types of start-up equity, the role of equity in raising capital for business, and strategies for managing equity during scaling.
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.
