When your company is just starting and you don’t have much to show for it, equity is the secret weapon you can leverage to get the investments you need to take off. But if equity is all you really have, how much of it should you give up? Unless you can bootstrap your entire business, you have to accept that you’re going to have to give some of your ownership stake away in exchange for essential capital – you just don’t want to be so flexible that you end up diluting your business from the start.
As an angel investor, I want a decent stake in the company so I can have a successful exit when the time’s right, but not at the expense of the success of the founders. The goal is for everyone to win, together.
Learn more about startup equity and how to determine how much to give up, when, and to whom below.
What is Equity and Why Do Startups Need it?
Simply put, equity is a slice of the ownership pie. Founders exchange a portion of ownership of their company for an injection of cash. Equity financing is not a loan and doesn’t need to be paid back, but angel investors like me will expect to profit from the investment when the company goes public or is sold.
Startups need equity because, without a product to sell or an established market, they don’t have much else to offer investors, especially pre-valuation. What they can offer, however, is the potential to win big in the future if the company is successful via equity.
Why sell part of your company?
Selling part of your company from the start might sound a little intimidating, but it’s standard procedure for most startups, and there are several reasons why.
- You need capital to continue growing your company and you’ve run out of personal funds and funds from friends and family.
- You want to take some of your own money out of the company since a startup, especially if it’s your biggest asset, is inherently risky. If you have the chance to move some of your personal funds into other, more conservative, investments, it can help you diversify and make your investment portfolio more resilient.
- You want more than just money and are looking for a partner to help you grow and scale your business through specialized expertise and entrepreneurial experience as well as access to a valuable network of industry connections. With such a high stake in your business, equity investors are incentivized to ensure it succeeds, so they often provide much more than just capital. When I invest, I take a hands-on approach and aim to mentor my founders using my own experience building and investing in companies to help theirs thrive.
Most startups give up a portion of equity for funding, and even though it may feel hard to give up some control if you need funding early on, this is the best way to do it. The trick is finding a way to make it worthwhile for both you and your investors.
What are Some of the Different Types of Equity In Startup Companies
Equity is not only available to investors in exchange for money. Founders obviously have some portion of ownership in their company from the start, but other kinds of people, including early employees and advisors, may also be compensated through equity.
Equity for Co-Founders
Founders typically begin by splitting up the equity of their company between them. A single founder may initially have 100% ownership, but many startups have co-founders. While there’s always the option of a 50/50 split, I find it makes more sense to divvy up equity considering what each co-founder can contribute as far as time, effort, and money go. The more contributions, the more equity a founder gets. You should also consider each cofounder’s expertise, the physical assets they provide, and their network.
Read more on Startup Compensation Guide
Try to split up equity among co-founders before moving on to additional parties, covered below.
Equity for Investors
Of course, investors often look for equity as well. Since we’re taking on an inherently big risk (especially in pre-seed and seed stages), we expect the equity we receive to eventually be harvested through an IPO or acquisition with a big payoff.
You can determine how much equity to give to investors by considering how much funding they’re providing and the perceived value of your company at the time they invest. It can be hard to determine an accurate valuation so early on, but talking with other startup founders in your niche at similar stages can help you understand what that landscape looks like, what a “normal” valuation is, and where your business might fall.
Equity for Employees
Startups are often short on cash but overflowing with potential for success, so offering early employees equity as a form of compensation can make your offers more enticing and help retain top talent.
Figuring out what percentage to give employees can be tricky, but some general guidelines are around .05-1% of ownership per employee, with around 10-15% of total equity reserved for an employee stock option pool. When determining an employee’s cut, consider how early they were hired (employee #1 should get more equity than employee #40), their experience and seniority level, and which department they’re in.
Equity for Advisors
Sometimes, advisors or mentors provide their knowledge and expertise to help startups succeed. While there are no hard and fast rules about using equity to compensate advisors, some founders like to compensate advisors that are regularly involved with somewhere between 0.5-1% equity, depending on the person’s background, prominence, etc.
How to Calculate Your Worth in Terms of Equity
Calculating your worth in terms of equity involves several moving parts, from the startups’ hypothetical exit value to how many options you have and the strike price per share.
When evaluating an equity offer and determining what it’s really worth, consider the following:
- Last Preferred Price – How much investors paid in exchange for one share in the most recent round of funding. This is a good point to gauge the potential for success but can be difficult if there haven’t been previous funding rounds.
- Post-Money Valuation – This represents the company’s broader value that comes after a funding round and we can reach this number but adding any new capital to its’ pre-money valuation.
- Hypothetical Exit Value – While most startups don’t make this information readily available, researching similar companies can give you a good idea. This would be the value generated if the company was sold in a hypothetical situation.
- Options – How many options were offered to you.
- Strike Price – This is the key determinant of an option value – the price per share to exercise options.
Most of this information should be available in any offer letter or agreement, which can then be used to calculate the value of the equity offered. There are a few equity calculators available online, like Carta’s helpful guide, to make the process easier.
How Much of the Company Should I Sell?
There’s a general rule of thumb that can help you determine how much of your company to sell, but you should also consider your unique situation, funding needs, progress, and offers.
I recommend that founders only go up to 20% equity in their pre-seed stage since you’ll still need to plan on selling more equity in later seed and Series rounds. If you give up more than 20% initially, you may find yourself too diluted later on.
It’s a situation where there’s a high potential for success, but also high risk, so investors like me want to know that we’ll get a worthwhile return if it turns out successfully. It also gives us a meaningful level of control in the company to help make decisions if things start to go south.
Give up 5% or 10%?
Some people take a minimalist approach and aim to give up just 5-10% of equity, but this simplified method can lead to a few issues:
First, if you’re only giving up 5-10% of your projected valuation, it may not get you enough capital in return for it to be worth it to you. On the other hand, it also may not be worth it to an investor to get such a small stake in an early-stage company.
If an investor is interested in an equity stake that small, they likely won’t be able to devote much time or attention to your investment as compared to other, larger investments in their portfolio. If you’re planning to rely on their guidance, you may need to give up more control to invite them in.
While giving up too much equity too quickly is a red flag to some angel investors, giving up too little can also turn us away. It’s all about finding the sweet spot that makes the deal worthwhile for both parties.
Early-Stage Equity: Key Takeaways
For most startups, giving up a portion of the equity in the company in exchange for funding is a rite of passage. It gives investors a vested interest in your company, gives you the funding you need to get your operation up and running, and creates a valuable partnership between founders and investors that drives the success of the business. It’s also common to use equity as a form of compensation for founders, employees, and advisors as the company begins to develop.
With so many parties interested in an equity stake in your company, it can be nerve-wracking to decide how much funding to give up. Offering too much can be cause for concern, while too little isn’t compelling enough.
You’ll likely be giving up equity throughout the years as you move on to later funding rounds, so limit yourself to giving up only 20% equity in the early stages so you can avoid dilution. Just be sure you’re giving up equity to the right people – investors who have your best interests at heart, want to see you succeed, and have the experience, skills, and network needed to usher you along the journey to becoming the next unicorn. If that’s the kind of angel investor you’re looking for, reach out to MacDonald Ventures.