Startup equity dilution works when the same pie is divided among more people. A company’s founder begins by owning all of the shares that represent the company’s ownership. Other people get equity in exchange for their efforts (employee stock options), money (seed, angel, and venture investors), and services over time (attorneys, consultants, etc.) Because the total percentage of equity will always be exactly 100 percent, every new piece of equity “dilutes” all prior equity holders by definition.
If a company has to do to avoid dilution to its existing shareholders is not hire any more employees with options or take any more money from investors. However, “A small piece of a big pie is better than a large piece of a small pie” – This quote is used regularly by investors when discussing startup equity.
What is startup equity?
You give away a piece of your firm every time you get funding. The more money you have, the more business you have to give up. The basic concept of equity is the division of a pie. When you first start something, you have the whole pie. You’ve got 100 percent of a tiny, bite-size pie. Your pie gets bigger as you take outside funding and build your business. Your slice of the larger pie will be larger than the bite-size pie you started with. When Google went public, Larry and Sergey each owned around 15% of the company. However, 15% was a little portion of a much larger pie.
The term for this part of the corporation is ‘equity.’ Everyone who receives it becomes a co-owner of your business. Smart business owners understand that owning 10% of a $5 million company is preferable to owning 51% of a $1 million company. In exchange for giving up a significant amount of power, a founder frequently receives enormous financial and non-financial resources.
A few factors influence how you value your startup equity.
1. Last Preferred Price
During the company’s most recent investment round, investors paid the last preferred price for a single share. It’s commonly used as a metric for determining the likelihood of a startup’s success.
2. Post-Money Valuation
After a round of fundraising, a startup’s post-money valuation shows the company’s overall value. It’s computed by multiplying the pre-money valuation (the value of a company before a round of funding) by the amount of fresh equity.
3. Hypothetical Exit Value
The value at which a corporation would exit — that is, the value that a company would create if it were sold — is known as hypothetical exit value. This information is often not easily available from startups. If you want to get a close estimate, look into similar businesses to see how theirs have fared.
4. The number of options available to you in your grant
This is a rather self-explanatory one. Your grant’s number of options is exactly that: the number of options in your grant.
5. The Strike Price
A strike price is a set price at which a derivative contract can be bought or sold when it is exercised. For call options, the strike price is where the security can be bought by the option holder; for put options, the strike price is the price at which the security can be sold.
Stages of Equity
Because there is no clear figure that can be associated with the founder’s wealth at the outset, there is no definitive number that can be associated with the founder’s wealth.
At the next stage, which is still in the early phases of a startup’s lifetime, the company has generated revenue but has not raised outside capital, therefore the founder’s wealth is equal to the company’s profits.
As a result of investment, we can observe that the company now has a third-party stake, and so a corporate valuation has been established. By investing funds in the company, the investor receives a 25% stake in the company. At this point, new shares are being issued, and the pie is growing in size. No, the founders’ shares have not changed, although the percentage of equity ownership has reduced.
The new investor joins the equity cap table at this point. In exchange for their cash deposits, new investors are awarded a new set of fresh shares. The pie is beginning to grow in size. The founders’ shares do not change, but their percentage equity ownership in the company does.
Fast forward if the firm is doing well and has raised numerous rounds of capital, the pie has grown even larger, and the founder’s wealth has increased as well, yet their stock percent ownership has decreased significantly.
Deciding equity split
When it comes to determining the stock split among founders, there is no right or wrong answer. To avoid an awkward dialogue, people frequently default to a 50/50 split or similar equal distribution. It’s a problem that, if not addressed properly, can cause major problems in a company’s future.
A 50/50 split isn’t always the best option. Founders have varying abilities and levels of dedication to the company. People are at various periods in their lives, and founders take on various roles.
The contributions to be evaluated should extend far beyond the talents, expertise, and contributions made at the time of the company’s inception. The initial notion on which the company was built, for example, has value, and whomever came up with it should be adequately compensated. However, the concept is only one aspect of the evaluation, as it may be worthless unless it is put into action.
Splitting equity smartly
“The CEO usually receives more,” says Peter Pham, a serial entrepreneur, angel investor, startup counsellor, and cofounder of Science, a Santa Monica-based incubator. Pham recounts a group who entered Science expecting to split their company 50/50. ‘Look, it can’t be 50-50,’ we had to tell them. Because you’re the CEO and your spouse isn’t, the value of their function will dwindle over time while yours grows,’ says Pham. “The equity should be distributed depending on value generation.” Pham continues, while the non-CEO founder deserved a big interest in the company.
Look into the future to see how things might change. According to Roy Bahat, CEO of Bloomberg Beta, an early-stage venture business funded by Bloomberg L.P., founders must “understand each other’s interests and goals.”
When it comes to raising financing, knowing the worth of your firm is critical. As it helps you choose how much startup equity to provide investors in exchange for their money. Giving each founder equal shares isn’t necessarily a good idea because it ignores their contributions in the startup.