How to structure startup equity
For many startups the early days of business are all about ideas, building out MVPs and getting enough early traction to raise capital. But there’s something missing in this picture – the equity agreement.
It may not sound exciting, but getting the right equity structure agreed early in an important step for startup founders. This article will shine a light on the importance of equity agreements, explaining the options, while demonstrating why agreeing equity is a task every startup should complete early.
Why agree on equity early
There are a number of common equity mistakes startup founders make. These include giving away too much too early, assuming all founders are equal, leaving equity agreements late, and not structuring the agreement to protect the company and the founders during the early stages of growth.
Consider this; you’re heading into a joint venture with a new business partner. Based on a shared vision and full-time commitment you split the company 50/50. After a short but strong growth period, one founder decides to quit taking half of the company stock with them.
Your company is now 50% owned by an external shareholder. You’ll be working to increase the value of their stock. To make things worse, when you need to raise capital or incentivise your team, it will further erode your stock.
This is why it’s important to formalise your equity agreement early. When it comes to equity, there are three things you need to know as a founder; vesting, cliff and accelerations.
Vesting is the processes of transferring non-forfeitable shares to a founder over an agreed period of time.
If we take the example, both founders would receive their full 50% stock, however, the vesting agreement would release the assets in increments, with the full asset being realised over a 4-year period. In this scenario, the partner who exits early only takes the vested shares.
A Cliff is a defined period of time which must pass before shares can be vested. Typically, this period is 12-months, but depending on the situation this may differ.
Again, using our previous example, if the partner exits before the Cliff period expires he would be leaving without stock. As no shares have been vested all of his stock will be absorbed by the company and will be vested to the remaining shareholders, or used to incentivise new partners, advisors or investors.
Accelerated vesting is an immediate release of the total agreed equity, it is a mechanism usually reserved for advisors.
Acceleration is used in combination with a vesting schedule, allowing for an acceleration to be triggered under specific circumstances such as the sales of the company or an IPO.
The Standard Startup Equity Agreement
There are numerous ways to structure a startup equity agreement, which may depend on personal circumstance, expertise, experience, market maturity or legal jurisdiction.
For many startups, Four Years with a One Year Cliff has become the base equity structure. This schedule provides a mechanism which rewards longevity, while also safeguarding against teething issues or early exits. Here’s how it works.
Founders enter the first year with zero equity. They start earning their equity in year one, at the end of this period they are vested with 25% of their total stock (percentage may differ). If either exists before the one year anniversary the equity is not vested to the founder exiting.
The total vesting period is four years. After the one year cliff, vesting will begin monthly or quarterly to the remaining founders. The founders will receive their total equity by the end of year four. If there are exits along the way, the shareholder can only leave with their current shares.
Over the course of the vesting period, unallocated shares are held and released by the company. The mechanics for this vary by legal justification, seek the advice of an expert startup lawyer in your country.
Creating a fair equity agreement
It’s common practice to split equity evenly between founders, but even isn’t always the fair and can trigger problems further down the road. Once agreed, you equity agreement and schedule are legal documents which can’t be easily reversed.
Before drafting your equity agreement, get your cofounders together to discuss what you’re each bringing to the startup and the value of your assets. Agree on a structure that will work for everyone over the total length of the agreement. Spending time here can mitigate issues and save the company a great deal of money later down the road.
Some things you may want to discuss:
- What if any capital is being brought to the company
- What if any assets are being brought to the company
- Value of experiences, expertise, network
- Factoring opportunity cost
- Work ethics and expectations
Get it done then move on quickly
No one starts a business to think about equity agreements (unless you’re a startup lawyer), but it’s an important process that should be dealt with quickly and early, so you can move on to build and grow your company.
As a founder it’s important to remember your time, expertise and experience are valuable assets. The equity agreement recognises your value and protects your personal investment in the company. It will also provide credibility with co-founders, investors and advisors.