Startups never stand still and startup founders are always looking forward; seeking out opportunities in new markets or looking for potential partnerships that can strengthen their offering.
While these are important for future-proofing the success of your startup, attention also needs to be paid to equity management.
A failure to consider equity management early on in your startup’s journey could lead to financial issues or you losing control of the company. On the other hand, getting a robust strategy in place from the beginning could see your startup achieving substantial growth that’s fuelled by the right backers and employees.
Let’s cover what an equity management strategy is and why it’s important for startups to have one in place. Next, we delve into what you should consider when developing your equity strategy.
Let’s start by taking a step back and reminding ourselves what equity is. The standard definition of startup equity is “The amount of ownership stakeholders have in a startup.” Stakeholders fall into four categories: co-founders, advisors, investors and employees.
The easiest way to think of equity is as a pie. As the sole founder of a startup, you’ll own the whole pie. As other people invest money, time or expertise, pieces of the pie are portioned out.
In exchange for money put into the startup (co-founders and investors) or expertise and skills (advisors and employees), stakeholders are offered shares. Each startup’s equity strategy will be unique; some will welcome investors, while others won't. And some will offer equity to employees, while some may consider this risky.
Say you’ve funded your startup yourself so far and it’s starting to gain traction. But you want to speed up this growth. Can you achieve it on your own? Most likely not. Unless you’re an expert in sales, marketing, development, HR, legal, finance and so on…
In exchange for equity, you can surround yourself with people who have the money and expertise to accelerate your startup to success. Be warned though, get your equity management strategy wrong and you could be in for a barrel load of problems.
The most common dispute over equity happens when a co-founder feels there’s an unfairness on how the equity is split. Maybe they feel they’re contributing more than others and as such are entitled to a bigger stake. Issues can also arise when founders are keen to get a set of investors on board, but they fail to negotiate properly. The result is the agreement is more favourable for the investors than the founders.
To avoid these issues and others, plan your equity management strategy in the early days of your startup.
Now that it’s clear on why you need an equity management strategy, here are some things to think about when building it:
Data is gold in startups; the more centralised your data is the more efficient your startup runs and the better business decisions you make. It’s as simple as that but getting to a point where data is centralised isn’t necessarily straightforward.
Let’s see why data can end up being stored in multiple places and what problems this causes.
In the early stages of a business, you may only need one or two systems. As the business grows and new people are brought in and departments are added or expanded, more systems will be needed. The result is that data is stored in different places. This data may be fragmented and be incompatible with other platforms. With decentralised data, answering the easiest of questions becomes a hassle.
Integrating multiple data sources into a centralised system isn’t easy but it will benefit your equity management strategy. Data that is easily accessible and integrated; enables informed decisions to be made across the business, it means stakeholders are clear on the direction that the startup is taking so they’re more invested in its success. Plus, having access to up-to-date data at all times makes forecasting easier. Overall, centralised data boosts a business’s performance and drives up revenue.
As a startup founder, your focus is on growing your company. This passion to succeed can be blinding. So, before agreeing to sign with new investors, take a moment to stop and ask yourself “Are they right for my business?”
The only way to be certain that they’re a good match for your startup is by doing your due diligence. In fact, you should be doing this for every potential investor. Particularly, when you consider that you may have a long relationship with them. And, if things do go bad, it could be costly to end the agreement.
When vetting potential investors ask yourself; other than money what value can they add to my startup? Can they introduce you to other investors? Do they have access to potential markets? Are they aligned to the ethos of the business or are they just out to make money? These are just some questions you’ll need answers to.
Vetting investors can be time-consuming. This is time that not many founders have to spare.
Don’t despair as Pitchdrive is here to help you find investors that are a great match for your startup. The process is so simple:
One of the reasons why startups fail is that disputes arise over the way equity has been allocated between founders. Research shows that as the startup matures the level of discontent among the founders also increases. So, coming to an agreement on how to split the equity is one of the most important decisions you’ll have to make.
Splitting equity between founders is done in different ways; some jump in feet first and do it on the first meeting (we don’t recommend this!). Others take the time to get to know each other before coming to an agreement, some go through a careful negotiation process, while some founders come to a verbal agreement (this isn’t a good idea) and others decide to split the equity equally.
Agreeing on an equal split may seem like the best solution in the beginning; it removes the hassle of negotiating and it means you can get on with growing your startup.
However, as time goes on, and it becomes obvious that some founders are putting more time and resources into the growth of the company than others. The decision to split the equity equally doesn’t look so good anymore. Renegotiating the equity split is time consuming and can be very costly.
So, what’s the right way of doing it? Well, the truth is there’s no ‘one size fits all’ solution. Before any agreement is made, we strongly recommend that serious discussions are had to uncover as founders how well you’ll work together, to discover whose skills will bring the most value, to see what connections each other have that could potentially lead to business partnerships and most importantly to gauge the level of commitment among the founders.
As you’re probably aware a cap (capitalisation) table does more than provide an overview of the ownership of a company. For example, a cap table breaks down the equity ownership of the startup, equity dilution and the value of equity in each funding round.
Cap tables play a major part in financial decisions, and new investors will probably ask to see a copy of your cap table before agreeing to invest.
In the early days of a startup, a cap table may be simplistic and easy to manage using as a spreadsheet. As investors are brought in and employees are taken on, the cap table becomes more complex and managing it using spreadsheets becomes difficult. Things can be missed, and mistakes can easily be made.
Using a centralised system for your cap table will ensure that it’s kept up to date, error-free and accessible 24/7 by the people who need to see it. Ledgy, is an all-in-one equity plan management platform. Data reports and document signing can be done within the platform, making it easier for the accounts and legal teams to keep track of what’s happening. Ledgy also makes equity management transparent, meaning employees are more invested in the company, while making it easier for you to nurture the relationship with your investors.
Find out more by visiting Ledgy.
As mentioned earlier, employees can be offered equity in a startup. This is known as ESOP - Employee Stock Ownership Plan. Even though ESOP’s are still a relatively new thing in startups, we believe that including them in your equity management strategy is a good move.
Firstly, for startups that want to hire but don’t have the cash to pay market rates, offering equity is a way of attracting and retaining skilled individuals. ESOPs are an attractive option for employees because they’re offered a financial pay-out for their part in making the startup a success. For founders, ESOP’s help to build motivated and invested teams.
By choosing not to offer an ESOP, you run the risk of losing good employees to other startups or companies that can offer higher salaries. This can slow the growth of your company, as well as jeopardise staff morale.
If you’re thinking to include ESOPs in your equity strategy, consider using vested ESOPs. This means employees have to remain at the company for a specific period before they can cash in all their shares.
Another consideration is cliff vesting. A vesting package typically covers four years, with a one-year cliff – on their one-year anniversary employees get 25% of their shares vested, but nothing before this. After this, vesting occurs monthly (remaining shares are vested over 36 months), until all shares are fully vested. For founders this can be an attractive option as it motivates employees to work hard during their first year and beyond, and it also means only those who are worthy of shares, get them.
Investors will want to know the value of the startup before investing. Because, well, who wants to invest in a company if they have no idea what pay out, they can expect to receive? Valuing a startup, particularly if it’s pre-profit, isn’t an easy task. But it is achievable with predictive valuation models.
Predictive modelling uses data to build systems that can predict future events. In this case, the value of a startup. Various predictive value models have been created, but the one most used to value startups is the Comparable Transactions Method.
The Comparable Transaction Model is one of the fairest methods of valuing startups. It looks at what other startups (that are similar to yours) were acquired for. For example, a fictional ride-share startup was acquired for €20 million. It has 500,000 users. That equates to EUR40 per user. Your startup has 100,000 users. Using the Comparable Transactions Method, your business value will be €4 million.
Of course, this model (like many others) has its downsides. Mainly, it’s dependent on market conditions. A shift in consumer need for a product or service, will greatly affect the value of a business. We’ve seen this recently with numerous businesses that have seen their user base drop due to Covid-19.
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