Navigating Startup Equity Models

Defining Startup Equity

The term "startup equity" refers to the ownership of a startup, usually demonstrated as a percentage of ownership (or shares) given to individuals who contribute to the growth of the business. Equity stakes entitle their holders to a proportion of the company’s future profits and give them voting rights in company decisions, usually in correlation with the size of their ownership.

Think of it like a pie. You own 100% of it. But if you want to scale the business, you will have to share the pie. This concept might be foreign to those who prefer to eat entire pies on their own, but I digress.

Successful startups are those that can scale and split the equity pie in a way that benefits more people. And you can’t be greedy about it.

Even Jeff Bezos, the world’s second-richest man, owns only around 9% of Amazon shares, the company he founded.

Who Gets Equity in a Startup

When your startup is in the initial stages, the founding team usually owns it entirely. However, as the company grows, equity starts to get distributed among those who contribute to the endeavor. This includes:

The first batch of investors, also known as friends and family.
Employees who invest their time and skills for little to no real pay.
Strategic advisors who provide expert advice and access to their network.
Other service providers who actually take equity as a form of compensation.
And, of course, the investors who provide capital.

Why Startup Equity Matters

Within startups, equity serves as the backbone of incentive structures, influencing both short-term actions and long-term strategic planning. Its importance surpasses mere ownership or potential financial rewards.

In other words, it isn’t just bragging rights. Equity gives you actual rights within the company. Equity impacts every facet of a startup's operations:

Motivation and Retention: Equity motivates individuals to invest maximum effort since their financial rewards are directly tied to the startup’s performance.

Talent Acquisition: An attractive equity package can compensate for lower salaries, enabling the company to hire top-tier talent.

Strategic Decision-Making: Equity holders, depending on the type of shares, often possess voting rights, influencing strategic decisions from fundraising to exit strategies.

Investor Relations: Equity structures communicate how the company values different contributions and risks to potential investors.

Exit Opportunities: During liquidity events such as IPOs or acquisitions, equity holders stand to gain significantly.

Capital Allocation and Financial Strategy: Equity is integral to the company’s financial framework. The type of equity and associated rights can affect the startup’s ability to raise capital, allocate resources, and manage debt.

So, what is the right way to split equity?

Splitting Equity According to Y Combinator

There are countless sources for startup advice online, most of which contradict one another. You don’t want to take advice from someone who, just a few years ago, thought a startup accelerator was something wrong with your car.

As equity is paramount among founders, we are going straight to the source, Y Combinator. For those not in the know, Y Combinator is a leading startup accelerator and venture capital firm launched in March 2005 which has been used to launch more than 5,000 companies. You may have heard of their alumni such as Airbnb, Dropbox, GitLab, Instacart, and more.

Needless to say, you can pay attention to what they have to say: split the equity equally (or nearly equally) among the founders.

That’s right. Equally.

Not based on who came up with the idea for the company (yes, we know you are the genius behind AI for hot dogs).
Not who worked on it first.
Not who took a salary while others didn’t.
Not who has more experience.
Not who brought in the first angel investor (thanks, Uncle Tom).
And certainly not someone who can act as a tie-break in the case of founder arguments.

This is because all of the work lies ahead of you.

Uneven Splits Have Consequences

Founders tend to make the mistake of splitting equity based on early work and early contributions. But this has consequences.

For example, investors will wonder why co-founders have such low percentages of equity. It sends a red flag that the CEO doesn’t value their own team, someone lacks a core competence, or they will have no significant impact on the business.

Ideas are a dime a dozen. Execution is what matters. Unequal founder equity splits often unfairly favor the co-founder who conceived the initial idea, rather than acknowledging the efforts of the team that brought the product to market and achieved initial traction.

Yes, the actions taken during the first year do have an impact. However, building a company of significant value typically takes 7 to 10 years of hard work. Minor differences in contributions during the first year do not warrant drastically different equity splits among founders in the subsequent years.

The founding team will determine the most important questions and determine the path forward. This will be hard to achieve when there is an unequal equity distribution.

Understand that founders are going to spend more time with their founding team than they will with their friends or family members.

And believe me, after hearing about the idea for so long, some friends and family members will truly appreciate the break!

Therefore, it is imperative that the founding team has an equal stake in the business.

Equity for your first external CEO

Let’s say your "Uber for ice cream" startup is taking off. Business is good, revenues are strong, and you want to bring in a CEO who actually knows what they are doing to run day-to-day operations. What then?

David Ehrenberg, a startup financial advisor, recommends that a fair equity stake for CEOs who join a company later is between 5 and 10 percent. Research by SaaStr supports his recommendation, showing that the average founder/CEO holds roughly 14 percent equity at the company’s IPO, while an outside CEO typically holds between 6 and 8 percent. This difference in equity is due to startup founders initially holding the majority of the company's shares. Founders who serve as CEO retain a larger stake compared to CEOs who join later and were not part of the founding team

When determining how much equity to distribute, founders should consult with a lawyer who specializes in startups for guidance.

Do Your Due Diligence

Determining startup equity is a key component in creating a sustainable company of value. Don’t brush it aside or save it for later. When forming your company, it pays to understand the role equity will play in the years to come. While there are various models to choose from, it is best to follow a market leader like Y Combinator, which has a proven track record, to provide the most value for everyone involved. You will thank us when the acquisition comes.

The insights shared in this article are based on our experiences and observations in recruiting for start-ups over many years. They are intended for informational purposes only and should not be considered as professional advice. We encourage you to consult with a qualified legal or financial advisor to address your specific needs and circumstances.

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Navigating Startup Equity Models When and How to Split Equity in Your Business

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