How to Allocate Equity

Plan for Different Stages

Startups have several stages involving different people filling different roles. Although some formulations of the stages vary, your startup will typically follow a path through:

• Pre-seed stage. You create your business plan. Only founders are involved.
• Seed stage. You search for investors to take your plan from idea to reality. Founders and core investors are involved, and you may begin hiring for other roles.
• Series A. You expand and look for more investors. You hire employees.
• Growth (Series B and C). You continue expanding, seeking additional investors, and working to scale your business appropriately. You continue to hire employees.
• Maturity. Your business is successful. You may continue as is, make a public offering, or decide to sell the company.

Ensure your plan accounts for the increasing number of individuals involved at each stage.

Plan for Different Roles

At the pre-seed and seed stages, smaller startups usually involve only the business’s founders. As your business grows, more people will likely join the effort. Typically, the later in the startup stages you get, the more equity will be spoken for and the less you can offer.

Founders

Every startup begins with its founders, but not all founders play an equal role. One founder may develop the idea and focus on the big picture, while others may devote more effort to the daily minutiae. Figuring out how to negotiate equity in a startup at this early stage can be tricky, especially when the workload is uneven or hard to quantify. Speak with the other founders early about your expectations. How you split equity amongst yourselves will likely depend on each founder’s:

• Responsibilities
• Skillset
• Risk assumption
• Time investment
• Money investment
• Preferences

Attempt to identify objective criteria to help you allocate shares as a group. Allocating shares fairly is a vital part of business longevity and helps avoid resentment over the long run. Speak honestly and openly about what you feel is fair, acknowledging the value of every individual’s contribution. Be honest with yourself as well. Don’t accept an arrangement that you find unfair just to appease your partners. One part of allocating shares in the pre-seed and seed stages that can be easily overlooked is addressing how to reallocate shares as more people gain equity. You’ll want to set aside a percentage of your equity to distribute as you move forward, but ensure everyone is on board and put the plan in writing.

C-Suite

Your C-suite includes your CEOs, CFOs, COOs, and more. These people may or may not be founders. If not founders, then the timing of filling these roles depends on your business needs. It may occur before or after you seek out investors. Decide what you’ll offer to the C-suite before hiring. Revisit what you can and should offer as your startup grows.

Investors

Usually, securing investments involves determining the cost of equity. Don’t overpromise to potential investors. Ensure you and your partners maintain enough shares to keep majority control of the business. Consider setting aside 10-20% of your total equity for investors.

Early Employees

When compared to established businesses, many startups can’t offer a competitive wage. Startups often compensate by offering their early-joining employees equity in the company. Typical equity for startup employees includes restricted stock options that require employees to remain with the company for a set time before the stock vests. Consider setting aside another 10-20% of your total equity for employees.

Later Employees

As the company grows, your number of employees will likely grow. At some point, you will probably be able to offer a competitive salary and benefits package. While you can continue to provide equity to employees who join later, you can only allocate so much. Consider offering equity only in rare circumstances or setting a cutoff to stop new employees from gaining equity altogether.

Know What Equity You Will Offer

Before you establish your startup equity compensation, you need to determine what kinds of equity you are willing and able to offer. Typically, startups offer equity in the form of stocks, including:

• Common stock—provides voting rights and can be sold but not liquidated.
• Preferred stock—does not provide voting rights, can be sold, and may be eligible for liquidation.
• Restricted stock units (RSUs)—once vested, these stocks become common or preferred stock;
• Stock options—once vested, holders can purchase stock at a fixed price.

If you offer restricted stock, select a timeline for vesting. Common timelines range from one to five years. You can set aside stock options in an option pool. The size of an option pool will generally dwindle over time but can be a selling point to attract talent.

Understand Beneficial Ownership Information (BOI) Reporting

In January 2024, many businesses must meet a new requirement: providing beneficial ownership information (BOI). You must provide BOI to the Financial Crimes Enforcement Network (FinCEN) if your business is a reporting company. Generally, reporting companies include businesses that must register with a state secretary of state before they can begin operating. Most common growth-focused structures—LLCs, C-Corps, and S-Corps—require registration. If your business is a reporting company, you have to report information about the individuals who:

• Exercise substantial control over the business
• Own or control at least 25% of the business’s ownership interests
• File to register the business

BOI requires names and identifying information, so it is important to keep your reporting requirements in mind in case anyone may want to avoid being included in a report.

Allocate in Advance, But Be Adaptable

Plan out how you expect to distribute equity at every stage in advance. Stick to your plan as well as possible—so long as it continues to make sense. Predicting how your startup will grow can be next to impossible, so don’t get bogged down if things change or don’t go as expected. Avoid diminishing the value of equity by spreading it too thin, but be ready to adapt. Ensure you make modifications deliberately and don’t lose track of who owns what and what powers they have. Finding the balance between adaptability and firmness can be difficult. There’s no one simple solution, but if you listen to your instincts and the insights of your partners and advisors, you can find a way forward.

Disclaimer: Bizee and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.