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MintzTech Connect: How to Distribute Equity in Your Start-Up

The purpose of granting equity to management, employees and certain consultants is to align the interests of the parties pivotal to the growth of your company with the interests of investors. There are a number of different ways to grant equity in a start-up, the most common of which is stock options. (For an in-depth discussion of granting options, including reasons to give options, differences between Incentive Stock Options and Non-Incentive Stock Options, determining fair market value and vesting schedules, please see this post on our MintzEdge blog.

One of the most difficult decisions entrepreneurs face when planning the growth of their start-up is determining how to distribute equity among the founders, the current (and/or future) management team and other employees and consultants. There is no one-size-fits-all model for determining whom to give equity to and how much to give them: this process requires an in-depth look at a number of factors pertaining to the company, generally, and the recipient of the equity, specifically.

With respect to the company, some factors to consider are:

  1. The Stage of the Company. Management and other employees who join the company before any funding often receive larger equity stakes to compensate for the risk assumed in working for an unproven company. Further, early-stage companies often cannot afford to pay salaries competitive with larger companies, and may make it up in equity.
  2. The Various Roles the Company Needs Filled. One company may reserve more equity for a strong Chief Financial Officer because it anticipates requiring several stages of funding; another company might put more into their option pool because it anticipates requiring a large sales team that it will want to properly incentivize. We recommend you identify the top four roles in your company, and how the importance of those roles might change over time.
  3. Whether (and if So, How Soon) the Company Anticipates Fundraising Through an Equity Financing. Future financings will result in dilution to ownership percentages. Projecting a pro forma cap table with anticipated future financings can help frame discussions about ownership percentages and leave less room for disappointment in the future.

In addition to the factors above, when determining the amount of equity to issue to any recipient (or group of recipients), there are a number of individual- or group-specific factors to consider, such as:

  1. Other Forms of Compensation. The amount of equity to grant an individual should be a piece of their total compensation package. If limiting the distribution of equity is important, consider increasing base salary or performance-based cash bonuses. If the company is unable to secure funds to do so, then consider issuing greater equity stakes as salary replacement.
  2. Past Contribution. Look at the individual’s past contribution: time and money spent, opportunity cost and their contribution to the “original idea.”
  3. Role / Specific Expertise and Experience. Determine the individual’s expertise and the importance of their role to the growth of the company. Is the individual in the “Top Four” list you prepared earlier? Will the importance of their role grow or shrink over time? For very early-stage companies, some resources (such as http://foundrs.com/) help you to determine equity splits among founders based on a list of specific contributions and roles. Some questions they ask are, “Who is well-connected in the target industry?,” “Who is the product leader?” and “Who will be pitching investors?,” among many others.

A start-up may also want to consider setting aside some equity for formal or informal advisors, who can be instrumental resources depending on their experience, network and industry influence.

Equity Compensation Trends in the Tech Industry

According to data provided by CompStudy, a survey of compensation for management positions at private companies, recent trends in the tech industry show a slight increase in equity compensation of Chief Executive Officers and Chief Operating Officers / Presidents of private tech companies. CEOs in 2017 received an average of 6.6% equity at time of hire (median = 5%), up from 6.1% in 2016. COOs / Presidents in 2017 received an average of 3.5% at time of hire (median = 1.5%), up from 2.1% (median = 1%) in 2016.

The calculus is different if the CEO or COO / President was a founder: Founder CEOs retained on average 33% ownership in their companies (median = 25%), while Founder COOs / Presidents retained ~14% (down from a 21% average in 2015).

On the other hand, equity compensation for Chief Financial Officers in private tech companies has gone down in recent years: CFOs in 2017 on average received 1.1% equity at time of hire, down from 1.4% in 2015 (but up from 0.9% in 2016).

CompStudy data also shows that a majority of external board members receives equity compensation of 0.25% or less, and the vast majority receives equity compensation of 0.5% of less. Notwithstanding, for board members that also serve as the Chairperson, roughly 30% of private tech companies in 2017 granted such individuals 2% or greater equity (up from 20% of companies in 2015, but down from 40% in 2016).

Summary

When considering equity distribution, consider the stage of the company, the roles it will need filled and the timeline of future fundraisings. Consider the people currently growing the company—their past contributions and future roles—and the other roles that will be needed in the future. Determining the appropriate equity distribution mix that aligns the interests of management, employees and the investors is a precarious, company-specific process that is best planned as early as possible.

Resources

Below are a few online tools that may help in determining how to distribute equity in your start-up.

 

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Author

Patrick Elahmadie is part of the Corporate & Securities Practice at Mintz. He was a Summer Associate in 2015. Before joining Mintz, Patrick provided transactional corporate legal assistance to small businesses and nonprofits at the USC Gould Small Business Clinic.