Part 2: Equity distribution for entrepreneurs, explained
Written By Dennis Cagan –
The Shadow CEO is an ongoing series with tips for entrepreneurs from serial founder and high-tech industry veteran Dennis Cagan, who has served on sixty-seven for-profit corporate boards, including ten publicly traded companies.
Many first, second, and even third-time founders get themselves into bad situations that could be avoided if they knew more about how corporate governance and equity distribution worked in early-stage companies.
Whether you hope to eventually sell your start-up to a larger firm or navigate through an IPO, if you plan on taking in investors—friends and family, angels, venture capital, or strategic corporate investors—you need to understand how to protect yourself and your management team.
The segments in this ongoing series can not only save you time and energy, but they could result in making—or saving—you millions of dollars.
Phases of equity distribution
The number one way to get equity in a company—and the most straightforward—is to simply buy it. Individuals, both accredited and non-accredited, sometimes termed ‘friends & family’ or ‘angels’, purchase shares or units in start-ups every day. But that is definitely not the only way to participate. Many non-investors get early-stage equity in exchange, one way or another, for contributing their efforts to the company. Whether as an employee working for reduced or no salary, or an advisor providing valuable experience-based insights, or a vendor providing products or services for below-market prices, all these folks can be granted or awarded equity in lieu of cash for their contributions.
As an enterprise grows and can increasingly afford to pay market-rate salaries and bonuses to its employees, it is still exceedingly common for firms to also grant equity, which holds the added incentive of the prospect of dramatic increases in value over time. Stories abound over the years of people getting a few stock options early on in a company’s formation, and then being able to sell the equity, for millions of dollars – either as a result of an initial public offering (IPO) or the acquisition of the company by another firm.
It’s rare for a first-time entrepreneur, and sometimes even a serial entrepreneur, to fully understand the complex strategies and dynamics of efficiently allocating capital, much less understand the intricate mathematical calculations usually involved.
There are typically several phases of equity distribution during the life cycle of any company.
- Initial founding – the founder(s) grant themselves a certain number of shares (or for LLC -units, or a given percentage of the LLC) when the firm is created.
- Seed investors – the very earliest investors, usually friends and family or angels, put in some actual capital to help finance the development of the product or service and build the company. Their money can buy them straight equity (a number of shares), or it can be in the form of a loan (which usually does not include equity), or frequently some form of convertible loan (which is considered a loan until the company raises more capital later at a specific price). At that time the loan is then automatically converted into equity at a discount to that later price.
- Required personnel – the founder(s) need other people to help them, particularly those with skill sets that complement the founder’s – e.g., software engineers, marketing, sales, finance, etc. Since funds are very limited, these people are usually compensated completely or in part with equity.
- Repeat cycle – more cycles of a combination of more investors (capital) and more people (talent).
Object lesson: A small % of a big number
In the mid-90s a sole founder funded the start-up of his company by charging expenses on his VISA. By the time he raised outside capital
to continue to fund his growth, he had run up charges that totaled 150% of his entire net worth at the time.
He continued to raise capital and grow the company. Each funding round further reduced his percentage of ownership (equity). However, just a few years later – early 2000, he sold the firm for a package totaling just under $5 billion.
Not bad at all, even though by the time of the sale, because of his various financings, his ownership had been diluted to under 5%.
Today, there are a variety of funding and governance strategies that allow entrepreneurs to retain much larger ownership positions, and even high degrees of company control, even as they distribute large amounts of equity to subsequent investors and employees.
Key questions about equity distribution
While it’s not uncommon to see early employees making millions of dollars, it is also not unusual to see founders who started with 100% ownership of their company, yet still end up with a very small percentage before getting any liquidity.
There are any number of key questions that any entrepreneur—or other early-stage company participant—should ask. For each one there is more than one answer, and each answer can have a magnified effect on the equity ownership dynamics of your company. Founder beware.
- How many shares/units did you authorize when you started the company?
- How many shares/units did you issue to yourself (and others)?
- Did you then later contribute cash, or other items to the company?
- What happened to the money and items you put into your company? Were they recorded on the ‘books’, if so, how?
- Have you accounted for the time and work you have contributed for no salary? How?
- How have other people’s financial and non-financial contributions accounted for on the company books?
Starting a company and guiding it through its growth to a satisfying exit – liquidity event of some type, has evolved a great deal from the ‘old’ days when you simply just think of an idea, develop your product or service, get a few customers/users (paying or even not paying), and then sell it. Everyone can name dozens of dynamics that come into play these days – from start-up to exit. However, one of the most important, yet least understood, least articulated, and least properly addressed by founders, is the distribution of equity.
Next up in the series: Equity Distribution for Entrepreneurs