Table of Contents
In Short
- Allocating equity early ensures fairness and clarity among founders.
- Vesting schedules protect the company if founders leave.
- Consider future investors when setting equity splits.
Tips for Businesses
When allocating equity, use vesting schedules to safeguard the company in case a founder exits. Ensure equity splits reflect each founder’s contributions and consider how future investors will impact ownership. Consulting with a legal expert can help you avoid common equity distribution mistakes.
Equity refers to ownership rights in a company. For startups, equity is one of the most valuable components of your business. This article will examine how your startup can allocate equity to the various stakeholders in your business.
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Founders’ Equity
Shares are a proxy for equity in a company. That is to say, you can value your equity in the startup by looking at how many shares you own. More specifically, the value of any one person’s equity in your business, be they founders, investors, or employees, is determined by the:
- number of shares they own;
- rights attached to the shares; and
- value of the company.
All companies must have at least one issued share held by a shareholder, though, in practice, most companies have multiples of 100 shares. In startups, the founders hold the shares.
For companies with only founders as shareholders, the value of the share reflects the value of the founders’ investment in the business. For example, if you invested £100,000 in the business, the equity is worth £100,000. To determine the equity value per share, you divide the total number of shares your startup has issued by the total equity. Hence, if you have 100 shares, each charge would be worth £1,000.
Equity Investors
As businesses grow, they often need access to additional cash. There are two primary ways of raising cash:
- equity; and
- debt financing.
Equity financing refers to issuing new shares in your startup to outside investors. In exchange for these shares, these investors will give your business cash. Your startup’s equity will increase by the amount of money the outside investors pay. For instance, if you raise £100,000 from your business network, not accounting for any profits or loss, the company’s equity value will double.
Because shares are a proxy measure of equity, these investors will expect a proportionate number of shares. This will, in turn, dilute your equity value in the company. To continue the example, if you give equity investors 100 more shares, the founders now only own half the shares in the company.
Valuation
Valuation refers to identifying the underlying value of your business. In raising equity finance, valuation is how the investors determine how much to invest and how many shares they receive in exchange.
Valuation is a complex and often a hotly-negotiated aspect of raising equity capital. There are several different ways to value a startup:
| Asset-based valuation | This looks at the net value of all your business assets. For instance, if your business owns £200,000 worth of assets and has £100,000 of liabilities (i.e., debts), its net asset value is £100,000. Asset-based valuations are simplistic. They do not account for your business being worth more as a going concern than if you were to sell its assets piecemeal. Accountants describe the added value of the business’ assets as “goodwill”. Accountants tend to value goodwill using earnings-based valuations. |
| Earnings-based valuation | Investors invest in startups on the premise that the business’s profitability will increase. Earnings-based valuations analyse how much revenue your business converts to profits after expenses to arrive at an underlying value of the business. For equity investors, earning-based valuations are helpful because they can predict if a business will generate a minimum rate of return in the future. Investors can use these forecasts to value the underlying business in the future. This is important because most equity investors seek to sell their shares in the future to make a return on their investment. |
The valuation method used to price your business depends on several factors, including the:
- negotiating power between the investors and your business;
- market your business operates in;
- amount of capital your business intends to raise; and
- outcome of the due diligence process.
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Share Classes
Shares give the shareholders a bundle of rights in the business. The three most important rights that shares govern are the right to:
- receive a dividend;
- a return of capital when the business is wound up; and
- vote at shareholder meetings.
When you incorporated your startup and received your shares, all founders received the same class of shares unless you created different classes from the outset. These ordinary shares entitle the shareholder to the same right to dividends, capital, and voting as any other shareholder.
When you raise equity, your investors often want shares that grant them preferable rights compared to the founders. This is to compensate them for the risk of investing in your business. Most commonly, investors seek shares that grant them preferential rights to receive dividends ahead of other investors. For instance, your business may issue investors preference shares that entitle them to £0.10 (10p) in dividends for each share held, which your company will pay before it pays the founders a dividend.
Employee Equity
Some businesses create schemes for their employees to receive shares in the company. The law grants businesses a great deal of flexibility in drafting the exact terms of the arrangement. But typically, such employee share schemes (ESS) take the form of share options where eligible employees receive an option to acquire shares at a later date. This later date may be conditional upon a specific outcome, such as your business raising a later fundraising round. Or the later date may be a specific point in time, such as five years from when your business implements the plan.
Providing your employees with equity aligns their compensation incentives with your company’s. If they are interested in your business performing well (because their shares will increase in value), they are more likely to work towards increasing the business’s value.
Similar issues arise with valuations when creating ESSs as with raising equity finance. Likewise, as with equity investors, you may wish to vary the rights attached to employee shares. For instance, most employee share schemes do not entitle employee shareholders to any shareholding votes.
Key Takeaways
Equity refers to ownership rights in your startup. A company’s founders typically own all the equity in the company until they raise outside financing. In exchange for cash, your business will issue the investors additional shares. You may also wish to give your employees shares in the business to align their incentives with your business. In all cases, determining how many shares and how to allocate equity in a startup requires a team of lawyers and accountants.
If you need help with your startup, our experienced startup lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page.
Frequently Asked Questions
Equity refers to ownership rights in a business. You can consider it a long-term liability the business owes its owners. Given most businesses are structured as companies, equity is measured by shares.
The founders own all the equity in the business until they raise outside financing or offer shares to employees. The number of shares offered depends on the value of the business and your objectives.
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