A founder’s take on equity allocation

Litan Yahav • October 17th, 2021

What makes more sense - Holding 100% of a company valued at $0 or holding 2% of a company valued at $500m? An easy decision that first-time founders often take way too long to make.

Hoarding equity usually doesn’t help founders or the company succeed. This doesn’t mean you should hand out equity easily, it just means you shouldn’t hold on to it as tight as you might think. Distributing equity to stakeholders helps align them with the success of the company a lot more than absolute dollar compensations.

Co-founder Equity

Back in 2012 we were two first-time, non-technical co-founders, working on our previous startup in search of a tech Co-Founder. At that point we were pretty deep in the game with substantial connections to key industry players and time and money invested into an initial POC (proof of concept).

During our search we were lucky enough to meet a brilliant engineer who, as part of his side gig, helped us solve some issues we were facing. He provided us with such impeccable service, we knew we had to have him on our team. The question was — what should we offer him?

Our thought process was that in order to build a powerful founding team with a healthy dynamic, we must all have equal stakes in the game. Keep in mind that we were two initial founders (and good friends) so the equality aspect was even more important to make sure our third Co-Founder would feel like a substantial part of the team — and not a third wheel.

We received endless push back from colleagues and fellow entrepreneurs who considered us to be crazy for “giving up” so much equity to someone who joined the team a year after we had begun working on the business.

At the end of the day, we decided that we could either each have 50% of nothing or 33% of something that has a lot more potential of being something super valuable. Our third Co-Founder had the potential to do just that.

It goes without saying that in order to align all of us with the success of the company we implemented a 3 year, quarterly vesting period— for all three of us.

Team member equity

Initial team members (aka “employees”) are the foundations of a rockstar Startup team and must be aligned with the success of the company. The common practice is allocating a certain percentage (usually around 10%) of the company’s stock towards an employee stock option plan (ESOP).

These shares are put aside and intend to be granted to new team members (for example, 10% may represent 1,000,000 company shares). The number of options granted to specific team members and positions vary from company to company and is usually based on the team member’s professional experience, how important they are to the success of the company, how much of a pay cut they took to join the company at this stage etc. During each funding round a new ESOP pool is usually agreed upon to continue incentivizing the team.

Many team members who receive options don’t really understand what they mean and many times think that what matters is their holding percentage out of the total company equity. From my perspective, there are two important parameters when allocating/receiving options, and their percentage of the company is NOT one of them. What really matters is:

  1. Number of options granted
  2. Strike price / Exercise price- This is the price the team member will pay to purchase these options when they become exercisable.

For example: A team member is granted 10,000 stock options with a strike price of $0.10 vested quarterly over 4 years.
What this means is that over the next 4 years the team member will receive 625 (10,000/4/4) stock options every quarter and accumulate them over the entire period. During this period (and after it for a limited time) she can decide to purchase the stock (exercise her options) at $0.10 X the number of accumulated options. Just imagine a scenario where the company’s stock is valued at $50 or $100 per share and the team member can exercise their option and buy the shares at $0.10, that would be a hell of a profit.

Investor equity

This is probably the most controversial subject because of its variance between companies and founders. So much has been written and talked about how much equity to grant investors throughout different stages of a company’s cycle. Unfortunately, there is no formula here. When we founded our last company in 2012, raising $500k-$1.5M was a successful seed round. In 2021 this is considered peanuts, with seed (and pre-seed) rounds completing at up to $100M… With that said, most companies grant between 20%-30% of their equity during each funding round.

A short story here — During the seed round of our pervious company we had the privilege to choose between three different investors, all for the same amounts of money but each at a different valuation (AKA number of shares in return to the investment).

The first investor offered no value other than money and requested 20%. The second offered some value, but nothing to write home about, and requested 30%. The third requested the highest amount, 40%, but also offered the highest value for money that we could have imagined.

Needless to say, we decided to go with the third because we believed that it would take us the longest distance business-wise. This turned out to be the correct decision for us because the value we received from the “smart-money” investor brought us to build a successful company which made a huge difference in the industry we were operating in (and led to its acquisition as well).

Advisor equity

A domain expert or general advisor can bring a lot of value to a Startup. The problem is that usually, you can’t test their value without working with them for a while. We had a good experience offering them a trial period during which we tested the relationship. During this trial period some advisors were offered a symbolic retainer and others preferred to take the risk and donate their time to us, hoping it would result in equity. If things went well then equity was on the table, and depending on the stage of the company it varied between 0.1%-0.5% (with a vesting period, of course).

Bottom line

Startup equity is a valuable commodity which should be allocated based on the recipient’s value to the company, incentivizing them to be aligned with the success of the company. Founders must apply a constant balance between holding on too tight to their equity and letting go of it too fast.

One important thing to keep in mind — The founding team must always hold on to enough equity to be properly incentivized. Good investors will make sure founders stay above a certain threshold to achieve this, even at the cost of rebalancing the cap table to bring the founders back to a reasonable amount of equity.

These are the basics around Startup equity, there is of course much more to be written and said on each of the subjects above - the pros and cons of each decision and a deeper dive into the mechanisms of each type of grant or allocation.