Some for you, and some for you… It happens more than you think.
Equity can get doled out in early days like candy thrown from a parade to anyone and everyone because that’s the only currency that founders can afford to pay. We see the following situations occur more than we like:
- 5–15%+ of equity given to early founder/external helper and this person doesn’t stick it out, gets bored, doesn’t help, but isn’t vested in any way (traunching out equity over a standard three to four years to make sure people stay to receive their grants). This equity becomes “dead” on the cap table, and conversations start around trying to get this equity back into company hands.
- Main founder brings on two other founders, splits equity equally between the three (all owning 33% of common at start), gives out 2–3% to external advisors that help intro company to investors, starts giving out 5% to early CTO, PM-type roles. Team believes it needs a strong external board member so they give out another 5%+ for this (and usually this person adds little value). Company raises first legitimate round with institutional capital (call it a $2–3M round). The founders are now all sitting with ownership in the low teens and now they have to hire out the team.
- One founder brings on co-founder, gives 1/3 of company to him or her, and this co-founder never fits with company. Founder smart with giving out equity but company’s traction comes fast and rounds raised rather quickly with co-founder now holding 15–20%+ of common. Due to higher valuation of company, harder to figure out exit for co-founder.
Listen, stuff happens. Nothing goes the way things are drawn up. Startups are hard, and people change, give up, or never were as advertised. Incredible how much founders learn about the hiring process as they scale. (Side note — there is plenty of info on how much equity to give out to team members, and AngelList is an incredible resource to gauge market for every type of position.)
Needless to say, equity should be granted very carefully. Standard three- to four-year vesting programs should always be in place. A 15% option pool should be established early and not put together later because “we’re just heads down building the product.” Option pools should be refreshed after each financing to make sure founders have put aside enough to hire talent (call me old school). Founders should not be so willy-nilly with 409(a) valuations and do these whenever they feel like it. People should prove they are committed to the company and earn it over time.
It is messy, time consuming and involves lawyers and investors when trying to bring back large equity grants from early recipients that never should have received these grants in the first place. There is a lot of misinformation and expectations about what people “deserve” in early stages that both sides can start digging in. More often than not, it gets personal and heated.
A lot can be learned about the founding team when looking at the cap table. If too much has been spread around, it is a warning sign that the founders possibly are moving too fast, don’t have good legal counsel, or don’t know what they’re doing. Teams that are on top of their cap table and can show a concise set of investors and employees early on earn a lot of points in our book.
Our internal data has shown that founding teams with large equity stakes into the Series A produce the highest returns for investors. I’ve pondered why this happens, as it seems contrarian, but there are good reasons:
- Early founding teams spend copious amounts of time thinking about who to bring on and when. They are patient with their hiring and smart with engaging external advisors. They make less mistakes when hiring key roles, and when hiring wrong, quick to cut losses early. As a result, less equity is thrown around and wasted in the precious early days of a startup.
- These teams are conservative with their burn, and make a little go a long way. The dilution is relatively small after early rounds thus preserving early capital ownership stakes.
- These founders are strong leaders, and attract team members that believe in the capability of the founders to execute the long-term vision of the company. Talent flocks to these startups and founders don’t have to dole out large stakes to attract the best employees in their prospective areas. 5% of zero is zero, .5%-1% of something big is, well, much bigger than zero.
Founders should conservatively plot out how much capital they feel they will need to raise over the life of their model if things go well (and then double that). They should get help understanding how dilution will play a role moving forward if that amount of capital will be raised.
If teams take care of the small things from day one, the big things will start to take care of themselves. It is vital to understand the power of equity and the consequences of being loose in this turn. There is only 100% of equity to give out on day 1 and unfortunately this pie does not expand. Be generous but be smart, and you’ll save your team hours of heartache and expense in the future.
Recipients of this post are not to construe it as investment, legal, or tax advice, and it is not intended to provide the basis for any evaluation of an investment in any fund. Prospective investors should consult with their own legal, investment, tax, accounting, and other advisors to determine the potential benefits, burdens, and risks associated with making an investment in any fund.
