A beginner's guide to startup equity

As an entrepreneur, one of the greatest challenges you’ll face is identifying the right time to start issuing equity and how to distribute ownership in your company. These early-stage decisions will have a critical impact on your long-term trajectory.

In this blog post, we will explore the basic principles of equity ownership in startups.

What is equity?

“Equity” refers to ownership in a company. Issuing equity enables startups to access the capital they need, garner support from investors, and build a foundation for future growth and success.

Equity is often considered in the context of stock, which represents a portion of a company's total equity. In other words, the stock is the means through which a company's equity is divided and distributed to investors.

When you purchase stock, you are buying a piece of the company's total equity, thereby becoming a partial owner of the company. Each stockholder's proportionate share depends on the number and type of shares they hold.

Common vs. preferred shares

There are two main types of stock: common and preferred shares.

Common stock is the most basic form of stock, usually granted to founders, employees, and early investors. Common shareholders have voting rights and can participate in major business decisions.

Preferred stock also represents ownership, but it confers a higher claim on the company’s assets and earnings. 

The difference between common and preferred stock is that preferred shareholders have a claim to the company's assets in the event of bankruptcy. Common shareholders do not. Preferred shareholders also have priority over common shareholders when dividends are paid out by the company.

How does a corporation issue stock?

A corporation can issue stock through an initial public offering (IPO) or a private placement. For startups, private placements are far more common. Private placements involve selling shares to private investors, such as angel investors, venture capitalists, or early-stage funds.

S-corps vs. C-corps

It's important to understand the difference between S-corps and C-corps when it comes to stock issuance. S-corps are restricted to 100 shareholders, while C-corps can have an unlimited number of shareholders. This gives C-corps more flexibility when it comes to raising capital.

Furthermore, S-corps are restricted to only being able to offer one class of stock, while C-corps can have multiple classes of stock (preferred, common, etc.), which can give shareholders different voting rights and privileges.

On the other hand, S-corps are pass-through entities, which means that they aren't required to pay corporate taxes. Whether or not to file as an S-corp depends on your company's current circumstances and long-term goals.

Note that an S-corp is not a business structure like an LLC or C-corp. Rather, it is a tax designation open to both LLCs and C-corps as long as they meet the requirements. Both LLCs and C-corps can elect to be taxed as S-corps by filing Form 2553.

How to authorize new shares

Set aside equity: Decide how much of the company's ownership you want to share with employees. We recommend setting aside 10-20% of company shares for employee equity. 

Create a plan: Make a clear plan for how you'll give equity to employees. Think about things like how much they'll get and when they'll actually own it.

Talk to experts: Get advice from lawyers, consultants, or other experts to ensure everything is legal and fair.

Pick how to share: Decide between giving employees stock options (giving them the right to buy shares later at a set price) or actual shares (ownership pieces) of the company. Both have different benefits: stock options can be attractive if you're unsure about future value, while actual shares grant immediate ownership. It's important to figure out what's right for your company.

Tell employees: Let your team know about the plan and how it works. Make sure they're excited and on board! 

Do the math:  Add up assets, subtract liabilities. Divide by total shares. This sets the value per share for fair equity distribution. Consider expert help for accuracy. 

Write it down: Write up a simple agreement that explains what employees get and when they get it. Keep a copy for everyone.

Check rules: Make sure you're staying compliant with relevant laws and regulations. 

Keep records: Keep track of who has what, and make sure it's all in order.

Check in: Ensure equitable rewards for current and future contributions, adjust shares as team size changes and investor involvement shifts, and maintain ownership levels for seeking new investment opportunities. You should also check the vesting timeline to sustain motivation, retain essential talent, and align goals effectively.

Concerns to keep in mind

Issuing stock is a great way to raise capital and incentivize employees, but it's not without its drawbacks. Here are a few things to consider before issuing shares: 

Loss of control

One major concern when issuing equity is the potential loss of control for founders and existing shareholders. Sharing ownership with new shareholders can often mean giving up some power, accepting investor demands, and dealing with too many cooks in the kitchen, so to speak. 

Valuation pressure

Issuing equity typically involves assigning a value to the company. Startups may face pressure to justify high valuations to potential investors, especially if the company is in the early stages or lacks substantial revenue or profitability. 

Timing is crucial here. For example, if you anticipate a future increase in valuation, you might need to offer equity at a lower value now to secure funding promptly. The challenge lies in committing at a specific moment, balancing future potential with immediate needs.

Information disclosure

Issuing equity often requires disclosing sensitive company information to investors. It's crucial to have appropriate legal agreements and confidentiality measures in place to safeguard proprietary information while still fulfilling disclosure obligations to shareholders.

Exit options and liquidity

Equity investors typically expect a return on their investment within a certain timeframe. This can create pressure for startups, and sometimes the smartest option is to get out. Disagreements over exit strategy are a common source of friction for startups with various stakeholders.

Balancing the investors' expectations with the founders' objectives requires careful consideration and planning to ensure a successful exit that aligns with the overall goals of the company.

Legal and regulatory compliance

Issuing equity involves complying with various legal and regulatory requirements, such as securities laws and shareholder rights. Startups must ensure they have the necessary legal expertise to navigate these complexities and avoid potential compliance issues. 

Wrapping up

Firstbase helps startups manage equity issuance with guidance, legal compliance assurance, and more. 

Things move quickly in a startup environment, so you could find yourself making key equity judgements shortly after incorporation. It’s important to fully understand your options in order to make informed decisions and put your company on the right path.

As always, we recommend you consult with legal and financial experts before making any decisions for your company's equity issuance.