What does a startup need to secure funding from its potential investors? The obvious answer is having a strong business model that’s underpinned by a good team and a robust balance sheet – with a well-honed pitch to tie them all together. What’s often neglected, however, is the company’s equity management. For a potential investor, this doesn’t just affect their shareholder rights, but also future operations and the exit itself.
To take a wider perspective, equity management can also make or break a startup at different stages of its development. What’s more, this isn’t a factor that can be easily fixed, so handling how equity is distributed is crucial for long-term success.
Equity 101
Equity represents ownership in a company, and thus entitles the holder to a portion of the company's profits and assets proportionate to their shareholding percentage. It is most typically represented by shares, and can be granted to founders, employees, and investors. Shareholders reap the greatest benefits of a company’s success, so equity is a powerful way to align interests, as well as to incentivise commitment and hard work.
When a startup is first established, the founders are typically the only shareholders in the business. To attract talent and investments, however, they may give up portions of their shares – or create new shares – which are then granted to employees and investors. The result is the same: the founders now have diluted ownership due to additional shareholders in the business.
The Importance of a Clean Cap Table
Just as a balance sheet tracks a company’s assets and liabilities, a cap table (short for capitalisation table) is a record of all the company's securities such as common stock, preferred stock, options, etc. The cap table details the shareholders of a company, how much of the company each one owns, and what they are entitled to.
A clean cap table is the foundation of a well-structured equity distribution, and proof of effective equity management. A messy cap table, on the other hand, can lead to confusion and disputes down the road, and hinder the startup’s ability to attract investors and grow.
"A clean cap table gives the investor and all stakeholders a clear picture about the ownership of the company; it should capture the company’s current shareholding structure, and all historical share changes and anticipated future share changes after any fundraising," Cairan He, VentureBlick’s Director of Investor Relations & Partnerships, shares.
Equity Management: Employees
Equity incentive plans are a powerful tool for attracting and retaining top talent, and de rigueur for startups and MNCs alike. When employees have a stake in the company's success, they are more motivated to do their best, as the business’ success translates to their own. Typically, this is done via Employee Stock Option Plans (ESOPs), which grant specific numbers of shares to employees at various milestones of their work with the firm.
To ensure the effectiveness of such plans, startups should consider the following:
Vesting schedule: A vesting schedule defines the timeline for employees’ stock options to vest. Consider this delayed gratification: a fair schedule ensures that employees remain committed and aligned with the long-term goals of the company.
Internal communications: A robust internal communications plan helps to explain the specifics of an ESOP, and fosters trust by helping employees to understand the value of their equity grants.
Equity refresh programme: Typical ESOPs target new hires. As a company matures, however, periodic equity refresh programs should be implemented for tenured employees to provide ongoing incentives for them. This is crucial for talent retention.
For employees, equity allocation usually varies based on their role and seniority within the organisation, with key executives and early employees receiving larger equity grants. Typically, 10% to 20% of a company's equity is set aside for employees, with adjustments being made as the company scales.
While it is important to provide employees with a well-managed equity plan, founders must also consider their own stakes in the business. They are, after all, the ones who assume the highest risk while also putting the most time and effort into the business. It is thus critical that they have enough equity to remain vested in their company's success. It is recommended that founders retain at least 20-30% of the business, even into its later stages, to remain vested in the startup’s success and to retain some decision-making rights.
He notes the importance of founders having enough equity to stay committed. “Startup founders normally accept lower salaries in exchange for a controlling stake and higher upside potential in their companies,” he observes. “So naturally, owning a fair share of their company will incentivise them to give their best."
Equity Management: Investors
Startups that are fundraising will grapple with similar issues centred on how much of their equity should be allocated to investors. This changes depending on the round of fundraising being conducted:
Seed round: In the seed round, founders typically retain most of the company’s equity. Angel investors and early-stage venture capitalists may receive equity ranging from 10% to 30% of the company – usually closer to the former – depending on their buy-in.
Series A: Higher valuations and cash requirements will see founders giving up slightly more equity in this round; investors may cumulatively receive 20-40% of equity by the end of this round.
Later rounds (Series B, C, etc.): As a startup matures and requires more significant investments, its founders' may give up more equity, and offset this with higher valuations. Investors often end up owning 30% or more of the company in aggregate.
Percentage aside, startups should also consider how other aspects of equity management align with their long-term goals:
Board control: While equity affects voting rights, board seats determine the company’s governance. Potential investors often ask for board seats as a condition for their investment – it is up to the founders to negotiate accordingly.
Founders’ agreement: A founders’ agreement details the rights and responsibilities of each founder, which in turn determines their relative contributions, management interests, etc. These are crucial details that anchor the startup’s management, especially as the number of stakeholders grow and ownership structure becomes more complex.
Exit strategy: Depending on the startup’s cap table, founders may lean towards specific exit scenarios. This needs to be planned – whether it’s a private equity trade sale, an IPO, or another exit event, much needs to be done to best position the startup for its intended exit.
Red Flags
Investors, accelerators, and potential partners often scrutinise a startup's equity structure before getting involved. Some red flags that they will look out for include:
Excessive founder dilution: If founders own just a small fraction of the company, it may signal a lack of commitment or poor equity management. Have the founders cashed out early by giving up more equity? Did poor management early in the startup’s development necessitate a larger investment than necessary?
Complex cap table: A convoluted cap table can mean future challenges in negotiations and decision-making. For a potential investor, this could mean unnecessary complications, whether in day-to-day operations or during exit.
Substandard ESOP: A poorly structured ESOP can hinder talent recruitment and retention, and manifest in various forms such as excessively high turnover. Talent acquisition costs are higher, institutional knowledge is lost, competitiveness is affected, and the startup’s growth is stifled.
Equity management is by no means the be all and end all for startup management. It is, however, a critical component for success, and key to attracting investors, retaining employees, and maintaining founders' commitment. By keeping a clean cap table, implementing effective equity incentive plans, and carefully considering equity distribution, startups can lay a strong foundation for growth and success.
At VentureBlick, we offer advisory services on focused on various matters including equity management, whether as part of startups under our Super Incubator programme, or via ad-hoc consulting projects. Need a hand? Speak to us to find out more about how we can offer both a fresh perspective and a detailed game plan to optimise your startup’s equity management. Alternatively, you can reach out to our industry advisors on VentureBlick Discovery for their input, or compare your experience with other Innovators on this proprietary platform.
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