Learn everything you need to know about section 409A of the internal revenue code. From what is a 409A valuation to 409A methodologies and process.
Disclaimer: I am not a financial advisor, and none of the advice below should be taken as legal or financial advice. I have worked with hundreds of cap tables, but it is always important to include a legal professional when dealing with equity.
Why you should care about equity
Understanding equity is something you should prioritize as soon as you’re ready to incorporate and distribute stock among co-founders, early investors, employees, and beyond. Knowing the basics will help you become “equity smart” and start your company off on the right track.
Part 1: Equity with co-founders
If you have co-founders, one of the most important early discussions is about equity distribution. When breaking down ownership between founders, each co-founder’s specific skill set, the contribution of capital, IP, and other value to the company should be addressed and weighted appropriately.
Focus on winning the war
A poor negotiating tactic with a co-founder is to try and get more out of them for less equity. Great companies can take close to a decade to become successful, and all overcome serious problems and roadblocks. Therefore, if you’re not aligned with your co-founder from the get-go, you may never come out on the other side of tough times, and the company’s potential may suffer as a result. Remember, long-term business success is a war, so choose your battles wisely.
Early equity distribution is more about aligning incentives and less about the percentage of ownership.
There is nothing wrong with simple
On the Carta platform, we see most early co-founders with equal distribution of common stock. If you reach your goals, a few percent of ownership percentage amongst co-founders likely won’t matter. (Just to be clear, I’m not referring to voting rights in the company, simply equity ownership percentage)
Remember, the more aligned the incentives between co-founders, the greater chance your company has for success.
The goal of proper equity distribution is to incentivize all stakeholders to work hard to grow the company. Obviously, you want your co-founders to be similarly motivated. If they are not, it’ll come back to haunt you at 3 AM when you need to execute on a project and they simply aren’t as motivated as you.
Execution is the game
The idea behind a successful business is important, but executing that idea is everything. Everyone has ideas, and many could turn into a successful company. But evolving an idea from a thought to an action to a profitable business is the hard part — rewarding those with technical and operational skills will help turn that idea into a reality. And the best way to incentivize this is creating ownership through equity issuances.
Part 2: Issuing equity to early investors
The idea has gained traction, and now you and your co-founder are ready to accept investment capital in order to grow the business. But before you start fundraising, you need to understand several fundamental elements.
A simple, cheap, and common way to raise capital for a newly incorporated startup is through a SAFE or Convertible Note issuance. A second option is issuing Preferred or Common stock to your initial investors.
SAFE is derived from the phrase “Simple Agreement for Future Equity,” A SAFE is not traditional debt and doesn’t have interest rates or maturity dates — instead, the SAFE sets a last possible date for the note to convert to stock or for the debt to be repaid.
As opposed to a SAFE, a Convertible Note includes an interest rate or a recurring payment to the investor (like a SAFE, a Convertible Note also has a required maturity date). The interest usually accrues overtime and isn’t paid until a trigger event like the maturity date. Raising through a Convertible Note is slightly more advantageous to the investor, and more costly to you as the founder. You will have to pay interest payments to the investor as opposed to the non-interest bearing SAFE.
Notes and SAFEs are typically the first injections of capital into a startup because of their simplicity. They are not technically considered your first equity financing because you and your investors don’t have to agree upon a valuation of the company. Instead, this capital gets the gears moving on your company by paying for the initial startup costs and to validate a product/market fit.
Initial Equity Round
When raising your initial equity round, understanding the process is the key to getting favorable terms. The conditions you accept now will have a lasting impact down the road.
First, when you raise a Seed or Series A round, the SAFEs or Convertible Notes will convert into shares of Preferred stock.
These are terms given to Preferred investors if/when the company exits through an IPO or is acquired. These liquidation preferences will drastically impact the payout to you and other shareholders with common stock.
These are common anti-dilution conditions that require an investor’s percentage ownership to remain the same no matter how many additional shares are given out.
Be acutely aware of these details and understand what you are giving up by agreeing to them.
Part 3: Employee equity
Shortly after issuing Preferred stock to new investors, you will want to create the company’s option plan. Below are the items you should strongly consider when setting up your company’s first option plan.
Size of the Option Pool
Stock option plans are created primarily for employees, so the first thing to consider is how much of the company employees should own. This percentage ranges wildly and can span anywhere from 5 percent – 15 percent of the total equity distribution (this is based on Carta data).
The rest of the company is owned by the founders and investors. Over the last decade, there has also been a shift to more employee ownership. Employee ownership has been shown to increase productivity and create a better company culture. Traditional forms of compensation (i.e. salary and benefits) and their value will affect how large of an option pool you decide to create.
Types of Securities (from the option plan)
The most common type of security issued are Incentive Stock Options (ISOs). They are more favorable since ISO holders don’t have to pay taxes upon issuance or at exercise (except for something called the Alternative Minimum Tax (AMT), if applicable).
NSOs are also very common. These types of option grants are typically issued to outside contractors, consultants, and international employees.
Most companies issue ISOs to their early employees. As your company scales, you may want to consider issuing RSA or RSUs in your option plan.
Post-termination Exercise Periods (PTE)
PTE periods are the amount of time after a termination that an employee is allowed to exercise their shares.
The standard is 90 days after voluntarily leaving, or zero days if they breach the employment contract and are terminated. Ninety days have arguably been far too short, particularly for option grants that cost a significant dollar amount to exercise. Pinterest and a few other tech companies have decided to drastically change their option plans by allowing seven-year post-termination exercise periods for employees.
This gives employees time to raise the funds to exercise or to wait for a liquidity event to cash out. For most stock options, that’s an eternity. Only very successful private companies can offer an almost decade-long window, so longer PTE windows are a welcome trend.
As a founder, you’re expected to be an expert in your industry. You know your product inside and out and understand the market. But as a CEO there’s additional foundational knowledge you need: the intricacies of running a business. You will be forced to learn about finance, sales, operations, analytics, marketing, human resources and anything else that will support your product’s or service’s success.
Equity will likely be one of the first things you will encounter that is tangential to your knowledge base as a founder. A full understanding of equity and your company’s equity structure will benefit you, your stakeholders and your company as a whole.
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