Equity

Equity is the foundation of startup ownership and one of the most important concepts for any entrepreneur to understand. It represents your actual ownership stake in the company and determines your control, decision-making power, and financial upside if the company succeeds.

Understanding Equity Basics

Equity represents proportional ownership in a company, typically expressed as a percentage or number of shares. When you own equity, you:

• Have voting rights on major company decisions
• Are entitled to a proportional share of any profits or distributions
• Have a claim on company assets in case of liquidation
• May receive dividends if the company pays them

Equity vs. Stock Options

• Equity: Direct ownership with immediate voting rights and economic benefits
• Stock Options: The right to purchase equity at a predetermined price (exercise price)
• Restricted Stock: Equity with vesting conditions that must be met before full ownership

Types of Equity

Common Stock

• Standard form of equity ownership
• Voting rights on board elections and major decisions
• Last in line for payouts during liquidation
• Most employees and founders hold common stock

Preferred Stock

• Special class of equity with enhanced rights
• Typically issued to investors in funding rounds
• May include liquidation preferences, anti-dilution protection, and board seats
• Often converts to common stock during an IPO or acquisition

Convertible Securities

• Convertible Notes: Debt that converts to equity under certain conditions
• SAFEs: Simple Agreements for Future Equity that convert during future funding
• Warrants: Long-term options to purchase equity at a fixed price

Equity Distribution in Startups

Founder Equity

Typical founder equity distribution:

• Single founder: 80-100% initially
• Two co-founders: 50/50 to 70/30 split
• Three co-founders: 50/25/25 to 60/20/20 split
• Four+ co-founders: Generally not recommended due to complexity

Factors in Founder Splits

• Idea contribution: Who conceived the original concept
• Execution capability: Who can build and scale the business
• Financial contribution: Initial capital investment
• Time commitment: Full-time vs. part-time involvement
• Risk tolerance: Who's taking the biggest personal/financial risk
• Network and expertise: Industry connections and relevant experience

Employee Equity Pool

• Typically 10-20% of company reserved for employee stock options
• Created before major funding rounds to avoid diluting investors
• Used to attract and retain top talent
• Vesting schedules ensure employees stay with the company

Investor Equity

Investors receive equity in exchange for capital:

• Angel investors: Typically 10-25% in early rounds
• Venture capital: 20-40% depending on round size and valuation
• Strategic investors: Variable based on strategic value provided

Equity Dilution

How Dilution Works

When new shares are issued (for investment, employee options, etc.), existing shareholders' percentage ownership decreases even though the absolute value may increase.

Example of Dilution

• Founder starts with 1,000 shares (100% ownership)
• Company issues 500 new shares to investor for $100K
• Founder now owns 1,000 of 1,500 shares (66.7% ownership)
• If company is now worth $150K, founder's stake is worth $100K vs. $0 before

Types of Dilution

• Primary dilution: New shares issued by the company
• Secondary dilution: Existing shareholders sell their shares
• Option pool dilution: Creating employee stock option pools

Anti-Dilution Protection

Investor protection against future down rounds:

• Full ratchet: Adjustment as if all money was invested at the lower price
• Weighted average: Considers amount of new money raised
• Pay-to-play: Must participate in future rounds to maintain protection

Vesting Schedules

Standard Vesting Terms

• Four-year vesting: Equity vests over four years
• One-year cliff: No vesting for the first year, then 25% vests
• Monthly vesting: After cliff, remaining equity vests monthly
• Acceleration: Vesting speeds up during certain events

Types of Acceleration

• Single trigger: Accelerated vesting upon acquisition/merger
• Double trigger: Requires both acquisition and termination/role change
• Partial acceleration: Only a portion of unvested equity accelerates

Founder Vesting Considerations

• Protects company if co-founder leaves early
• Shows commitment to investors
• Prevents one founder from holding company hostage
• May include founder-friendly terms like partial acceleration

Valuation and Equity Value

Pre-Money vs. Post-Money Valuation

• Pre-money: Company value before new investment
• Post-money: Company value after new investment
• Investor percentage: Investment amount ÷ Post-money valuation

409A Valuations

• Required for US companies issuing stock options
• Independent third-party valuation for tax purposes
• Updated annually or after major events
• Determines exercise price for stock options

Equity Value Calculation

Equity Value = Company Valuation × Ownership Percentage

For preferred stock, liquidation preferences may affect actual value in exit scenarios.

Canadian Equity Considerations

Tax Implications

• Capital gains treatment: 50% of gains included in taxable income
• Lifetime capital gains exemption: Up to $913,630 tax-free on qualified small business shares
• Stock option tax: Deferred taxation possible with certain conditions
• Phantom stock plans: Alternative to actual equity for tax optimization

Legal Structure

• Corporation: Most common for equity issuance
• Federal vs. Provincial: Incorporation choice affects compliance
• Securities regulations: Provincial rules govern equity issuance
• Unanimous shareholder agreements: Common in Canadian startups

Government Programs

• SR&ED credits: R&D tax incentives that benefit equity holders
• Angel investor tax credits: Provincial programs encouraging investment
• Labour-sponsored funds: Specialized equity investment vehicles

Managing Equity

Cap Table Management

Essential tracking includes:

• Current ownership percentages
• Vesting schedules and unvested amounts
• Option pool sizes and grants
• Liquidation preferences and rights
• Pro-rata rights and obligations

Best Practices

• Regular updates: Keep cap table current with all changes
• Professional help: Use lawyers for complex equity structures
• Clear documentation: Ensure all equity grants are properly documented
• Communication: Keep stakeholders informed about equity matters
• Planning ahead: Model dilution for future funding rounds

Common Mistakes

• Verbal agreements: Always document equity arrangements legally
• No vesting: Failing to implement vesting schedules
• Overcomplicating: Keeping structures simple when possible
• Ignoring taxes: Not considering tax implications of equity decisions
• Poor record keeping: Inadequate cap table maintenance

Equity Exit Scenarios

Acquisition

• Equity converts to cash or acquiring company stock
• Liquidation preferences affect actual payouts
• Employment agreements may affect equity value
• Tax implications vary by structure and timing

Initial Public Offering (IPO)

• Private equity converts to publicly tradable stock
• Lock-up periods may restrict immediate sales
• Significant dilution from public offering
• Ongoing reporting and compliance requirements

Secondary Sales

• Private sales of equity to other investors
• May require company and investor approval
• Pricing based on recent valuations or negotiations
• Can provide liquidity before major exit events

Employee Equity Compensation

Stock Option Grants

• Attract and retain talented employees
• Align employee interests with company success
• Typical grants: 0.1-2% for senior employees, less for junior roles
• Exercise price based on 409A valuation

Restricted Stock Units (RSUs)

• Grants of actual stock that vest over time
• No exercise price required
• Immediate voting rights upon vesting
• More favorable tax treatment than options

Employee Stock Purchase Plans (ESPPs)

• Allow employees to purchase company stock at discount
• Often with lookback provisions for favorable pricing
• Encourage broad-based employee ownership
• Subject to specific tax rules and limits

Equity is both the foundation of startup ownership and one of the most complex aspects of building a company. Understanding equity structures, dilution, and tax implications is crucial for founders making decisions that will affect their company's future and their own financial outcomes. Whether you're splitting equity with co-founders, raising investment, or compensating employees, careful consideration and professional guidance can help ensure equity serves as a powerful tool for building and growing your business.