Key Takeaways

  • Startup shares can be classified as common or preferred, with common shares usually going to employees and preferred shares to investors.
  • Equity typically vests over time to incentivize long-term commitment, often with a four-year vesting schedule and a one-year cliff.
  • Stock options and RSUs are common forms of employee equity but come with distinct tax considerations.
  • At formation, startups often authorize 10 million shares of common stock but only issue a portion of them.
  • Founders should consider contributions, responsibilities, and risk when deciding how to allocate initial shares.
  • Equity dilution occurs when new shares are issued, reducing existing shareholders’ ownership percentages.
  • Legal and HR complexities can arise during share allocation—consulting with an attorney is advisable.

How do shares work in a startup? In simple terms, equity is owning a share of a company. Shares are typically issued in a series and categorized as either common or preferred.

One of the definitive characteristics of working for a startup is gaining a piece of the company through equity compensation. Not only does it carry monetary value, but it also offers a feeling of ownership to its employees. It's important for employees to understand that participating in an equity plan does have risks associated with it. For example, when Good Technology was sold to BlackBerry for less than half of its valuation, employees of the company lost money on their stock options.

Stock Options

One growing trend is the issuance of restricted stock units (RSUs), which are usually granted directly to the employee without any required purchase. However, they carry distinct tax implications.

Employee stock options have a couple characteristics that are meant to keep talent from leaving the company too early:

  • Shares associated with a startup company are different than those of a public company, which are fully vested. Initially, unvested shares are not owned 100 percent by you, but vest (becomes yours) over time, alongside the company's loss of the right to repurchase shares from you. Equity vestment occurs over time according to a vesting schedule. If you are given 100 shares at four-year vesting, you'll receive 20 shares at the end of each of the four years until it becomes fully vested. A four-year vesting period is most common.
  • In addition to vesting, you'll likely be working with a cliff, which is the probationary time required before vesting officially begins. Usually, a cliff period is between six months and a year. Your shares will not vest before you reach the cliff, but once you do, all of your associated shares will vest. In other words, if you have a one-year cliff, you will not vest equity during the first year of hire, but once you reach the one-year mark, you'll have vested one year's worth of equity. After that, your company shares will continue vesting each month.

Company employees are usually offered common stock, which is different than the preferred stock offered to investors. Employee equity is distributed from an option pool, which is a set amount of equity allowed for employee distribution. Preferred stock usually includes rights such as board seats, voting rights, or liquidation preference.

The IRS recognizes standard stock options as incentive stock options (ISOs). ISOs do not create a legally taxable event until they are sold. No income is reported until you sell it, which then incurs tax as a long-term capital gain. If you're thinking of selling, keep these tax implications in mind.

Founders and Initial Share Allocation

When launching a startup, one of the first critical steps is deciding how to allocate shares among the founding team. This process is essential because it reflects each founder’s contribution, expectations, and commitment to the business. A common practice is to authorize 10,000,000 shares of common stock at incorporation. However, not all shares are issued right away—many remain in the unissued pool for future hires, advisors, or investors.

Key factors to consider when determining how to allocate shares in a startup among founders include:

  • Contributions and Skills: What expertise or assets (e.g., intellectual property, capital) each founder brings.
  • Time Commitment: Whether founders are working full-time or part-time.
  • Risk Tolerance: Who is taking financial or career risks to build the company.
  • Roles and Responsibilities: CEO, CTO, or operational roles may warrant different equity stakes.
  • Previous Experience: A track record in building companies may influence share allocations.

Even split allocations (e.g., 50/50 for two co-founders) are common but not always ideal. It's often better to objectively assess each person’s value-add to avoid conflict later.

To prevent premature departures from disrupting the company, founder shares typically also follow a vesting schedule, similar to that of employees. This allows the company to repurchase unvested shares if a founder leaves early.

Equity Valuation

It can be difficult to determine the actual dollar value of your equity. Generally, there is a range of value that depends on the exit options the business is considering. Determining equity valuation is further complicated by human resources and legal concerns that may occur during discussions of equity valuation between company founders and their employees. Legal professionals often advise company founders to be very cautious about having that discussion.

The value of equity may be diluted when the total amount is divided among many people. A company founder begins by owning all shares representing complete ownership of the company. As time passes, other parties obtain pieces of equity as compensation for work (e.g. employee stock options), funding (e.g. seed, angel, and venture investors), or professional services (e.g. directors, attorneys).

As equity is calculated as a total percentage of ownership, it will always total exactly 100 percent. This means that anytime a person gains another piece of equity, by default it dilutes the percentage of all other equity holders. To avoid equity dilution to its current equity holders, a company must not hire additional employees who receive stock options or accept additional money from investors.

The shares that have been given or sold to people within the company (e.g. subsequent investors) are called issued and outstanding shares. Without including stock options, the number of shares issued amounts to 100 percent of the company's equity.

Authorized, Issued, and Outstanding Shares

Understanding the difference between authorized, issued, and outstanding shares is vital when managing startup equity:

  • Authorized Shares: The maximum number of shares a startup can legally issue, set in the certificate of incorporation. Typically, startups authorize 10 million shares.
  • Issued Shares: The portion of authorized shares that have actually been granted to founders, employees, or investors.
  • Outstanding Shares: Issued shares currently held by shareholders, excluding shares held in reserve (such as the option pool).

Startups often issue only a portion of their authorized shares at formation. For example, 5 million out of 10 million authorized shares may be issued, leaving room for future fundraising and hiring.

Option Pool and Employee Equity

The option pool is a reserve of shares set aside from the total authorized shares for future equity compensation. It's typically 10–20% of the company’s total shares and is used to attract talent without immediate cash compensation.

Key points regarding the option pool:

  • Pre-Funding vs. Post-Funding: Investors often require the pool to be created or expanded before their investment, which can dilute founders.
  • Size Considerations: The larger the option pool, the more diluted the founders’ equity becomes—so it should be sized strategically based on hiring plans.
  • Granting Process: Employees usually receive stock options (common shares) that vest over time. The board of directors must approve each grant.

Setting clear expectations on how to allocate shares in a startup through an equity compensation plan helps maintain transparency and employee motivation.

How Equity Dilution Happens Over Time

As a startup grows, it raises funding and hires employees—both of which typically require issuing additional shares. Each issuance decreases the ownership percentage of existing shareholders, a process known as equity dilution.

Example of dilution:

  • Initially, a founder owns 100% of the company with 5 million shares.
  • After raising seed funding and granting employee options, the total share count increases to 10 million.
  • The founder now owns 50%, even though they still hold 5 million shares.

While dilution is inevitable, it's not necessarily negative—each round of dilution should correspond to added value, like funding or talent. It’s crucial to track share issuances with cap table software or legal guidance to understand dilution’s impact.

Frequently Asked Questions

  • How do startups decide how many shares to issue?
    Startups typically authorize 10 million shares but only issue a portion to founders and employees. The number issued depends on ownership goals and future needs.
  • What is the best way to allocate shares among co-founders?
    Shares should be allocated based on each founder’s contributions, responsibilities, risk, and time commitment—not necessarily equally.
  • What is an option pool and why does it matter?
    An option pool is a reserve of shares for future employees. It affects founder equity, especially if expanded before a funding round.
  • Do employee shares have the same value as investor shares?
    No. Employees usually get common stock, which has fewer rights than the preferred stock offered to investors.
  • What happens to my shares if I leave a startup early?
    If your shares are unvested, the company can typically repurchase them. After vesting, you generally keep the shares unless otherwise stated in your agreement.

If you need help understanding how shares work in a startup, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.