How to Allocate Shares in a Startup?
Wondering how to allocate shares in a startup? When your company initially incorporates, you'll authorize a specific number of shares.3 min read
Updated June 24, 2020:
Wondering how to allocate shares in a startup? When your company initially incorporates, you'll authorize a specific number of shares. In general, startups typically authorize 10,000,000 shares of common stock. This amount is easily divisible and will enable you to distribute round numbers of shares. It's also common practice.
How you determine the allocation of equity will depend on many different factors. During your company's early stages, you won't have enough information to predict founders' contributions and added value. You won't have any objective data that might assist you in accurately predicting your company's potential. Thus, your equity agreement will be an estimation based on your company's best guess.
It's best to come to an agreement regarding founders' equity, and the respective amount of shares issued, as soon as possible after your company incorporates. Although this is an important decision, by necessity it must be made without much information.
Determining Founder Equity
Deciding how to distribute equity among co-founders depends on the unique circumstances of your startup. There is no one answer or specific formula that can produce the best answer for your situation.
To understand each founder's value, first determine the roles that each founder will play throughout your company's long-term development. Make sure to discern each founder's expertise and experience when it comes to determining their respective roles. For example, which founder is best suited to be a successful CEO? Roles may change as the company evolves, but it's helpful to begin with some role distinctions in mind.
Consider the level of risk that each founder is taking. Those taking higher risks should receive more equity.
Most importantly, don't avoid having these difficult conversations and simply decide that an equal amount of equity should go to each founder. If roles, responsibilities, and expectations are not defined early on, future conflict is more likely to arise. In addition, potential investors will question your motives if they are not rational and logical.
When calculating a founder's value, you can divide it into five categories: idea, commitment and risk, business plan development, domain expertise, and responsibilities. You can assign a value between 0 and 10, and then multiply by the founder's score in order to determine a weighted score.
Vesting schedules determine when an individual may exercise his or her stock options. Schedules are time-based, and will vary according to your startup. The most common vesting provisions usually include:
- A four-year vesting schedule.
- A one-year cliff.
- Single-trigger acceleration.
Most startups utilize vesting schedules, which are intended to discourage people from leaving the startup and reduce the risk of diluting equity. According to a four-year vesting schedule, each stockholder's equity will vest equally in 48 phases: once a month for four years. If the person leaves the startup before the first year has been completed, they relinquish all equity they have vested. On the other hand, if the startup leaves before all shares have vested, they all immediately vest by default.
In Silicon Valley, tech startup companies began routinely offering stock options to their employees, which soon became a trend. In California, state legislation cannot prohibit employees from leaving or being approached by competitors. Companies can only offer better incentives and more of a stake in developing an impactful business. As a result, employers are often granting "Evergreen" stock options, which are additional stock grants that typically activate after two and a half years. This avoids the situation in which employees no longer vest any equity after four years (or the company's vesting schedule).
Dividing equity within a startup company can be broken down into five simple steps:
- Divide equity within the organization.
- Divide equity among company founders.
- Allocate money to investors.
- Divide the option pool into three groups: board of directors, advisors, and employees.
- Create a vesting schedule.
The first step, dividing within the organization, is the most important. The total amount (100 percent) must be divided into three main groups: founders, investors, and option pool.
The standard distribution of equity to each of these groups is listed below. Keep in mind that these are guidelines and excellent starting points for discussion.
- Founders: 50 to 70 percent.
- Investors: 20 to 30 percent.
- Option pool: 10 to 20 percent.
- Total: 100 percent.
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