The crux of equity management can be distilled into a single question: How do I attract new stakeholders while keeping existing ones happy?
It may seem deceptively simple but the reality is, you must stay abreast of regulatory requirements, be familiar with cap tables, and ensure your stakeholders are compensated fairly, among other things.
Good equity management separates average startups from excellent ones. With effective equity management, startup leaders will find it easier to attract top talent and investors, boost internal productivity, and lay the foundations that can support the startup’s growth for years to come.
To grasp the fundamentals of equity management along with what you should and should not do, read on.
- Equity management is the practice of creating and distributing equity among stakeholders.
- Good equity management helps you retain control over your startup and attract investors and hires.
- The consequences of non-compliance are substantial if a valuation falls short of regulations.
- Bad equity management results in excessive dilution, hefty penalties, and a loss of control over the startup.
- Using equity management platforms is key to effective management.
What is equity management?
Equity management is one of the most crucial processes a startup must nail down. At its core, equity management is all about planning, balancing, and dividing up ownership of your startup amongst three main groups: founders, investors, and employees:
- Equity management helps determine ownership stakes and ensures that founders are fairly rewarded for their efforts.
- Equity is often given in exchange for their funding and expertise.
- Equity-based compensation packages are powerful motivators used to incentivize and retain employees and attract top talent.
Without good equity management, maintaining a healthy capital structure is impossible.
Startup ABC has three founders who are proficient in their fields but are too focused on retaining their own equity.
As a result, they ignore equity management. They neglect to offer equity-based compensation to employees and are reluctant to offer adequate equity to investors. This is self-sabotaging as it leads to difficulty in retaining and attracting employees and investors, ultimately constricting ABC’s potential for growth.
Why good equity management matters
Allocating equity is easy. Managing it properly, however, is not. Though equity management may seem straightforward in definition, bad equity management has been the root cause of failure for countless startups. Here’s what equity management can do for you:
Ensure compliance with regulations
Getting equity management right requires you to consider all regulatory implications before allocating equity. Startups need to ensure that equity is issued in accordance with relevant regulations and laws, such as keeping proper documentation and filing required reports (e.g., 409A valuations) as well as maintaining clear records (e.g., via cap tables).
Though this may seem like general housekeeping, it goes a long way in helping startups avoid damaging legal issues down the line, thereby mitigating regulatory risks.
Foster a culture of ownership, transparency, and fairness
When employees are given equity, their efforts become directly associated with the success (or failure) of your startup. This is invaluable as it creates a sense of accountability and ownership, which can motivate employees to be performance-driven and increase employee tenure.
Clear and open communication with employees regarding equity allocation and distribution is also a must, as it demonstrates your startup’s commitment to transparency and fairness.
Attract talent and investors
Standing out amongst a sea of startups can be difficult. But equity management can help startups differentiate themselves on two fronts.
- A well-planned and executed equity compensation plan can attract top hires who might otherwise be employed by a competitor.
- Effective equity management signals to investors that your startup is financially competent and trustworthy. If a startup cannot manage its own equity and finances, how could it be trusted to manage someone else’s?
Support planning and decision-making
Ultimately, equity management should reduce distractions and legal disputes for startups. By ensuring that founders, investors, and employees are fairly compensated, you can focus more on vital activities like decision-making and planning with minimal interruptions.
In the long run, this goes a long way in fostering a stable environment with strong corporate governance and a motivated team that is aligned with the company’s goals, thereby promoting long-term success.
Effective equity management is a complex and multifaceted process. Our list is entirely non-exhaustive as the full range of benefits goes well beyond what we have covered—from reduced turnovers to improving financial management.
Different types of equity accounts
Good equity management requires you to be familiar with the various types of equity accounts. Some of the most common types include:
- The most common unit of startup ownership.
- Entitles the holder to both voting rights and a portion of the startup’s profits, though the specifics will vary by startup.
- Similar to common shares, but they do not come with voting rights.
- Provide a guaranteed dividend payment and are prioritized over common shares instead.
- Have been repurchased from either existing shareholders (e.g., investors) or from the open market.
- Can either be reissued or canceled altogether depending on the startup’s needs.
- A form of equity compensation with pre-specified restrictions on their transferability or sale.
- Example: A vesting period requiring employees to work for a set number of years before they can sell or transfer their shares.
- Give holders the right to purchase shares at a strike price within a specified period.
- Holders are not obligated to purchase shares but must do so before the expiration date.
- Debt instruments that can be converted to equity in the future so long as certain conditions are fulfilled.
- Often used by early-stage startups to raise capital without needing to determine their startup’s value.
3 Common equity management mistakes to avoid
As good equity management can spell the difference between success and failure for your startup, it’s critical to get things right as the potential costs of mistakes are high. Some of the most common mistakes startups make include:
#1 Support planning and decision-making
A solid, well-researched equity management plan should be designed early on, during the planning stage. It should be used as a reference point to inform policies around how your startup distributes and allocates equity.
You must also
- include insights and benchmarks based on industry standards (i.e., to ensure that your equity compensation packages are competitive),
- have a clearly defined purpose, and
- communicate the plan clearly to all relevant stakeholders to minimize confusion and potential disputes.
#2 Not consulting professional advice
Equity management is a complex skill that takes a lifetime to master. Therefore, it’s safe to assume that most founders lack the expertise and experience to manage equity effectively from the get-go.
For this reason, founders shouldn’t hesitate to seek external counsel. This may involve obtaining advice from lawyers on possible regulatory issues surrounding equity distribution or insights from financial experts on the risks of certain equity policies.
Understanding that your startup may not have all the equity-related knowledge required is imperative to avoid costly mistakes.
#3 Not communicating clearly when dealing with equity compensation
Equity compensation can be a sensitive topic; it can potentially escalate into serious legal and financial disputes that can negatively impact your startup’s workplace, turnover rates, and more.
This is why founders must communicate equity compensation clearly to employees as this ties an employee’s efforts to the startup’s success, representing more than monetary compensation.
It touches on loyalty, pride, and other strong emotions. Not recognizing this can be detrimental to any equity management effort.
Equity management is a challenging process, even for experienced startups. While the best lessons are often taught through experience and failure, it’s worthwhile to familiarize yourself with what not to do by reading about equity management mistakes that startups must avoid.
Best equity management practices
Equity management can feel daunting, especially for inexperienced founders and startups. However, keeping in mind the following best practices can make your experience much smoother.
Update the equity management plan regularly
Creating and recording a solid equity management plan (e.g., with a cap table) is only one part of the equation. The other part is updating it.
As your startup grows from seed to series, its equity structure evolves in tandem. For instance, if your startup takes on several new investors, the plan must reflect this immediately. Therefore, equity plans, no matter how well-planned or researched, must be constantly reviewed and updated to ensure their relevance, as they are only snapshots in time.
Take equity dilution seriously
Equity dilution is a serious issue that can derail all your equity management efforts. Dilution refers to a reduction in shareholders’ ownership percentage.
If left unchecked, it can lead to serious consequences such as difficulties in raising additional capital in the future. Though dilution is generally bad, it can be planned and managed with the right steps.
Use an equity management platform
Equity management consumes your time significantly, diverting your attention from fundraising and other important activities.
While it is possible to use generalist software like Excel, a dedicated equity management platform like LTSE Equity can help you
- streamline and automate lengthy processes (e.g., tracking vesting schedules),
- minimize human errors, and
- promote transparency amongst stakeholders.
Ensuring that you familiarize yourself with some of the most important best practices surrounding equity management is a must for any founder. Read here to find out more.
Consequences of poor equity management
While effective equity management can be rewarding, getting it wrong can lead to serious consequences. Even small mistakes can have long-lasting consequences that can negatively impact your startup for years as they may lead to:
A loss of control over the startup and mission
Poor equity management goes hand in hand with ownership dilution. This can leave you with a much smaller stake in your startup than originally anticipated, leading to a loss of control. Ultimately, you’re compromising your startup’s ability to fulfill its mission and stay true to its values.
If you mishandle equity plans and compensation, you can reduce workplace morale, making employees feel underappreciated and discontent, eventually decreasing productivity.
Bad equity management increases the likelihood of falling afoul of various regulations and laws. For instance, poor record keeping of equity transactions and issuances can lead to incorrect reporting, subjecting the startup to penalties imposed by the IRS and SEC.
Issues attracting talent and investment
Without solid equity management practices, potential employees and investors will feel reluctant to join your startup. They may have less trust in your management skills and could feel that they would not be adequately rewarded or compensated for their contributions.
Founder vs employee equity
Founder and employee equity form the main pillars of equity management, which is why it is important to understand their differences and similarities. Here’s a breakdown:
|Equity that has been distributed and held by the startup’s founders.
|Equity that has been given to employees after startup formation.
|Given in exchange for taking on startup risks and incentivizing growth.
||To attract or retain employees and to align their interests with the startup’s success.
|To ensure that founders have enough ownership stake to give them sufficient control over its direction.
||To incentivize and motivate employees to contribute to the startup.
|Generally speaking, founders are given a much larger amount of equity.
||Employees are given comparatively smaller proportions of equity.
|Though they have the right, founder equity is often subject to restrictions; they cannot sell shares or transfer ownership without prior approval (e.g., from the board of directors).
||Similar to founder equity, employee equity is also usually subject to specific restrictions that will vary across startups, e.g., clawback provisions.
Option pools are powerful tools to efficiently grant equity to employees, advisors, investors, and other key stakeholders. Learn more about them here and how to properly calculate their size here.
Manage your equity with a platform like LTSE equity
A solid equity management platform can be your best companion if used properly. It can cut out unnecessary headaches, promote transparency over ownership, and optimize time-consuming processes such as tracking stock option issuances.
Accordingly, if you’re looking for a solid equity management platform for your startup, why not consider LTSE Equity? We’ve helped thousands of startups from pre-seed through to series A, B, C, and beyond achieve their goals and missions.
We also provide one of the most intuitive user interfaces in the market, along with high-priority support and founder-friendly pricing. To get a feel for what we can offer, try out our free public demo today.