Constant equity management is key to ensuring your start-up remains healthy and viable. As your startup grows, you’ll reach out to more investors and welcome new team members. But with more stakeholders on board, you’ll need to keep a close eye on your equity division or risk over-diluting.
In this article, we’ll review some tips to ensure you’re managing your equity effectively, and cover what might happen if you don’t.
6 best practices for good equity management
Equity management can make or break a startup. Keep a close eye on your division. Here are some tips to consider when managing your equity:
1. Distribute equity sparingly
A general rule of thumb for angel and seed-stage funding rounds is to put up between 10% and 20% of equity. Be careful not to give away too much equity too early, as this may limit your ability to attract potential investors in the future.
So, plan your distributions ahead. Note down any future equity investment rounds and add up the amounts of equity you’re willing to give at each stage. This should include shares for investors as well as any incentives for talent.
2. Properly define and communicate equity terms
Just like any relationship, communication is key to making sure all parties are satisfied with an equity division. Define your terms from the start—state how much equity is transferred and what you expect to receive in return. An open discussion will help prevent misunderstandings and resentment over unequal or unfair shares.
3. Keep a close eye on your cap table
Always keep your cap table clean. It’s your first point of reference for equity division, so make sure everything is up-to-date and accurate. While it can be tempting to update only occasionally, keeping an inaccurate cap table will lead to mistakes that will be costly to rectify.
Empower yourself with the right cap table management knowledge—here are nine tips to make managing your cap table a breeze.
4. Evaluate equity distribution regularly
Early-stage startups usually need more funds to compete with other companies. If they want to attract top talent, they need to make up for it in equity. But as your business grows, you may no longer need to offer such a large stake.
Make it a habit to go back and evaluate your distribution model regularly. Your financial situation will shift as you proceed through funding rounds, so it’s always good to adjust your distribution plans depending on where you are on your startup journey.
5. Consider vesting founder shares
A vesting clause determines when a founder can exercise their stock options, allowing them to own their stock fully only after a certain period or milestone. For example, if you own shares vested over a three-year period, you can only exercise them after three years of working for the company.
Vesting encourages commitment, protects other founders, and reduces the risk of one person owning a large percentage of the company and leaving after a year. Investors may also insist on a vesting schedule before committing.
6. Consider option pools to manage employee equity
Option pools, or shares reserved just for employees, are a great way to attract talent as an early-stage startup. They are also a good option for startups to provide equity options to their team in an orderly way; without one, you’ll have to grant equity on a one-off basis each time you hire a new employee.
If you’re unsure how the breakdown of your equity would be after an option pool, you can use a calculator like the TLDR Stock Options Calculator to plan ahead.
The consequences of poor equity management
Poor equity management is the fastest way to ruin a reputation. Practicing poor equity management can cause you to:
1. Lose control due to over-dilution
Each time you issue stock, you’re reducing or diluting the ownership stake that each shareholder has in your startup, including your own. All startups deal with this, but the key here is to avoid over-dilution.
If you accidentally cede a larger percentage of your shares to investors and employees, it can lead to serious disputes over ownership and put your startup’s mission at risk.
2. Create internal conflict among founders, employees, and other stakeholders
One of the biggest reasons why startups fail is disharmony among the team and investors. Bad equity management can lead to misunderstandings or a perception that someone’s share is unfair, opening the door to stakeholder disputes and resentment.
Keep a vigilant eye on your equity and communicate any changes to equity terms upfront to avoid conflicts.
3. Sour your reputation in the industry
Neglecting your equity can tarnish your reputation, especially among investors. They will surely question your ability to manage other aspects of your business. Poor equity management is simply a red flag to any potential investors or talent.
On the flip side, careful share management can attract investors and top talent.
Get into the habit of good equity management
You don’t need to do it all yourself. Equity management will only get more complex the bigger your company gets, so don’t waste hours of valuable time sweating over an Excel sheet. Instead, follow the lead of thousands of startup leaders who have decided to streamline their management process using equity management tools.
LTSE Equity’s equity management software makes it easier for you to manage the status and breakdown of your equity, enabling you to catch any mistakes or possible over-dilution easily. And best of all, it’s all on one platform.
Here’s a last pro tip for you: use option pools to manage your employee equity. Many startups have found they’re a good way to avoid over-dilution and attract talent.