Founders part with equity way too easy
In the startup world, it’s common practice for founders to use equity rather than cash as their primary compensation method. Although there are instances where founders pay in cash to assemble their team, it’s often viewed as unconventional.
Numerous startup founders perceive offering equity as an enticing proposition. The notion of leveraging the potential prosperity of their entrepreneurial vision for a significant injection of cash now in exchange for tangible returns later is rather appealing.
However, employing this tactic harbors underlying risks. In the early stages of a startup, equity can be seen as a simple method of payment like cash. But, in truth, equity carries far greater potential worth. This misunderstanding of equity’s rightful worth can cause founders to squander it prematurely, realizing its true value when it’s impossible to recover it.
Why paying with equity is not a good idea?
Quite the opposite, providing equity as compensation is not always a disadvantageous move provided the equity is accurately appreciated. The real issue emerges when founders of startups in their early stages fail to acknowledge the genuine worth of equity and erroneously consider it as a negligible resource. This leads to it being shared without much foresight.
Here’s a typical scenario: “I’m offering you X% of the company if you develop my website/mobile app.” This proposition is what the majority of developers regularly hear from founders keen to steer them towards manifesting their startup vision.
As a founder, though, it’s essential to regard equity as an asset. This means that the form of payment offered for a service should be viewed as an asset, i.e., something that can generate profits in the future, assuming the startup thrives.
To translate this into a cash payment proportion, it would be like saying, “I’m paying $10,000 now to have my website built. As part of the deal, I’ll continue to pay dividends on the $10,000 yearly. Once I sell my primary asset—the company—I will distribute an additional X% of the overall company value.”
Developers tasked with building websites and apps find this deal beneficial. The website or app represents only a minor part of the company, but thanks to the equity obtained, they can secure a percentage of the company’s total value. That’s a prospect too good to pass up!
What to do, when you don’t have cash?
Equity stands as an invaluable possession for startups, and its preservation is of utmost importance.
Yet, startup founders frequently find themselves caught in the competitive landscape of talent acquisition. Despite any discomfort it may bring, the necessity of offering equity to incentivize your team is unequivocal. Exceptional workforce requires equity-based incentives, compelling founders to propose generous equity packages.
Indeed, if salary payouts are your sole means of remuneration, and if there are no team members pushing for a slice of your company’s ownership, it might point to their lack of faith in the startup’s future. They might see it as just another short-term project and not a flourishing company. While salaries help you to maintain your company’s ownership, be aware that your startup is often perceived as a stepping stone to other opportunities.
Always remember to view the money poured into your startup as an investment.
A savvy move to consider is combining equity and future salaries into a scheme known as equity deferral. The concept involves splitting payments into part salary, part equity. This method curbs equity dilution and decreases salaries, mitigating risks on both ends.
To put it simply, equity deferral suggests that you’re granting yourself a chance to pay for a service at a later date and regain your equity. Ideally, if you could come to an agreement where all the payment is deferred equity, it would be hugely beneficial for both you and your startup. It also gives you the option to keep your equity for future collaborations and partners who are specifically interested in your company’s equity, like investors, and not the ones providing services.
For service providers, this arrangement can be seen as a golden opportunity to cash in your equity faster, circumventing the need to wait for the elusive “big exit.” Moreover, you’ll have the added advantage of receiving salaries based on the enhanced company value.
Did I spend my equity wisely?
Simply put, this is not a clear-cut question.
The value of the choices you make for your startup is not something that can be definitively calculated due to the inherent unpredictability of business ventures. Given the myriad factors and uncertainties, providing a definite assessment of these decisions can feel like an insurmountable task.
Haphazardly doling out equity without regard for ownership stakes in your company could lead to you coming away empty-handed, despite your relentless work to get your venture off the ground.
On the other side of the spectrum, stinginess with equity could deter prospective partners from joining your startup. Remember that, during its inception, your idea might not yet command any significant value.
As an entrepreneur, one of the hurdles you will need to overcome is acknowledging that even the best decisions can sometimes culminate in failure. There are countless elements at play in getting a business off the ground, hence success is never a guaranteed prospect.
To strengthen your decision-making prowess, having access to all relevant information is paramount. This doesn’t mean that you can fully comprehend the global implications of your decisions, but rather, it’s about making smart, informed decisions at the micro level based on what information is accessible to you.
Diving headfirst into equity allocation requires you to adequately research about equity. Understand the industry-specific equity allotments for unique positions within your niche and locality. Overstepping or falling short of these equity parameters could raise investors’ concerns once you initiate the fundraising process. For example, if your industry and locality suggests that a 10% equity stake for a CTO is standard, aligning as closely as possible to this recommendation is advised. Offering fewer equities could make investors skeptical about your CTO’s abilities, whereas giving more equities could lead to questions about your understanding of basic entrepreneurial principles. You should be prepared to provide valid reasoning to address any potential queries. Always bear in mind that the decisions you make for your startup, including those relating to equity distribution, significantly influence the trajectory of your business toward success.
Conclusion
Entrepreneurs are advised to practice extreme caution when conducting equity-related transactions. Indeed, even in the infancy of the startup, when such measures might not seem vital, equity should be seen as a precious resource. As your startup evolves, the expenses incurred through equity transactions can skyrocket dramatically. Remember, once distributed, recovering your equity as the owner becomes highly improbable. You’re likely to find it less challenging to recover cash than to regain equity. Therefore, it’s wise to judiciously use your equity, reserving it for partners and potential investors who would naturally desire an ownership stake in your startup.
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