Founders part with equity way too easy
When you talk about startups, it is assumed and expected that you as a founder will be paying with equity. In fact, it is strange and even raises questions, if you pay cash to your team to build the startup.
Founders too prefer and like to use equity as a transactional currency. What’s not to like – you are using the potential of your dream for a huge windfall eventually, someday, and getting something real in exchange.
The problem is that at very early stages of your startup you see equity as a payment vehicle (cash), while in reality, equity is much more valuable. It feels like it is free, and founders tend to spend it like it is. By the time that equity becomes valuable, it is too late to get it back.
Why paying with equity is not a good idea?
If equity is properly valued, then it is not such a bad idea to pay with it. Again, the issue is that in very early stages of your startup, equity really has no or holds very little value. That is why it is spent so easy with very little long-term considerations.
“I will give you X% of the company, if you create my website/mobile app” – this is probably the most popular conversation and offer developers receive from founders to join the company and help build their dream.
You as a founder you need to understand that equity is an asset. This simply means that you are paying for a service with an asset – something that will continue paying in the future (assuming your startup succeeds).
If we want to translate this to a cash payment, the equivalent would sound like this: “I am paying (for example) $10’000 now to get my website built. Then I will continue to pay dividends on the $10’000 every year, and when I sell my main asset (the company), I will pay additional X% of the value of the whole company”.
Well, this sounds like a great deal, if you are building websites and apps. Because the website/app is just part of the company, yet you will be cashing out on the equity you own of the whole company. Sign me in!
What to do, when you don’t have cash?
Equity is one of your most valuable assets and you need to guard it carefully.
Keeping your equity sounds good, but in reality, you as a founder compete with other founders for talent. Like it or not, you will have to offer equity to your team. Good talent gets paid with equity and founders have no choice but make compelling offers.
In fact, if your only option is to pay cash and other team members don’t ask for equity in your company, it is possible they don’t believe enough in your startup to be part of it. Paying cash helps you keep your company ownership, but remember that many people see your startup as the next consulting job.
One good option would be to consider a combination of equity and future cash payments as an equity deferral. The idea is to pay partially in cash, partially with equity. This way you lose less equity, pay less cash and in fact, such schedule reduces the risks on both sides.
Equity deferral simply means you are giving yourself the option to pay for a service later and get your equity back. If you can make a deal to pay with equity deferral 100%, that will be the most beneficial to you and your startup, allowing you to keep your equity for future spending and partners who are only interested in equity in your company (investors, not service providers).
If you are a service provider, this is a good option to liquid your equity in a shorter period, so you don’t have to wait for the “big exit”. In addition to that, you will be receiving cash, based on the increased value of the company.
Did I spend my equity wisely?
Well, this is a loaded question.
You can’t really know if your decisions were the best, in the long run. A startup deals with so many unknowns and variables, that it is impossible to evaluate such decisions.
Of course, if you are giving equity left and right and not thinking about your stake in the company, you would find yourself with nothing but experience after working extremely hard to get things running.
On the other side of the spectrum – being extremely stingy with equity will simply turn people away from you and your startup. Remember that this sill is just an idea and has very little or no value yet.
As a founder, you also need to remember that you can make all the right decisions and still lose. There are simply too many factors to consider when starting a business, that it is impossible to guarantee success.
Make sure you have all the information that you need at any given time to make the right decisions. This simply means you cannot comprehend the global effect of your decisions; just make sure on a micro-level you are making the best ones.
When offering equity, do your research and understand what the ranges are for a given position in your industry in your area. Offering equity outside these ranges may become a problem later when you start looking for investments. Investors will ask you why you have given too little or too much. For example, if it is expected to give a CTO in your area and industry 10% of the company, they try to stay as close as possible to that value. Less than that will make investors nervous that the CTO may not be that good. Giving more may raise the questions why you have given that much and make you look like you don’t know what you are doing. At lease make sure you have a good explanation if one is requested.
Founders need to be extremely careful when paying with equity. At the very beginning, even when it doesn’t feel like it, remember that equity needs to be treated as an asset. Paying with equity gest extremely expensive with your startup development. Once given, it is forever and there is very little you can do as a founder to get it back. Cash is easier to earn that to re-acquire equity. Spend it wisely and keep it for partners and investors, who are by definition going to join your startup for equity.