Equity structure is perhaps the most beguiling characteristic of a startup. It’s emotional, meaningful, misunderstood, complicated, and easy to fuck up.
Early on in my career, a mentor said to me:
Equity is commensurate to the risk you take, not the work you put in.
In simple terms, there are just 3 locations you can land on the cap table:
founder
investor
employee
I’ve been in each of these roles, and I’d like to share my experience with each of the roles and how each is reflected in the equity structure based on the risk taken.
Founder
I co-founded my first company, BachelorBlowOut, in 2001 while I was in business school at USC. I was clueless, just like most first time founders. As we got the business off the ground, and started to generate revenue, we understand we had a real company on our hands.
When I graduated, my mom asked me if I was getting a job, and I told her I wasn’t, that I was going to make a go of this whole bachelor party planning business.
“That seems pretty risky” she said to me.
After graduation, my co-founder and I had a decision on our hands. I decided to go all-in on BBO, and he decided to take the job at the law firm. We hand wrote a contract on a sheet of paper that gave him the option of putting in $1000/month over the next 12 months to retain his 50% otherwise shares shifted to me each month. After all, I was taking the risk to launch the company.
After a year, I owned 100% of the company.
After three years, I had 15 employees, $650,000/yr in revenue. I also had $125,000 in credit card debt. (This was pre-accelerator times, and credit cards were how you financed companies).
In the fourth year, I sold the company to a competitor, VegasHotSpots and paid off my debt.
I had taken the risk. That is why founding risk is the highest level of risk and is reflected as such on the cap table.
Investor
I’ve invested in 6 companies as an angel and 25 that have been in the Launch Pad accelerator.
“I’ll do whatever I can to help” I told Patrick Comer
“I need you to write a check, to put your money at risk.”
I logged onto Vanguard.com, sold some stock and put the money I was saving for retirement into Federated Sample as the first investor in the company.
There is a hell of a lot more risk that you’re going to lose all of your money as an angel investor in a startup than in an index fund at Vanguard.
During the first year of the Launch Pad accelerator program, we raised $125,000 to fund our class from outside investors. When we learned that one of the founders we had invested in was buying a nice couch when he company was floundering, we were pissed. As a founder, he was supposed to be taking more of a risk on his company, not less of a risk than we were as investors.
Angel investors put their cold hard cash at risk. Professional VC’s put other people’s cash at risk. That is a big responsibility, and the reason investor risk earns investors a large spot on the cap table.
Employee
Working for a startup often provides an opportunity to earn equity. Startups like to compensate employees with equity to align interests and manage their cash burn.
There are a lot of good resources on how much equity should be allocated to employees at various stages of a companies life. A rule of thumb is 15-20% should be the options pool for employees.
Early employees will get larger options grants because they joined the company at a riskier stage.
It’s important to understand standard structures for employee equity as both a founder and an employee, because this is where I see the most confusion and misaligned expectations.
Opportunity Cost ≠ Risk
In my first company, I tried to accrue my unpaid salary since I couldn’t afford to pay myself. I figured as an MBA, I had a certain earning power, and the company “owed” me this compensation even though it couldn’t pay. These IOU’s didn’t pass muster with my accountant or the IRS.
Opportunity cost is not the same as risk. I was being compensated for the risk I was taking by the equity I held in the company. The opportunity cost was just the choice I had made to start a company.
This misconception comes up a lot:
When an exec joins a company and demands options because he left a job where he was making more salary. — Leaving OldCo was a choice to join hot startup NewCo, but the opportunity cost of what the exec might have been making is not equivalent to taking risk.
Sweat Equity ≠ Risk
“I worked my ass off, and I didn’t get a fair equity stake.”
“Were you getting paid?”
“Yes.”
“Then you were doing your job and being compensated for it.”
Some version of this conversation has happened at a number of companies I’ve been involved with, usually in the early days and involving co-founders.
Approach this scenario by understanding who is taking the risk, rather than who is doing the work. Putting money at risk is investor risk. Starting a company before you can pay yourself is founding risk.
I’d love to hear feedback on if the framework laid out above for equity structure makes sense to you. Please feel free to share your feedback.