Avoid These 5 Common Startup Equity Mistakes
Keeping to the fundamentals can be tough. As a busy startup founder, it’s tempting to look for “do it yourself” stop-gap solutions for equity issues with a mantra of “we can deal with this later.” But early mistakes in allocating equity almost always catch up with you.
As advisors to life sciences and other technology companies for over three decades, we’ve seen plenty of these mistakes made by eager and ill-prepared entrepreneurs. This article will outline five of the most common startup equity distribution mistakes many founders make and how to avoid them. They include:
- Failing to understand the tax consequences of granting equity to employees
- Failing to devise a clear equity distribution strategy
- Ignoring vesting schedules when issuing equity
- Failing to comply with industry regulations
- Giving away too much control when issuing equity.
But first, what is startup equity?
Understanding Startup Equity Distribution
Equity refers to the ownership structure of a startup, expressed as a percentage of shares or stock. Initially, the founders typically own 100% of the company’s equity. As the company grows, they exchange portions of this equity for capital and use it to incentivize employees. So, who should receive equity compensation? Let’s explore the key stakeholders:
- Founders
Startup founders are the brains and the brawn behind a venture’s early growth. They deserve to be rewarded for their hard work and the risks they’ve undertaken. This is why founders typically retain a significant stake in the enterprise throughout its tenure. While equity distribution varies by company, most founders and co-founders usually hold around 70% or more of the initial shares. - Investors
Needless to say, “bootstrap financing,” e.g., lines of credit, personal loans, mortgage refinancings and credit cards aren’t enough to keep a startup afloat in the long run. When seed-stage funding becomes necessary, founders typically seek cash infusions from venture capitalists and angel investors. In exchange, they may offer anywhere between 20% to 30% of the startup’s equity, sometimes even more. - Employees
Most startups reserve around 5% to 15% of equity for employee stock option pools. In some cases, these options cover shares of non-voting common stock, allowing employees to gain financially without affecting control. Another approach is to grant stock (it can be voting or non-voting). Alternatively, companies offer stock appreciation rights (“SARs”), which grant employees the value increase of the company’s stock over a specific period. This approach incentivizes workers without diluting the startup’s ownership structure.
Up to this point, you understand who typically receives startup equity. Now, to the crux of our discussion: What are the common mistakes startup founders make regarding equity distribution and how can you avoid them?
5 Most Common Startup Equity Mistakes to Avoid
Failing to Understand the Tax Implications of Equity Compensation
Distributing company stock or shares often creates a taxable event, depending on the method of equity compensation and the type of startup. Interestingly, entrepreneurs are sometimes surprised to learn that receiving stock from their companies can create taxable income even when they don’t have the cash to fulfill these obligations. Here’s how taxation typically unfolds when receiving equity:
- Restricted stock: Employees can elect to be taxed on the stock’s value when granted under Section 83(b) of the Internal Revenue Code to avoid taxes during vesting. This is usually done when the value of the stock is low or nominal.
- Incentive stock Options (“ISOs”): Exercising ISOs may trigger Alternative Minimum Tax (“AMT”). Capital gains taxes apply if they are sold two years after the grant date and one year after the exercise date.
- Non-Qualified stock options (“NSOs” ): The difference between the fair market value and the exercise price is subject to ordinary income tax on exercise. Upon selling the shares, the employee will pay capital gains (or losses) tax depending on how long they’ve held the shares.
- Restricted stock units (“RSUs”): Fair market value when vesting is subject to ordinary income tax.
- Phantom stock: Taxed as ordinary income when the cash payout is made to the employee.
For example, if you grant non-qualified stock options to employees, they may owe income taxes when they exercise these options. Distributing restricted stock that is subject to vesting over time to early employees can result in income tax liabilities during vesting unless they elect to be taxed on the value of the stock when it is granted pursuant to Section 83(b) of the Internal Revenue Code.
Maximizing after-tax income is crucial. Therefore, seek counsel from qualified tax and legal counselors to develop an intelligent tax strategy.
Failing to Devise a Clear Equity Distribution Strategy
Many startup founders opt to split the equity equally among co-founders because it’s easy and seems fair, avoiding initial conflict. While this might work in some cases, it can create issues later.
Some founders may assume more critical and time-consuming roles than others. Tensions arise when one person contributes more but shares equally in the rewards. To avoid this, consider the following factors when distributing equity among founders:
- Experience, network and expertise
- Time and commitment to the startup
- Personal capital invested in the venture
- Relative risk and responsibilities
Interestingly, research from the Harvard Business Review shows that companies with equal founder splits have a harder time raising venture capital. An equity split that doesn’t reflect each founder’s contribution can undermine investor confidence. Avoiding the tough discussions needed for a thoughtful split may signal to investors that founders lack essential negotiation skills.
Devising a clear equity compensation strategy is crucial. Skipping this step can lead to a situation where you’ve given away too much equity, diluting your startup’s ownership structure and creating unrealistic expectations among stakeholders. Before implementing any equity distribution strategy, take time to map your vision and goals in regard to what you aim to achieve.
Getting Vesting Wrong
A vesting schedule outlines how and when equity recipients gain full ownership of their shares. Early employees might need to work for a certain period or achieve specific milestones to “earn” their equity. The two primary vesting frameworks are:
- Time-based vesting
Equity vests over a set period, with specific percentages earned at designated intervals. For instance, under cliff vesting, employees gain full access to a portion or all of their assets on a specific date. In many venture capital-based transactions, equity is subject to four-year vesting with a one-year “cliff vesting” of 25% of the equity, with the remaining vesting monthly or quarterly over the ensuing two or three years. - Milestone vesting
Equity vests upon achieving specific targets, like reaching sales goals, completing product development or hitting marketing objectives.
Ideally, a well-designed vesting schedule ensures that founders, employees and other stakeholders are rewarded equitably over time and incentivized to stay with the company. A common mistake is using a vesting schedule that is poorly aligned to the position or tasks at hand.
For example, relying heavily on milestone vesting for an executive’s compensation can be problematic. Startups often need to pivot quickly, making set milestones obsolete or unachievable.
Milestone-based vesting works best for short-term, predictable and clear objectives. If you choose this approach, ensure that both the employment contract and vesting agreements explicitly state the requirements for earning equity.
Failing to Comply With Regulations
The Securities and Exchange Commission (“SEC”) and the Internal Revenue Service (“IRS”) are the Federal agencies responsible for overseeing securities issuance. Additionally, State security laws must be followed to avoid financial penalties and lawsuits. Here’s a rundown of the equity regulations you should be aware of:
- Section 409A of the Internal Revenue Code: Governs nonqualified deferred compensation plans. These plans defer the employee’s income to a later date and do not meet the requirements of the Employee Retirement Income Security Act for tax benefits. Examples include stock options.
- Section 83 (b) election: A tax election that applies to restricted stock, allowing founders and employees who receive such equity to choose to be taxed on the value at the time of grant (e.g., when the value is low) rather than when it vests (e.g., when the hoped-for value is much higher).
- Rule 701 (Securities Act of 1933): Allows private companies to issue equity compensation without having to register with the SEC, provided they meet specific requirements.
- Regulation D (SEC): Allows startups to raise capital without registering with the SEC provided they meet specific rules like limiting the offering to accredited investors
- State Blue Sky Laws: Regulate the offer and sale of securities at the State level.
Ensuring compliance with all relevant laws and regulations is essential. Seeking guidance from legal counselors experienced in equity compensation can help you navigate these complexities.
Giving Away Too Much Management Control
In the haste to raise capital, some founders agree to restrictions on their freedom to operate unless they have the consent of the early investors. It is common for early investors to request or demand that they consent to major changes in the business. However, founders need to think carefully about how the restrictions on their freedom to run the business may affect them and the company.
Startup founders who give up too much equity to raise capital may find themselves hamstrung in running the business. Conservative investors may not see the benefits of seizing opportunities and entering new markets.
Another problem is that restrictions tend to grow over time with subsequent financings. So, a restriction given to early investors is likely to also be demanded by subsequent investors.
It’s important to carefully forecast and understand your initial cash requirements and bootstrap as much as possible in the early stages. When it is time to take on investors, many savvy founders raise only what they need for a set period, e.g., 18 months of capital, to get the venture to the next reasonable financing point. They also work hard to obtain equity terms that adequately balance the investors’ rights with the long-term interests of founders and employees in the growth of the business.
Conclusion
This blog is a primer on the basics of managing equity for startup founders and co-founders. We invite you to join our future publications, where we’ll discuss the type of business entities available to startup founders and the type of equity compensation they can offer stakeholders.
Crowley Law can help you navigate this vital aspect of your life sciences or technology venture. We have years of experience providing full-service representation to emerging life-sciences and tech companies and their founders. You can learn more about our services here.
The Crowley Law team provides ongoing proactive legal counseling to help your start-up identify and mitigate risk at every stage of your journey. If you need assistance drafting or reviewing agreements relating to equity compensation, contact us today.
FAQ
What Are the Challenges of Offering Equity Compensation in Highly Regulated Industries Like Life Sciences and Other Technology?
- Regulatory compliance: SEC and IRS regulations must be followed to avoid potential legal and financial consequences.
- Long development cycles: May complicate vesting schedules, demotivating employees waiting for liquidity events.
- Valuation difficulties: Determining the fair market value of early-stage biotech companies with less revenue but significant intellectual property (“IP”) can be complicated.
- IP concerns: Equity compensation agreements must define and outline control of ownership of IP developed by key employees.
- Risk of dilution: With multiple stages of funding, founders’ and early employees’ equity stakes may be diluted, making it harder to retain control and ownership.
What Special Considerations Should Life Sciences and Other Technology Companies Keep In Mind When Raising Capital?
- Development timelines: Investors must know that getting a return on their investment may take a long time.
- IP protection: Biotech and life science companies must secure IP rights to attract investors.
- High capital requirements: Startups in the life sciences and other technology industries often require significant funding through multiple stages.
- Strategic partnerships: Partnerships with large pharmaceutical companies can help provide additional funding, access to resources and validation.
