Ownership of a company is typically expressed in terms of stocks or shares. Each person with a stake in the company is given a percentage of shares of stock. Ownership in early-stage startups usually depends on each person’s contributions to the company.
As a startup grows, different factors begin to arise that entail the founders giving out more company ownership. Some of these factors include the need to take on investors, employ new staff, engage the services of specialists for business expansion, etc.
What is Equity in a Startup?
Equity in a startup refers to direct ownership of shares of stocks in a company. Holders of Equity in a company are called stockholders or shareholders. The amount of Equity held by each stockholder is usually described in percentages calculated as the number of shares owned by the stockholder divided by the total number of shares multiplied by 100. For example, Company A has 10 million stocks. If Stockholder A owns 1 million shares, Stockholder B has 200,000 shares, and Stockholder C owns 450,000. Their ownership percentage will be calculated as follows;
Stockholder A = (1,000,000/10,000,000) x 100 = 10%
Stockholder B = (200,000/10,000,000) x 100 = 2%
Stockholder C = (450,000/10,000,000) x 100 = 4.5%
Therefore, Stockholder A owns 10% of Company A, Stockholder B owns 2%, and Stockholder C owns 4.5%.
Who owns Equity in a Startup?
- Founders/Founding team: The Founders of a startup are usually the first holders of Equity in the company. They typically decide how much Equity in the company they want to own. Sometimes, as an alternative to cash compensation, they compensate their key team members who contributed to building and growing business, if any, with direct Equity in the company.
- Advisors: Advisors are skilled professionals startups employ for business development or achieving specific company goals. Common areas for which startups engage advisors’ services include finance, legal, and business. Legal advisors may help with regulatory compliance and other legal matters; Financial/Investment advisors may help with fundraising; Business advisors may help with business strategy, marketing, etc.
Advisory shares are equity grants given to advisors in compensation for the services rendered to the company. These shares of stock are typically subject to a vesting schedule and tied to certain KPIs.
- Investors: Investors are individuals who inject capital into startups and businesses with the expectation of achieving a profit. Different types of investors are classified based on their types of investments, the stage in which they invest in startups, and their terms of investment. These include Angel investors, Venture capital firms, venture studios, etc.
Some investors inject capital in exchange for equity ownership in the startup with the expectation that the value of the company stock will increase over time.
Types of Equity
The two most common types of Equity in a startup are;
- Common stock: Common stock refers to company stock that grants the holder voting rights, enabling the holder to participate in corporate policies such as the board members’ election. In addition, in the event of liquidation, holders of common stock own rights to company assets.
- Preferred stock: Preferred stock refers to company stock that does not grant the holder voting rights. They, therefore, do not participate in corporate governance. However, a preferred stockholder has a priority claim to dividends paid by the company or company assets distributed to stockholders.
What are Stock Options?
Stock options are a form of nonfinancial employee benefit that grants employees the option to buy shares of stock in a startup at a set price after a certain period. Further, employees usually have a specific period within which they can elect to purchase the stocks or lose their rights to the stock options. When employees decide to pay for the supplies, they are typically said to have exercised their options. Stock options are a means of attracting, motivating, and retaining employees.
All the terms and information guiding the stock options are typically stated in a contract given to employees on the grant date, either at the time of employment or during their work. Some terms guiding eligibility for stock options may include the type of employment, the time spent in the company, the position/role, etc.
Typically, a vesting period is also included; this is a specified duration within which the employee is to stay employed in the company before being able to exercise their options. Each company selects the terms suitable for their business and in line with their future road maps.
Companies contemplating stock options as part of the employment benefits package usually need to reserve a certain number of stocks that will be sufficient for the purpose.
Types of Stock Options
- Incentive Stock Options (ISOs) are sometimes called Qualified or Statutory Stock Options. They are stock options granted only to employees as part of their hiring or promotion packages. ISOs attract certain tax advantages which are not available to Non-qualified Stock options.
- Non-qualified Stock Options (NSOs): NSOs are sometimes referred to as Non-statutory Stock Options. They are stock options that can be granted to both employees and other service providers, such as consultants, advisors, directors, etc., as benefits attached in exchange for services rendered. In addition, NSOs do not receive preferential tax treatment like ISOs; therefore, they often attract higher tax burdens than ISOs.
Conclusion
A significant difference between Equity and Stock Options is that Equity represents direct ownership in a startup. On the other hand, stock options are a benefit that gives employees and other service providers the option of paying to own Equity in a startup. Starts should consult with their legal, financial, and tax advisors to properly structure and manage equity ownership in the company.