In the realm of business and entrepreneurship, equity is a term that holds significant weight. Fundamentally it is the pure ownership of a company, however, it is a tool that founders can use with larger implications that are crucial to a business’s success.
To put it simply, equity is a term used to describe ownership stakes in a company. It denotes the portion of the company’s value that’s owned outright by its shareholders. The ownership is typically represented by shares of stock, which entitles the holder to a proportional claim on the company’s assets and earnings. When you start a company, you typically divide the company's ownership into shares, which can then be distributed among various equity holders.
While we typically think of equity in a public company context, it is a fundamental component in private businesses, startups, and partnerships. It aligns the interests of owners (shareholders) with the performance and profitability of the company.
Equity ownership stakes in early-stage companies are typically divided among three main groups: founders, employees, and investors. Founders usually receive the largest portion of equity, reflecting their ideation, initial contribution, and assumption of risk. Equity is then usually offered to employees as part of their compensation package; it is used to attract top-tier talent and align the employees’ interests with the company’s success. Lastly, investors purchase equity in a company to provide it with capital that is used for business expansion and growth. Investors include angel investors, earlier-stage venture capitalists (VCs), and later-stage institutional investors. The percentage of equity investors receive depends on the amount of capital they contribute and the negotiated valuation of the company and the specific rights/terms of the investment deal.
The ownership structure outlines how equity is distributed among these groups, often represented in a Cap Table (capitalization table). The Cap Table is basically a ledger that details each stakeholder’s share of ownership, helping maintain transparency and clarity.
Evaluating equity for a startup involves determining the company's overall value and how much each share is worth. For public companies, the value is determined every day on public markets where investors are constantly valuing the company through transacting their stock. For a private company such as an early-stage startup, that typically entails a 409A valuation, which determines a company’s fair market value and helps establish the price per share in lieu of regular, public transactions. The valuation of equity involves assessing the company’s financial health, growth prospects, market conditions, and comparable companies and transactions. Once that’s established, companies use this valuation to meet compliance and tax guidelines related to the issuance of equity compensation.
Within the scope of a typical early-stage company that is a Delaware C-Corp, are three primary types of equity:
SAFE and Convertible Notes
In addition to common and preferred stock, there are other mechanisms such as Simple Agreement for Future Equity (SAFE) and Convertible Notes, which allow for flexible and simplified investment terms that push off the equity issuance to a future date:
Equity is the lifeblood of every early-stage company. As these companies grow, continued equity financing is vital for fueling the growth and expansion needed for a business to thrive. In contrast to pure cash, ownership ensures that everyone has a vested interest in the company’s performance, fostering a unified vision and collaborative, dedicated approach to achieving business goals. While the initial motivations of the founder, employees, and investors may slightly differ, they merge at the epicenter of aligned beliefs and interests for the company’s success.
Understanding and managing equity effectively can set the foundation for a thriving startup. By demystifying equity, founders can make informed decisions that promote growth, attract talent, and align the interests of all stakeholders.
