If you’re brand new to business, it’s important to consider the ownership of your startup. Depending on your business structure, you may start out and continue to own 100 percent of the company. However, this is rare. Typically, your percentage of ownership decreases overtime as co-founders, essential employees (those you cannot smoothly run the business without), and investors take on a greater amount of equity. This is known as dilution of ownership.
Bringing on new employees and securing rounds of investments shouldn't make you cede control of your business, though. Read on to learn why an experienced transactional attorney is your strongest ally.
Early employees and co-founders
To get your business off the ground, you may need one or more co-founders. These are individuals who bring something important to the table. Their knowledge, skills, or resources are either necessary or highly beneficial to the growth of the business. For example, if you wish to design, manufacture, and sell clothing, it may benefit you to bring on a co-founder who already has experience and connections in the textiles industry.
Co-founders usually receive equity in a company, though they may not get as much as you. You may have started out owning 100 percent of the company, but now one or more co-founders may each have a significant percentage of equity. Cleverism, a website dedicated to entrepreneurs and job hunters, writes if you anticipate multiple rounds of investments, you may reserve up to 30 percent of equity for founders.
Next come your early employees. These initial workers often receive a small amount of equity in a startup as part of their compensation package. This may be because the business can’t afford significant salaries yet. It also encourages early employees to work hard and make the company a success. As Willy Braun, co-founder of the VC fund daphni, pointed out the value of equity is the difference between the price of the option, which is the value of the company when an employee comes aboard, and the price of selling, which is the value of the company at a later date. Equity within early employees’ compensation packages encourage those workers to increase the value of the company in hopes of a large payout down the road. You might choose to set aside an equity pool of up to 20 percent for your early employees.
Investors taking more ownership
Some investments may not be in exchange for equity in your business. Instead, initial investments may be gifts from family and friends, crowdfunding from strangers, or loans that you pay back. However, there will quickly come a time when you obtain investors, and those individuals or businesses will want an ownership interest in the company. If you are expecting multiple rounds of investments (Series A, B, and C), then you can anticipate giving up to 70 percent of the company to investors.
“Those decisions that [founders] make with respect to investment deals are important, and they need to understand what they are," says J. Fred Kingren, a Business and Finance lawyer with Hand Arendall. “Having a lawyer by their side can help deal with those questions, like, how do we do a deal on the best possible terms so that they structure the investment as equity or debt? What investing schedules might be? What valuations to be used? what kind of price adjustments there might be?”
While startup culture valorizes learn-on-the-go individualism, the advice of an expert in matters of business is crucial: “There’s all kinds of important issues that need to be thought through and for the entrepreneur that’s going through a startup for the first time it’s important to have someone that’s experienced at their side.”
One way to think of percentages is to visualize a pie. When you’re the initial founder, the whole pie is yours. But then you need to consider slices of pie for your co-founders, important/early employees, and investors. The more individual owners you add over time, the thinner each person’s slice becomes. “What is dilution, after all, but dealing with issuances and new equity that decrease an existing shareholders ownership of a company,” says Kingren.
This is why it is essential to work with an experienced business and transactional attorney. Your lawyer will help you carefully consider agreeing to co-founders, the percentage pool you leave for employees, and how much equity you negotiate away in your Series A, B, and C investment rounds. Whether you start with two or three co-founders matters, whether you leave 10 or 15 percent for employees is important, and how much equity you give in each funding round may need to be as little as possible.
You want to retain as much of your business as possible while also doing what is best to make a profitable company. To balance out the decrease in your percentage of ownership, you need your business to do well. The greater the value of your company, the greater your small percentage of the business is worth.
How a business lawyer can help
A business and transactional lawyer can help you in multiple ways as you start a new business. Many entrepreneurs call making equity decisions at the beginning of a business an art, not a science. These decisions require a thorough review of all the circumstances and thoughtful consideration. As someone new to business, you will benefit from the seasoned advice and insight your lawyer can provide. An experienced business lawyer will advise you on how much equity may be too little or too much for founders and early employees.
However, the equity decisions are not entirely your own. Most co-founders and even some early employees will negotiate their equity interest. Sophisticated investors are sure to negotiate and seek the maximum amount of equity possible. “There’s also things that in addition to [equity] that affect dilution,” Kingren says. “Things like liquidation preferences and participation rights and culminative dividends, and those are not as apparent to the founders and original owners in the business when they’re bringing in investors. An attorney can help point those things out and way what might otherwise look to be an equal offer.” An attorney will advise you during your negotiations, or they can directly handle the negotiations on your behalf.
After you agree on compensation packages with co-founders and early employees, and form agreements with investors, then it is time to put those agreements into writing. You should have an experienced transactional attorney draft, review, and finalize these contracts to ensure they are binding, protect your interests as much as possible, and reflect your and the other party’s intentions.
If you are taking the plunge into business ownership, there are a great number of things to consider, including ownership dilution. The best way to protect your ownership interests is to find a business attorney to help you navigate the early days of founding and growing the business.