Many startups find it difficult or make mistakes in determining how to allocate shares in their business. When a company is initially incorporated, the promoters will authorize a specific number of shares in accordance with the laws where the business is established. This amount is easily divisible and will enable you to distribute round numbers of shares.
How you determine the allocation of equity will depend on many different factors. During your company's early stages, you won't have enough information to predict founders' contributions and added value. You won't have any objective data that might assist you in accurately predicting your company's potential. Thus, your equity agreement will be an estimation based on your business projections.
It's best to come to an agreement regarding founders' equity, and the respective amount of shares issued, as soon as possible after your company incorporates. Although this is an important decision, by necessity it must be made without much information.
Equity Distribution
Equity distribution, also known as share allocation or stock allocation, refers to the process of dividing ownership interests in a company among its shareholders. Deciding the best method for allocating shares depends on various factors, including the company's goals, structure, and the preferences of its stakeholders. Here are some common methods of allocating shares in a company:
Equally among Founders/initial Investors
One straightforward approach is to divide the shares equally among the founders or initial investors. This method can foster a sense of equality and shared ownership among the company's founders and early contributors.
Proportional to Investment
Allocating shares based on the amount of capital each founder or investor contributes is a common practice. This method aligns incentives with the level of financial commitment, rewarding those who invest more significantly.
Proportional to Effort or Expertise
Shares can also be distributed based on the contributions of each founder or team member in terms of effort, skills, or expertise. This approach aims to recognize and reward the value brought to the company beyond just financial investments.
Vesting Schedules
Founders and employees might be subject to vesting schedules that distribute shares over time. This ensures that shareholders have a continued commitment to the company and discourages early departures.
Performance-based Allocation
Incentivizing performance by tying share allocation to predefined performance metrics can be an effective way to motivate founders and employees to achieve specific business objectives.
Advisors and Consultants
Companies may allocate shares to advisors or consultants who provide valuable guidance and support to the company.
Employee Stock Option Plans (ESOPs)
ESOPs are a popular way to allocate shares to employees. This provides them with a sense of ownership and aligns their interests with the company's success.
Preferred shares vs. common shares
Different classes of shares can be issued, such as preferred shares that carry additional benefits or voting rights compared to common shares.
Convertible Notes
Startups often use convertible notes during early-stage funding rounds, which convert into shares at a later financing event.
Reserving shares for future funding rounds
Companies may reserve a portion of shares for future investors, employees, or strategic partnerships.
Buyback Agreements
Shareholders may agree to buyback arrangements in certain circumstances, allowing the company to repurchase shares from certain shareholders.
It's important to note that the best method for allocating shares can vary depending on the specific context of the company and its stakeholders. Legal and tax implications also play a crucial role in the decision-making process. Seeking advice from legal and financial professionals is essential to ensure that the chosen equity distribution method aligns with the company's objectives and complies with relevant regulations.