Startup Equity Explained: Pies vs. Bricks and the Value of Shares

How startup equity works

Imagine you are a startup founder. There's one thing you've been told for years: the percentage of the company you own is essential. It matters for control, voting rights, and for-profit sharing. It also helps you determine what you will get when selling the company. 

For what seems like ages, we've been told that startup equity is vital to startup founders and that ownership plays a crucial role in a startup's present and future. It might shock you when I say that this is wrong.  

Sadly, most founders don't correctly understand equity. It all starts with how we view startup equity, which is like this: a pie chart. 

The problem is that companies don't behave like pie charts. A pie chart is an overly simplified approach to a company. Though it's harder to grasp, your startup works more like bricks, and it's essential to understand the difference. 

What do we mean by bricks and pies? The following section will explain how we use this example. Moreover, why are we changing the way we see startups? 

Suppose you're building a startup, looking for investors, and giving equity to your employees. In that case, you need to understand how your company works. After all, making a mistake can be extremely expensive. 

What do startup founders get wrong about equity?

For simplicity's sake, we will stick to our pies vs. bricks comparison and use two businesses: an LLC and a C-Corp. 

A Limited Liability Company (LLC) is a legal structure in the United States that protects its owners from responsibility should the company have debts or liabilities, hence the name. It's important to note that while LLCs are legal, each state can view them differently. 

 In our case, LLCs are pies. An LLC is like a partnership and is usually split in percentages, such as the image we used above. 

This means that each partner has a determined percentage of the company. Such a division makes it easy to understand how the LLC is formed. Still, it's more challenging to bring in multiple investor rounds. 

Most startups aren't LLCs. Instead, they are C-corporations. 

What are C-corporations? A C-corporation is a legal structure in which the owners, or shareholders, are taxed separately from the entity. It's an independent legal entity owned by its shareholders. 

As you can see, we've introduced a new term: shareholders. They're vital for a startup, and that's where bricks come into the picture.

How do startups split their shares? 

As we've said, startups are more often C-Corporations. So, startup equity doesn't work in percentages but in company shares. 

For example, Founder A and Founder B create one company and split it equally. Each gets ten shares, and the percentages are 50% for each. 

Founder A's shares will never change hands unless they want to, nor will Founder B. If they decide to bring in an investor to the startup, the company will create new shares. 

Founder A still has ten shares, and so does Founder B. At the same time, investor C will get new shares. As you can see, the shares remain the same, but the percentages change. 

Founders A and B will no longer own 50% of the company, though each still has ten shares. This situation creates another question: How do founders and investors define the percentage they get? 

How startup valuations work and how they impact shares

Startup valuations are an essential part of how these companies define share value. The problem is that it can be challenging to understand. 

Let's use Facebook as an example. It's easily the world's most famous company and a fascinating study case. 

When Mark Zuckerberg and Eduardo Saverin started Facebook, they agreed to a 70/30 split on their founder equity. These are common shares, and we'll explain them further in the article. 

Peter Thiel was one of the first investors in Facebook. He agreed to give them $510,000, which would eventually become approximately 10% of the company. 

However, it's important to remember that startups deal with shares, not percentages. So, $510,000 has to equate to a number of shares. The question is: how many? 

At the time when Thiel decided to invest, Facebook had no revenue or assets. That's why valuations relate to the company's potential. Facebook founders and investors had to agree on the company's value when Thiel put down $510,000. 

How a company can define a valuation

At its core, a startup valuation is like betting odds: agreeing on how much to risk and what the reward will be if the investor, in this case, Thiel, is right. The investor is betting that the company will work and that, eventually, he'll get his money back. 

Since uncertainty surrounds startups, the founders need motivation to keep going. Part of that motivation comes from holding on to plenty of shares. So, it's common for investors to get a small part of the company first. 

That's what happened in the Facebook case. Mark Zuckerberg and Peter Thiel agreed that 10% of the company equated to around $500,000. 

It's time to introduce two crucial terms: pre-money and post-money valuations. We're starting with the latter. 

What are pre-money and post-money valuations?

Using the Facebook example, if $500,000 is 10% of the company, then the entire company is worth $5,000,000. That's the post-money valuation because it's assuming the money is already part of the business. 

Before the money came in, the company had another valuation. This is the pre-money valuation; in Facebook's case, it was $4,500,000. 

Pre-money valuation is the estimated value of a company before investor money comes into play. Post-money valuation is the value of the same company after investors put funds into it. 

Using Facebook as an example for startup equity

Before we start explaining, it's crucial to highlight that these are rough estimations to explain how startup equity works. The first gross estimation is that startups can't split stocks, so shares will usually be in the 1,000,000 to 10,000,000 range because they're easier to split. 

In our Facebook case, we'll use 100 shares. Let's assume that Mark Zuckerberg, Eduardo Saverin, and the rest established the company with 100 shares. 

Since the company is worth $4,500,000, each share is worth $45,000. This is when Peter Thiel comes into play. His $500,000 is enough to buy 11 shares ($495,000). 

Facebook creates the shares and sells them to Peter Thiel. Now, the company has 111 shares, and Peter owns 9,9% of those shares. 

Eduardo Saverin originally had 30 shares, which equated to 30%. He still has the 30 shares, but their value has dropped to around 27%. 

For the most part, the shares a founder or an employee gets don't change over time, but the percentage they represent gets smaller as more shares get created. The same applies to startup stock options, which is another valuable aspect. 

How do startup stock options work? 

The first misconception that we can debunk is that giving stock options means that employees get shares in the business. That's not true. 

Let's keep using the early Facebook example. Peter Thiel has just dished out the funds, and the company has a $5,000,000 valuation. 

When the first outside employees come in, the company wants to give them stock options. A stock option doesn't mean giving the employee stocks but rather the option to buy them at a pre-determined price called a "strike price."

A stock option is a legal guarantee that employees can buy a certain number of stocks at the strike price whenever they want. Let's say Facebook gave one employee the option of buying 30,000 shares at a strike price of $0.89 per share. 

30,000 shares equaled around 0.5% of the company in its earliest days. Still, we've said percentages weren't important because other investors came along, further changing that percentage. What mattered was that 30,000 shares were still 30,000. 

When Facebook went public, the price per share was $38. So, stock option owners could buy for $0.89 and then sell for $38. This imaginary employee netted $1.1 million after buying $27,000 worth of stock. 

Stock options are enticing and an advantageous compensation as long as the company increases in value. That's why companies love increasing their valuation, but it doesn't always turn out well. 

At one point, WeWork was worth $47 billion, and employees with stock options were optimistic. Then, everything changed. 

What are common shares?

At the beginning of the article, we spoke of common shares. A common share is an ordinary share, which usually entitles the owner to one vote (out of the total number of shares) and one share of the business's profits. 

In our Facebook example, Zuckerberg and Saverin had common shares. However, some investors prefer other conditions. Zuckerberg famously retained more control of Facebook through the years because he could negotiate investor shares with non-voting rights. 

If the share has an exception, rule, or exceptional condition, it becomes a preferred share. Depending on the specific condition, preferred shares might be better or worse than common shares. 

Many investors, for example, want protection in case the company goes bankrupt. The company is liquidated when bankruptcy occurs, and whatever money is left is distributed among shareholders. 

Liquidation preference would allow those shareholders to get some money before other shareholders. Usually, the last to invest lack better conditions. 

To make matters worse, a company might have many generations of preferred shares with different rules stacked on each other. These varied conditions can complicate things quickly. 

For a company to grow adequately, it should control how it distributes shares. As more investors come into play, the scenario can get very messy very quickly, leading to chaos in both good and bad situations. 

If you're an employee, while there's little you can do about how the company handles its investors, staying on your toes is always important. Researching how the company deals with shares is crucial. In the end, be it WeWork or Facebook, knowing where you are when the company goes public can be a lifesaver.

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Remember, getting the concept of shares and valuations right is crucial for any startup founder or investor. Misunderstanding these principles can lead to costly mistakes. For a deeper dive into how equity works in startups, including the intricacies of common and preferred shares, as well as the nuances of valuation, you can watch the full explanation in the video. Understanding Startup Shares and Valuations