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

Understanding Startup Shares: Beyond the Pie Analogy

Startup founders often visualize their equity as slices of a pie representing their percentage of ownership. However, this analogy fails to accurately depict how companies operate, especially when it comes to control, voting rights, and profit sharing. Instead, viewing a company as a stack of bricks can offer a much more precise understanding of its structure and valuation.

LLCs vs. C Corporations: Pies and Bricks

LLCs (Limited Liability Corporations) are typically partnerships divided into percentages, making it challenging to accommodate multiple rounds of investors. On the other hand, C Corporations are structured more like bricks, with the ability to create and distribute new shares to investors.

The Reality of Startup Shares and Investor Involvement

When founders bring investors on board, the company issues new shares rather than transferring existing ones. This dilutes the percentage each share represents but does not change the number of shares owned by the founders. For example, if Walt and Jesse each start with 10 shares in their venture and later issue new shares for an investor, their individual share count remains the same, but the percentage each share represents decreases.

The Confusing World of Startup Valuations

Valuations in the startup world are notoriously complex. They're not just about the current state of the business but also its potential future value. The valuation process involves determining an appropriate risk-reward ratio for investors, often leading to post-money and pre-money valuations that influence share worth and investment equity.

Facebook's Early Valuation Example

The case of Facebook is illustrative. When Mark Zuckerberg and Eduardo Savin first started the company, they agreed on a 70/30 split. Later, Peter Thiel invested $500,000 for what would become about 10% of the company. This valued Facebook at $5 million post-money and $4.5 million pre-money, establishing the worth of each share and the amount of new shares issued to Thiel.

Understanding Stock Options in Startups

Stock options are a common form of compensation for early-stage startup employees. Rather than giving actual shares, companies offer the option to purchase shares at a fixed price (strike price) in the future, providing a potential windfall if the company's value increases significantly.

Common vs. Preferred Shares

Common shares typically offer one vote per share and a proportionate share of the profits. In contrast, preferred shares may have different rights, such as non-voting status or liquidation preferences, which can complicate the equity structure of a company.

Key Takeaways for Startup Founders and Investors

• Think in bricks, not pies: Shares don't usually change hands; new shares are created instead.
• Valuations are complex: They represent a bet on the future potential of the company.
• Understand the difference between common and preferred shares: This impacts control and profit distribution.
• Stock options: A valuable tool for compensating key employees when cash is scarce.

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 below.

Understanding Startup Shares and Valuations