Equity stakes owned by founders, investors, and employees are important to a business because they help determine the it’s value. For small business founders, deciding how much equity to share with investors and employees is often a difficult decision. There are some factors that can make this decision a little easier.
What is Equity, How is it Calculated, and How Does it Value a Business?
Stockholders’s equity is the section of the balance sheet that represents the capital received by investors for company stock shares. It represents the stake of all the company’s investors held on the books. It is calculated in the following way:
Total equity = total assets – total liabilitiesFor example, if a company has $10 million is assets and $1 million in liabilities, the total equity equals $9 million.
If a small business is just starting, founders often seek an initial investment to get the company going. Here, another formula can be used to determine value:
Business value = investment offered / equity percentage allocated
For example, assume an investor offers you $250,000 for 10% equity in your business. By doing so, the investor is implying a total business value of $2.5 million, or $250,000 divided by 10%.
Factors Affecting Equity Allocation
Investor allocation is very straightforward. Investors offer a sum of capital and expect a certain allocation in return. The investor and the founder can directly negotiate the capital and business valuation to arrive at a fair equity percentage for the investor using the formula mentioned previously. As for employees, there a few factors that come into account.
Who came up with the idea? A founder doesn’t necessarily have to be the person who came up with the idea. However, the “idea person” should get a premium allocation of equity shares.
Salary or no salary. If an employee is getting a fixed salary, the equity should probably be reduced. If the employee is not taking a salary, the equity should likely be increased.
Employee role. The importance of the role needs to be taken into account. An important role like a CFO should likely get a higher equity share than an entry-level analyst.
Contribution. What the person is contributing is a big factor in equity allocation. A person could contribute ideas, patents, capital, business expertise, labour, or a mixture of any of these. The more contribution, the more equity should be allocated to the person.
Irreplaceability. More equity should be given to those who are irreplaceable.
In all cases, equity should serve as a incentive to work harder since a larger business valuation in the future directly translates to a higher equity value and payoff for the employee.
Typical Equity Allocations
As a general example, small businesses on their first round of funding should having equity allocations that look similar to the following:
Founders: 50 to 70 percentInvestors: 20 to 30 percentEmployee option pool: 10 to 20 percent