When it comes to the division of equity in startup, there is a similar process every entrepreneur must follow beginning with raising the first round of startup funding and, if you’re lucky, finishing at the point of IPO. Today we are going to describe and analyze the stages up through friends and family funding. At this point, you should have a good idea of how you want to divide up your company and will be prepared for more sophisticated, future investors.
Stage 1: Idea
It’s just you and your idea. You created value in your company the moment you started working on your idea. This value will later turn into equity, but since you are the sole person and 100% owner in your company, you are more focused on the success of your idea and equity is simply not on your mind.
Stage 2: Co-Founder
As you continue to work on your idea, you realize you could use another body and brain to help with converting this idea into a physical prototype. You bring someone in and quickly see the added value of this person. You do not have the funds to pay this person, so you decided to add them on as a co-founder. In exchange for their work, you offer equity in your company.
How much equity do you offer? It can be difficult to give away a piece of your “baby”, and this early in the startup stage it is almost impossible to determine the valuation to your company. In reality, your company is probably worth close to nothing and your new co-founder is taking a huge risk. Each case is significantly different and there is no right answer. To ensure that the co-founder works out and sticks around for the 3-5 years that it takes consider vesting there shares over 3-5 years.
Stage 3: Friends and Family Funding
You need funding. The thought alone of another Ramen noodle meal makes you sick to your stomach, but you know you do not have enough of a working product, or time, to go to a VC or get a loan from the bank. You decide the next best thing is going to your family and friends for funding. You have looked at the advantages and disadvantages, and have decided it is the best option for your startup.
What is next?
Often, your friends and family are not going to willingly throw money your way. They want to know how much value you can give them in exchange for their investment. You need to come prepared with a kitchen table pitch and prove that your idea is the next best thing.
Your rich relative is on board and has agreed to give $10,000 in exchange for equity in the company. How much equity do you give her? It depends. Before you can give any amount of equity out, you must register your company. You then need to figure out what your long term financial goals are in regards to the amount of investors you need, want, or plan on having. You also need to think about how much equity you want to have set aside and available for your future employees in your option pool. Future investors will want and option pool, and more importantly it is ways of attracting talented employees to your startup. Employees will know the earlier they join your startup, the greater percentage of the option pool they will receive and will want to work hard to help your company on its possible journey to go public. Another thing you must keep in mind how these shares are going to diminish over time. The more investors you bring on and the more funding you receive, the more your company will grow; however, this also means less equity for you, your co-founder, and your future employees will receive. One way to do this is to agree on a value and give them the percentage based on what they invest. Another way to do this is set it up as a loan or a convertible note which avoids the need to agree on valuation until the next round of funding.
Want To Learn More?
Download our free Raising Capital From Friends, Family & Founders eBook.
This book overviews best practices for raising money from the first people you go to — your family, friends & founders. Dealing with money in personal relationships can get a bit tricky. This guide will cover fundamental concepts, legal issues and material you’ll need. It will help prepare you for the difficult conversations and in some cases enable you to avoid them altogether.