The decision to allocate equity to stakeholders is one of the most critical choices a startup founder can make.
Equity distribution not only determines ownership and control but also sets the tone for relationships within the company. If handled poorly, it can lead to disputes that fracture partnerships, derail growth, and even lead to the death of the company.
With over 13 years of experience in corporate law, Mary Ekemezie has guided large corporations, startups, and SMEs through mergers, acquisitions, and corporate compliance. Now, as the founder of ME Academy, she leads the team in filling the knowledge gap between the study of law and its practice.
Considering its potential impact on a startup’s performance, Ekemezie advises that founders approach equity allocation with a long-term view.
Splitting equity among founders
Many founders start businesses with friends, family, or former colleagues. At the outset, they’re often excited about the product and may dismiss conversations around ownership, but Ekemezie explains that this is when decisions about equity need to be made.
“Before you even get into splitting equity, just keep in mind that this is a business. And while it is great that we're friends, it is a business, and the rules of engagement are different.”
Equity represents more than just ownership; it reflects the value of each founder’s contribution and dictates the power dynamics within the company. Founders who fail to clearly define and document equity splits from the start may find themselves entangled in disputes.
The main consideration when allocating equity among founders is each person’s contribution, Ekemezie says. It’s impossible to have all founders contribute the same efforts to the building of a company. While some may be able to go full-time, others may work part-time at least in the initial stages.
Ekemezie notes that factors such as financial investment, time commitment, skills, and even networks should be taken into account, and allocated equity should reflect the value of the contribution.
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While startups always need money, she insists that a founder who only provides capital should not hold the same equity as one who puts in skills and time.
Founders often assume that verbal agreements are good enough, but conflicts arising from ownership will frequently involve legal processes. It is crucial to document every aspect of the equity distribution in formal agreements.
These documents should outline each founder’s role, the conditions under which equity can change (e.g., if a founder leaves), and any vesting schedules that might apply.
Equity allocations must also be allocated with an eye on the future. Raising money from investors and allocating equity to employees or new co-founders are just some common scenarios that founders should consider.
What to consider when allocating equity to investors
When startups receive external funding, they often give up equity and control. Consequently, any funding conversation must be entered into with an understanding of potential consequences.
A startup’s valuation is often a sticking point in these conversations as it determines how much equity a startup gives up. Ekemezie advises that founders should consider how much they need to raise and how much dilution they’re willing to part with in exchange for the funding they need.
Venture-backed startups often have to raise multiple funding rounds. Founders must plan ahead, ensuring that even after several rounds, they still retain enough equity to stay motivated and committed to the company.
Allocating equity to co-founders that join later
Startups often need to bring in new talent who may join as co-founders. How equity is allocated to them is equally crucial. Ekemezie notes that the same principle that guides allocating equity to early co-founders also applies.
New co-founders must be evaluated according to their potential contribution. When a startup is already up and running, new co-founders must bring significant value to the table to justify their equity stake.
It’s important that equity allocation conversations are as objective as possible. Ekemezie advises the use of a weighting system allocating importance to specific factors agreed on by the team.
By scoring the new co-founder against specific criteria, founders can arrive at a more objective decision about how much equity to offer.
Additionally, the timing of the co-founder’s entry into the company should be considered. A co-founder who joins late should not necessarily receive the same equity as those who were there from the start, as the risks and contributions differ significantly.
Employee stock options
Attracting and retaining top talent is one of the major goals for startups. One tool for achieving this is the use of employee stock options (ESOs), which align employees’ interests with the long-term success of the company.
While not yet widespread in Nigeria, employee stock options are gaining traction, particularly among startups.
The first step in implementing an ESO plan is to determine how much equity to reserve for employees. Generally, startups can set aside between 5% and 10% of their total equity for this purpose. This pool of shares needs to be carefully managed to ensure that it serves as an effective incentive without overly diluting the equity of the founders and other key stakeholders.
Clear eligibility criteria must be defined when allocating ESOs. This could involve prioritising early employees who took on significant risk by joining the company when it was just an idea and key employees who are critical to the company’s ongoing success.
Vesting schedules are another important consideration. A vesting schedule determines when employees actually gain ownership of their stock options.
Commonly, companies implement a four-year vesting schedule with a one-year cliff. This means that employees must stay with the company for at least one year before any of their stock options vest, and after that, the options vest incrementally each month or quarter.
This structure encourages long-term commitment and aligns the interests of employees with the success of the company.
It’s also essential to consider the balance between rewarding early and later employees. While early employees may receive a larger share of the equity pool due to the higher risks they took, later employees, who bring valuable experience and skills as the company scales, also need to be incentivised.
As the company grows and raises additional rounds of funding, the equity held by employees will often be diluted. And startups must communicate clearly with employees about how the process works.
Should you allocate equity to advisors?
Advisors and board members play crucial roles in a startup’s development, providing valuable insights, guidance, and connections.
However, determining how much equity to allocate to these stakeholders can be tricky, as they are neither full-time employees nor investors. Their contributions, while significant, are typically more intermittent and specialised.
The first step in allocating equity to advisors is to assign a value to their contribution. This can involve assessing the time they will dedicate to the company, the expertise they bring, and the tangible impact they are expected to have on the business.
Ekemezie advises that founders cap the total amount of equity allocated to advisors. Typically, this will range from 1% to 5% depending on the startup’s stage.
In addition to capping the equity, it’s important to establish clear terms around how the equity will be earned. A vesting schedule similar to what is used for employees can be employed here. Dilution provisions should also be included in the equity agreements, while the performance of advisors can be reviewed periodically.
Always have legal guidance
When negotiating equity with stakeholders, having the right legal guidance makes all the difference. In Nigeria, vesting schedules are not recognised by law, and the only way a startup can be protected is by using a clawback mechanism.
A competent legal professional can draw up a clawback mechanism that ensures the startup’s interests are protected, and Ekemezie advises that founders always consult legal professionals before committing to contracts.
