Thoughts on startups by investors that
fund them & entrepreneurs that run them

Should a startup set aside equity?

The first thing you should do is talk to a lawyer who is familiar with setting up startups, rather than trying to handle things yourself. This need not be expensive; at the very high end from a top tier firm, you’re probably talking no more than $5,000, for which you’d get absolutely everything a startup needs.

Typically, since only you and your co-founders are going to be owning the company at the beginning, you wouldn’t “set aside” shares for anyone else.  That would usually happen only when either (a) you start hiring employees who will receive options instead of shares, or (b) you take your first equity investment (such as a typical Series Seed or Series A Convertible Preferred stock) from outside investors.

At that point, the company would establish what is known as an option pool, consisting of a block of shares of Common stock that are reserved for use when employees or others eventually exercise their options. Since an “option” is precisely what it says—a piece of paper giving the holder the option of purchasing a share of stock—the company needs to ensure that it will always have those shares available.

In contrast, when investors come along, they are directly purchasing shares of stock from the company, and as part of the process around the transaction, the company will typically authorize and issue new shares (which will, of course, have the effect of diluting anyone who already has shares.)

Two things to note here:

  1. Although the option pool for employee grants will likely be established at the time of your first investment, and cover options that will be granted in the future, the full amount of the option pool (typically 10-20% of the company’s ownership) will be deducted before the investors make their calculation of the company’s valuation. While this doesn’t seem fair from an entrepreneur’s perspective, there are pretty valid reasons for it (and your entreaties to do it any other way will be about as effective as a dog howling at the moon.
  2. Although your option plan likely won’t kick in until after your first investment, I would highly, highly suggest that from the very beginning you establish founder reverse vesting with your partners.  This is something that gets an undeserved bad rap among entrepreneurs, but without it you are simply asking for trouble. (Think about it: three people co-found a startup with equal shares, you have a hit, raise a million bucks in angel or venture money, and then the next day one of your partners says “thanks, it was fun, but I’m outta here (and oh, by the way, I’m keeping my 1/3 ownership of the company which I’m sure you guys will make really valuable, thanks!)”)

 

*original post can be found on Quora @ http://www.quora.com/David-S-Rose/answers *

 

Written by David S. Rose

user David S. Rose Founder and CEO,
Gust

David has been described as "the Father of Angel Investing in New York" by Crain's New York Business, & a "world conquering entrepreneur" by BusinessWeek. He is a serial entrepreneur & Inc 500 CEO who chairs New York Angels, one of the most active angel investment groups. David is also CEO of Gust.

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