The 4 Equity Rules Every Startup Founder Should Live By
There are two types of startups — sailboats, and speedboats.
Before your business really takes off, it’s critical to determine which type you are. Speedboats are first movers. They know where they’re heading, and plan to be the first to get there. Speedboats require a lot of fuel and are often unsustainable (and unprofitable) in their quest to become leaders. But it’s worth it when they end up in first place.
Uber, Airbnb, and Facebook are all examples of this winner-take-most model. With all these businesses, each incremental user makes the service more valuable, in turn making it more difficult for users to switch to a competitor. The more people use them instead of a competitor, the more likely they’ll be used by the next customer.
Sailboat companies, on the other hand, are heading in a general direction, but are at the mercy of the winds. As such, they leave their options open. They may not come in first, but they learn from first movers and unsatisfied market needs.
Slack is a great example. Its founders were originally working as a company called Tiny Speck, helping to create a game called Glitch. The game’s founder realized that his team had created fun and engaging ways to encourage people to perform work tasks. He and his team quickly pivoted to Slack in 2013.
Today, Slack is valued at around $5 billion.
Most startups fall into the sailboat category. That’s because speedboats are riskier and less flexible. But both types need capital. And knowing whether you’re a sailboat or a speedboat is crucial to determining how to make your initial financial decisions. If you don’t, you won’t be able to make strategic business decisions and your fledgling company is much likelier to fail. But if you do, you’ve got a much better shot at outlasting the competition.
No matter whether you’re a sailboat or a speedboat, your equity decisions will prove critical.
Here are some rules to keep in mind:
1. Treat equity like gold.
Early-stage founders should be cautious about giving away equity — it’s literally ownership of your company. And if you give up too much, your company isn’t really yours anymore. On the other hand, if you don’t give away any, you’re probably not going to grow fast enough.
As an entrepreneur and investor, I frequently cross paths with founders who don’t want to give up equity. They shortchange themselves in terms of funding and expertise because they don’t want their equity diluted. We call this the founder’s dilemma.
Of course, it depends on the situation, but typically keeping all your equity to yourself is shortsighted.
Unless your goal is to stay very small and grow organically, you should aim to have the value of your startup increase by enough that your small piece is eventually worth more.
Speedboats and sailboats alike will have to decide how much equity to take and to give away, and for both — it’s a delicate balance.
2. The pie of ownership is fixed, but the value of the company is variable.
If you own 100% of something that’s worth nothing, you have nothing.
On the other hand, if you own just 5% of a truly amazing startup, that could translate to millions of dollars.
Let’s say you own 20 percent of a $2 million company. That means your stake is worth $400,000. If the business does well and you raise an additional $2.5 million of venture capital in a new round at a $7.5 million pre-money valuation (which is $10 million post-money), your stake is diluted by 25%. ($2.5 million divided by $10 million.)
By taking a lesser percentage, you’ve created a $1.1 million profit investment.
When it comes time to make this sort of decision, it’s important to know whether you’re a speedboat or a sailboat. While both company types experience dilution, they raise money in different ways and over different time frames. It helps to speak to a professional as early as possible because each round of funding implicates future rounds.
When it comes to equity, you’ve got to ensure there are enough pie slices to go around.
3. Know which employees are motivated by equity and which aren’t.
You might think every employee wants a piece of the pie, but the fact is that’s just not true. Everyone has a different risk tolerance motivated by his or her unique circumstances. For example, some employees would rather have a larger salary than a large portion of equity because they need liquid cash each week to pay rent or feed their kids.
Keep in mind that everyone has different needs and values. Some people are more concerned about security and lifestyle than about getting rich. But that doesn’t mean they won’t serve your company’s needs.
Be sure not to overlook a great employee just because he or she isn’t motivated by the same potential gain as you.
4. Take equity decisions seriously.
Often, people wait too long to divide up the pie.
Regardless of whether you’re a speedboat or a sailboat, you should make equity decisions before the company is worth a lot, and think about the decision as if it already is.
On the flipside, don’t just throw around percentages because you think they aren’t worth anything. If you wait too long, the difference of 2% percent can mean a few hundred grand. That’s a difficult conversation. You should have it early and take it seriously.
Funding and equity can be intimidating topics even for seasoned entrepreneurs. But when you don’t have experience, it’s key to jump in quickly to understand what’s at stake if those things are mismanaged. Equity is a delicate dance, so keep in mind that it requires awareness, balance, and foresight. For speedboats and sailboats alike.