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Introduction

We have often witnessed that most important decisions of the business are taken with proper discussion and therefore the chances of a bad decision are often on a rise. When we incorporate a company and divide equity shares, we never discuss its distribution because we never this as something important. But one should remember that equity distribution is more or less like dividing the hard cash.

Why is Equity important to the business?

Equity is the combination of all the efforts put together by the entity. All the efforts put together by you and your team will create some value and that value can be measured by your equity. So the relationship between equity and the efforts is directly proportional. The figure below will describe the relationship between equity and efforts:

*The above diagram represents the relationship between equity and efforts.

So it is proved that a good idea, a good execution, and commitment will always be valued and in business, its value can be seen in its equity shares. Since equity demonstrates the value, so it is the most valued thing in the business, hence, the decision of its distribution automatically becomes the most important decision of the founder.

Is it advisable to split?

It is not mandatory to split the shares. You can keep the entire pie. But as per research, companies with single founder are most likely to fail. If you fail, the value of most precious thing becomes nil. So it's better to have a piece of something than a company of nothing. Hence it is advisable to focus on the process of the split of equity rather than thinking of owning the company completely.

Concept of equity

Equity is nothing but a share. A share is the smallest part of the ownership of the company. Consider a company like a cake, as you can cut the cake into n number of pieces, likewise you can do the same with the equity. More the pieces more will be the number of shares resulting into less valued shares. Hence, the person who holds the maximum number of shares will be considered more powerful and the actual owner.

As per India's legal system, shares are major of two types:

1. Equity Share: It reflects the true ownership of the company. Equity shares are also considered as owner's share as it reflects the ownership of the company.

2. Preference shares: These are the shares which are preferred over the equity capital in terms of dividends and redemption (means paying back). In the events of the wind up, company needs to pay the preference shareholder first and then what is left over is shared with equity shareholders. But this share does not represent the ownership of the company.

In the startup community, preference share is not considered much important as everyone plays the game for ownership. Hence, they do not accept anything less than equity shares.

There are many further types of equity shares as well, but we will discuss that later on and now let us understand more about the equity cycle.

Equity Cycle

As the company grows and you raise funds or provide options to the employees, it has a direct impact on your equity and that is why it is always important to share the equity realistically.  Also, you will never have an UNDO button; equity once divided is gone, and you will own the company equivalent to your equity. A pictorial representation of equity cycle hereby describes the impact on equity.

*Diagram showing the equity cycle during the life of a startup.

*Now, we will understand the each stage in detail so that, we can understand the equity cycle pretty well.


 

Idea Stage

Co-founder Stage

Family round stage

ESOP stage

Angel Investment stage

Venture Capitalist stage

IPO stage

Founder 1

100%

50%

42.5%

37.5%

30%

21%

15.75%

Founder 2

-

50%

42.5%

37.%

30%

21%

15.75%

Family member

-

-

15%

15%

12%

8.4%

6.3%

ESOP

-

-

-

10%

8%

5.6%

4.2%

Angel Investor

-

-

-

-

20%

14%

10.5%

Venture Capitalist

-

-

-

-

-

30%

22.5%

IPO (Public)

-

-

-

-

-

-

25%

Total

100%

100%

100%

100%

100%

100%

100%


Looking at the table, we can see the journey of a founder from 100% to 15.75%. But this mark is not to worry about, as equity may have diluted, but the value has been increased manifold. As said, 20% of something is better than 100% of nothing. Let's discuss the different stages of equity.

#Stage 1: The idea stage: At this stage, there is an only single founder with 100% capital with only an idea and no execution at all. At this stage, he owns the 100% capital. This is the earliest stage of start up where a founder from a plethora of ideas selected one to be worked upon.

#Stage 2: The Co-founder stage: At this stage, the equity is divided for the first time. Further, the co-founder stage is the most important stage of any business because it is the team who creates a business and not an individual. Hence, selecting a right co-cofounder is the most important thing.  

#Stage 3: The family round: This is one of the stages where founders raise funds from their friends or family circle to start the workflow and to meet the expenses of the business. Generally, in this stage, equity ratio will depend upon the mutual agreement. Moreover, in this round, fewer equity shares are allotted against the amount raised. This is due to the psychological advantage we have over our friends and family members. Though you can negotiate the equity, we have just assumed that equity given in this stage is 15%.

#Stage 4: ESOP Stage: ESOP stands for Employee Stock Option Scheme (ESOP). In the stage, a pool of equity shares is set aside to issue them to the future employee to retain the existing employees or to hire new talent from the Industry. ESOP pool is very famous among the young technological firms. It is calculated as a percentage of total Options outstanding to total shares which is also called Options overhang.

For example, if you have total outstanding options of 2500 and the total outstanding share capital is 10000 shares, the option overhang will be 25%. The overhang is higher in new firms and lowers in mature or old firms.

Though there is no prescribed formula for calculating it, but yes you have to calculate this figure. Usually it is 10 to 20%, however, the younger firm overhang is 24%, which means the companies sometimes, even file an ESOP pool of 20 to 30%. Usually, it depends on case to case. We will discuss it about in full detail in chapter 8.

In our case, we have assumed the ESOP pool to be 10%.

#Stage 5: Angel Investment: When nobody is giving you to eat, it is the Angel that feeds.” The same goes with the angel investment. Early stage startups are the riskiest business and that is why access to capital is low as compared to mature business. Banks and financial institution do not offer any finance to these early startups. Where nobody is interested in financing these startups, there are angel investors who do it and they are actually like an angel for the early stage startups.

Angel investors generally invest around $75000 to $100,000 in the startups. We will understand the about the angel investors in details in the 7th chapter.

In our case, we have issued 20% of our capital to angel investors.

#Stage 6: Venture Capitalist: Venture capitalists are the investors who generally invest big into the startups. They sometimes invest in groups (like 2 to 3 investors). In our case, we have raised funds from VC against the equity of 30%.

#Stage 7: Initial Public Offer: IPO is the last and the largest way of raising the funds directly from the public. After this stage all the shares of the founders, investors become marketable and can be sold through any recognized stock exchange.

Equity Divide: What is the real motive?

Actually, there is no right answer for splitting the equity. The real motive is that when everything is done, every founder, co-founder or any person who is associated with the equity must feel good about the divide. As discussed above, equity sets the base for the business and the between the founders. So its divide must satisfy all. If you are not satisfied with the equity, discuss it with the other founders and resolve the issue as quickly as possible. Don't wait for the right time to come because it will never come and this issue will remain in your heart forever.

About the Author

CA Paras Mehra is a thinker, writer, reader and speaker. He is also professionally associated with hubco.in, a brand to register a private company and other related services. 

Connect to him:

Twitter Handle: @IamParasMehra
Linkedin: https://www.linkedin.com/in/caparasmehra/

The author can also be reached at paras.mehra18@gmail.com

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