Startup Equity Unicorn Myth

The power of startup equity is almost a myth in and of itself, with swirling stories of unicorns and overnight millionaires.

In truth, startup equity is often misunderstood, misinterpreted, and sometimes founders granting startup equity are misinformed.

The real problem with that…. Misinformation is costing you, a lot. You’re not just losing money, you’re losing upside, control, investors, retention, and time.

Which is why we rounded up the biggest myths holding back entrepreneurs who are using startup equity, whether that equity is for stock option grants, fundraising, or building their own upside. Knowing the truth behind startup equity will help founders maximize the potential of their startup’s equity and prepare them for all the changes their equity will go through.

Startup Equity Myth #1) All Stock Options are Created Equally

Even your options have options. Yes, we’re being intentionally “punny” but for good reason. The reality behind this myth is that you have several choices when granting stock-based compensation.

When granting stock options, you’ve got to consider what type of equity compensation is right for your company, as well as the recipient.

For example, are you looking to grant stock options to employees? Then you’re probably looking for incentive stock options or ISOs. You might also be looking to grant restricted stock units (RSUs) or restricted stock awards (RSAs).

Here are a couple of tables to help you understand the differences in equity compensation methods and determine which method is right for you.

Commonly Used Securities for Granting Startup Equity

The most common securities for granting startup equity are Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs). The main difference is that ISOs are used for employees and founders.

 

Differences in Incentive Stock Options and Non-qualified Stock Options

This table shows the most important differences between Incentive Stock Options and Non-qualified Stock Options. If you’re granting startup equity, you’ll need to understand which type of equity you are granting and who it’s for.

So, you see, stock options are not created equally. And, for that matter neither is how you grant shares…

Bonus Myth: Shares can be certificated or uncertificated, meaning the ownership of the shares can be documented using a paper or digital certificate or they can be book-entry shares. There is no law requiring private companies to issue certificated shares. In fact, we think uncertificated shares are a much better option for most companies. The good news is that Capshare supports both certificated and uncertificated shares. Learn more about certificated and uncertificated shares here.

There’s a lot of terminology thrown out there around stock options, and it’s easy to confuse terms when everything is abbreviated, like RSA and RSU. These resources will help you understand the intricacies of each equity type.

One more thing – it’s not just choosing which equity vehicle is right for your grants, it’s also deciding how much you should grant and what an appropriate vesting schedule would be.

FYI: Vesting refers to the period of time between receiving an equity grant and when you become eligible to exercise that equity grant and convert it to stock.

Vesting is particularly important when granting stock options because vesting is a key resource in retaining talent. A typical vesting schedule spreads a full equity grant over four years, with small portions of that grant becoming available for exercise a little at a time, like after one year of employment or a little each month. Vesting schedules can also be based on milestones or achievements for your job function.

Deciding a vesting schedule and grant size will influence which type of equity you want to grant. To determine how much equity you want to grant you’ll likely want to model out some option pool scenarios and dilution expectations. You can use Capshare to do that.

Why Does Understanding Stock Options Matter?

We mentioned that making equity decisions without accurate information can lead to very real consequences. When you grant stock options, you’re giving people the right to buy shares in your company. That means they become shareholders in your business and that’s equity you can’t get back.

It’s important to look at a comprehensive picture of your equity and the future of your company and then grant stock options accordingly.

Stock options are a great way to retain key employees, vest founders for the long haul, and show investors that you’ve already prepared your option pools. But granting stock options without a thoughtful plan can lead to an unbalanced equity distribution, which can turn off potential investors and cost you dollars in the future.

Startup Equity Myth #2) You Can Prevent Dilution

How can you prevent dilution? Well, you could stop growing your company…. That’s pretty much the only way to prevent dilution.

Dilution is a normal part of growing your business and not something to be feared so much as something to be prepared for.

Now, to be fair, you can prevent dilution to a certain extent… By understanding the factors that cause the most dilution, you can forecast equity dilution before it happens and make smarter choices when negotiating term sheets and investments. You can learn more about preventing dilution here.

A few actions you can take right now to prepare for dilution include:

  • Organize Your Equity
    Getting your equity under control is the first step you should take if you want to prevent unfair startup dilution. A lot of companies use spreadsheets in the early stages, but that will quickly become unmanageable. A dedicated equity management platform has the resources and tools to help you plan ahead and stay organized.
  • Learn The Lingo
    Knowing what a term sheet means is a preventative measure that can really help you negotiate better and help you avoid a bad situation. Capshare’s blog is a great resource if you want to learn the ropes of startup equity jargon.
  • Ask Your Attorney
    Your lawyer should be on the phone and fully briefed before you commit to any kind of funding. Lawyers will be invaluable when it’s time to negotiate a term sheet, and they’ll help you understand when to hold ‘em and when to fold ‘em.

Not preparing for equity dilution is a big risk. Making investment or stock option decisions without fully understanding how those choices will affect your dilution can lead to big loses down the line.

Where Did This Myth Come From?

The myth of preventing equity dilution stems from a desire to keep the largest ownership percentage in the company and thus benefit the most from your stock. However, what is often overlooked is that dilution is absolutely necessary if you want to grow your company and create opportunity for your startup equity to actually be worth a meaningful sum.

You can make smart choices and keep dilution in check, but you really shouldn’t be trying to “prevent” dilution from happening.

There’s one more part to this myth and it’s the underlying perception that investors are somehow out to get you. But investors aren’t all sharks, and the vast majority of the time their success is financially tied to your success. Plus, investment funds are driven by relationship building, so burning bridges isn’t in their best interest.

You can use Capshare as a startup equity calculator to instantly see how you’ll be diluted in any given scenario, from a funding round raise to issuing new option grants.

Startup Equity Waterfall Analysis with Capshare

A waterfall analysis shows the distribution of your equity during a given scenario. You can use this tool like a startup equity calculator to forecast different scenarios, including dilution and payouts, with Capshare.

Startup Equity Myth #3) You Can’t Afford a Lawyer

The truth is you can’t afford to go without a lawyer, at least not in this case. Equity has a lot of tiny details, confusing regulations and compliance obstacles that you may not be well-versed in enough to risk going without a lawyer’s help.

You’re probably asking yourself, “How can I afford a lawyer at this stage?” We feel you. Yes, lawyers are expensive and startups are usually keeping the purse strings tight, but there are some options…

A lot of lawyers will defer fees until a later date, like your Series A financing round. It also helps if you’ve handled the administrative mess so you’re not asking a lawyer to clean up your cap table.

Another option is to use a lawyer sparingly. The trick here is to consult with your attorney to make sure you’re not signing over your firstborn while managing the paperwork elsewhere.

For example, having a lawyer manage your cap table is expensive, and there are a lot of alternatives to that, some of which are free…. (cough) capshare (cough).

Capshare offers a freemium plan for early-stage companies so you can manage your startup’s equity the right way from the beginning.

The Key Takeaways for This Myth:

1) Get your lawyer involved at least to advise you on important decisions.

2) Don’t waste a lot of money paying lawyers to manage your cap table when you can use a dedicated platform for little to no cost.

Buying into this myth can really hurt you. For example, a lot of founders make the mistake of using mismatched templates they find online. The problem with that approach is that those templates weren’t made to go together.

The language and definitions in those various templates may not be transferable or consistent across your documents. So, if the day comes when someone challenges those templates you could spend a significant amount of time and cash to fix a mistake a lawyer could have solved for you early on.

Startup Equity Myth #4) A Strike Price is the Same Thing as the Value of Your Common Stock

This is a pretty common misunderstanding and one I made myself when I was researching how to pick a 409A provider. So, let’s define a few terms…

A strike price is determined by a 409A valuation and sets a threshold for the lowest amount you can legally grant stock options. 409A valuations are linked to IRS requirements and came about after tech companies back in the 90s and 00s were giving out stock options for WAY less than the stock was worth, thus skirting IRS tax standards.

Because of all that, corporations that grant stock options are required to receive a 409A valuation which determines a range for how much your common stock is worth.

Getting a strike price is sort of like playing limbo with a bad back – it’s as low as you can safely go. You can read more about 409A valuations here.

The value of your common stock is a little trickier to define. The value of anything is essentially what someone else is willing to pay for it… you can read more about how to value stock and companies here.

The reason strike prices are often confused for the value of common stock is because they give a definitive price for something that’s hard to price. Many companies use the strike price as the value of common stock, but that’s not required.

A company could decide to grant options at a higher value than the strike price outlined in your 409A valuation. So, while a strike price and the value of common stock can be the same thing, they are not required to be. The more you know, right…

Not sure if you need a 409A valuation? Double check here.

Startup Equity Myth #5) Cap Table Management is Just a Spreadsheet

Assuming cap table management is just a spreadsheet is sort of like saying running a marathon is just exercise. It’s partially true, but there’s a lot more to it than that.

And while many companies start their equity management using a spreadsheet, they quickly feel the pain associated with that and turn to an equity management platform to alleviate that pain. You can see some of the most costly cap table mistakes here.

The reason this myth comes back around time and time again is because so many people underestimate what their cap table is and should be.

A capitalization table is not just a record of who owns what percentage of a company. A capitalization table is a full reckoning of every stock and equity transaction from granting options to exercising shares, from vesting schedules to expired stock options. Your cap table is more than just a spreadsheet!

Bonus Myth: Some people are under the impression they need a transfer agent to move from one equity management platform to another. That’s a big myth! Check out why needing a transfer agent is bogus here.

Here are a few problems people tend to come up against when they use a spreadsheet to manage their cap table:

  • Version Control
    So you sent the cap table to the CEO and he made a change and didn’t send it back… well, now the cap table you have is incorrect. Now imagine this same situation happens with your lawyers, CFO, Controller, etc. How many versions of your cap table are out there and which one is the true and accurate depiction of your startup equity?
  • Manual Record Keeping
    When you’ve got two founders splitting the equity it’s easy to keep manual records, but when you start adding employees, investors, vesting schedules, terminations, etc. it gets complicated fast. Spreadsheets weren’t made to integrate all those fields and tie them back to one owner.
  • Error-prone Scenario Modeling
    If you’re storing all your equity data in a spreadsheet, at some point you’ll be asked to model out a “what if” scenario. Even if you are the master/wizard/guru of Excel, running an equity model with spreadsheets is hard and precludes that all your equity data is accurate, which may not be the case. And what’s worse, your company could end up making big decisions off the faulty scenario that spreadsheet spit out…

You can see how mismanaging a cap table can lead to wasting serious amounts of time and money. Properly managing your startup’s equity is the first step in solving the most common mistakes founders make and prevents losing upside, turning off investors, and failing to retain key team members.

Using a platform like Capshare to manage your cap table solves all those problems and provides additional support for entrepreneurs and CFOs, like advanced modeling tools to help accurately forecast equity and finance decisions and dedicated account managers to walk through specific situations and support you every step of the way.

If you want to learn more about how to manage your cap table, watch our free webinar, “How to Manage Your Cap Table Like a Boss!”

There’s one other myth we’d like to crack while we’ve got you here…. It’s the myth that Capshare is being “phased out.” It’s a myth with no merit.

Last year Capshare was acquired by Solium Capital, a publicly traded company dedicated to solving equity management for companies at every stage. Their product, Shareworks, is already the market leader for large, mature companies. They brought Capshare under their umbrella specifically to help small to medium size companies manage their equity needs.

Capshare is far from being phased out. It’s actually the opposite, as we’re expanding our offices, our support, and our product team. Not to mention, we’ve released a full re-design of Capshare’s user interface and are embarking on new features every day.

Want to bust more startup equity myths? Our team of experts is up for the task. Schedule a walk-through of your startup equity needs with a solutions specialist today.