What is the Most Important Consideration When Giving or Selling Equity in Your Startup?

The most important consideration to make when giving out or selling startup equity is:

Will this person create value and grow the company?

What does this mean?

It means that equity should only be given to those who you foresee as creating value down the road. You need to give equity to those who will grow the company.

The problem is that a lot of founders think of giving/selling equity from a compensation perspective when the emphasis should actually be from an incentive perspective to create value down the road. The emphasis isn’t something nebulous either like “I want to incentivize this guy to do better for the company.” Don’t be vague. Be specific with it. The emphasis needs to be will this incentivize this person to create and grow the company. The small shift in mentality makes a huge difference. The emphasis is the key.

Startups are often using equity simply to solve an immediate issue. In the context of an equity priced round such as a Series A, when equity is sold to an investor in exchange for funds to be used by a startup, go one step further and make sure that investor relationship is a strategic one that can help grow the company (more on this below). Be forward thinking with your equity. Equity and the disbursement of equity is the most powerful tool that your company has. And if it’s not, then it should be. Why? Because it represent the company itself.

Selling equity strategically is all part of the proper growth mindset. This is one of the fundamentals of startup development. This whole site is structured in a way for you to easily understand the fundamentals of startups and startup law. You have to pay attention to fundamentals regarding your startup, and this is a huge fundamental that many founders either don’t realize or don’t take the message home hard enough.

Don’t be stingy with startup equity. Be smart with it.

One thing investors repeatedly tell me is that they are wary of founders who are not willing to share equity. Look. I get it. When it comes to a financing round, investors and founders are on opposite sides of the table (though I would argue that that’s a pessimistic and limited way of looking at it). Both sides want equity. The point is not to give out a ton of equity. Nor is it to be stingy with it. The important thing is to be smart with it and to be reasonable with it.

So realize that you have to share equity and you have to do it intelligently. You could do it alone and own your company alone, but not for very long and your competitors will out compete you. How do you do share equity intelligently? By focusing on sharing equity with those who will help the company grow.

If you adopt the mentality that future equity rounds and stock options are for the purposes of really growing the company two things will happen. First, you will suffer less dilution. The reason is because you’re less likely to be willy-nilly in your equity disbursement. You will become more thoughtful about the process. And second, when you do get diluted, it will be for a good reason. It will be to grow the company.

So here are the main points to have on your mind when you’re giving out equity in the hopes of future growth:

Pay attention to who you’re giving startup equity to

Ask yourself whether this person or this investment will really go to create value for the company. The fact of the matter is that unless you’re getting a great investment deal (and which funds you can use to add value and grow the company) then if the person/investor is not creating value/not making the company grow, then don’t use equity in the deal or simply don’t do the deal.

The shift needs to happen between “awarding or giving equity to this person for compensation” to something more along the lines of, “We are giving this equity because this person will create value in the future.” Make that shift happen and consider who you’re sharing equity with.

Find out what startup investors can do beyond money

I’ve said this before and I’ll say it again. There are lots of investors out there. Always ask, “What can this investor do beyond writing a check?”

Look—investors are not going to do everything for you. In fact, one of the most important things investors tell me that they look for when making an investment in a company is: “Does this founder know the market?” “Does this founder have the contacts?” “Does this founder team know the industry?” But even though the investor expects the founders to know the market well and to have a handle on it, know that there are things that an investor can do besides money.

A lot of individuals and groups can write a check. And if your startup is awesome, there will be a lot of options as far as who can write that check. Writing a check can be pretty powerful, but see if there’s something beyond money that the investor can bring to the table. Are there any distribution channels that the investor can open up? Any strategic partnerships? Product networks? Anything like that? Find out what they can do beyond money. These are the things that will help the company grow.

Understand startup math

This is the most important thing you can do to really understand just how value of the company works in relation to the ownership of the company.

When you understand how startup math works, then you get a better idea of how ownership is being dished out of the company. It gives you a more technical, fundamental understanding of all of this.

Read and understand this article https://www.startuplegalstuff.com/startup-math/

Give stock options appropriately

The fact of the matter is that there will be a number of individuals on your team that are helpful with your company. They’ve worked there. They’ve done things. They’ve smoothed things out.

That’s all well and good. You need people like that on your team. And they should be properly and well compensated for it. But should they be given stock options and equity?

Maybe. Maybe not.

If you don’t need to give options, don’t give it. If you feel like you can properly compensate and incentivize your employees with cash and you have cash, then just use cash. If you feel like that giving out stock options to this person can really make this person add value and grow the company in the future then go for it. The important thing is to be smart about stock options and stock option allocation.

Understand that dilution happens

A lot of founders are extremely paranoid about dilution and tell me they don’t want to be diluted. The problem is that they have this fear because they don’t understand dilution and how it works.

If, as a founder you are raising money, you will be diluted. There is no question about it.

The trick is to control how much you’re being diluted by being smart about how you’re raising the money, about the terms that you’re negotiating, and the type of anti-dilution protection that is on the table.

But one the most important items to consider with equity and dilution is the topic of this article. And that’s that when you DO give equity, yes you will be diluted, but make sure that the equity creates value moving forward. The person who is giving you equity should either directly or indirectly be able to help grow the company.

At the end of the day, you can either have a lot of pie that is worth nothing, or have a small amount of pie that is worth a huge amount. You want the latter.

Key takeaway: you will have to share company equity. Dilution WILL happen. Be smart about it. Make sure those that receive equity will create value for the company and will help grow it.

When Should a Startup Raise Money?

This question comes up a lot. When should a startup company raise money?

when it is strong

Here’s why:

1. Investors want to invest in a good startup business

Newsflash: investors want to invest in a good business, not a bad one.

For the purposes of this article, a good business is one with potential for considerable growth, and that potential for growth is reasonably achievable. That’s what investors are looking for. They want the price of the startup stock they purchased to ‘grow’.

This is the fundamental game for investors. When thinking about anyone dealing with your startup company, always remember what is it that someone fundamentally wants. What is their real goal?

The real goal of an investor is to have the price of their investment increase. How do they plan to achieve this? They plan to do this by investing in a company with potential for growth and with the knowledge that the potential is achievable with reasonable efforts.

Strong startups attract investors to invest in it so they get stronger. This is simply another case of the rich getting richer and the poor getting poorer. Poorly forming startups perform poorly in part because they are not able to attract investors.

Investors want to invest in a good business. The best course of action is to be multiple steps ahead. Every company is going to go through strong periods and weak periods, when you’re on the up that’s the time to shoot for that investment.

2. When the startup company is strong it’s the right time to raise money

The startup should raise money when it is strong because that is the right time to raise money. I realize that sounds circular but here’s the logic behind that.

The problem is one of being overly content.

A lot of founders don’t think about raising money when their company is strong. Why? Because founders, when their startup is doing well, believe that the startup is enough unto itself. These founders think: “what is the need?”

The problem is that when your startup is strong, you’re more likely to forget some of the fundamentals. These are the fundamentals we have discussed all along on this site--they include growing operations, raising money, growing, raising money, growing and so on. When your company is riding at the top, that is the time to remember the functions of a business.

And when a strong company keeps doing the fundamentals correctly, that’s when it can reach the higher realms of operations. Get that financing, and also have a plan of what to do with that cash injection.

As I said—it is difficult to realize that the best time to raise money is when you’re strong. This is because of founders being overly-content and arrogant. But when you’re strong, this is the right time. If you feel like your company is strong right now, then keep going and raise that money. When you’re feeling successful, these are the times to remember. This is the right time—don’t miss the opportunity.

The weaker companies don’t have the same problem of overlooking the necessity of startup funding. The weak companies realize they are not enough unto themselves so they have to ask for funding. When the founders start to tremble, and things are not good—that’s when founders think about raising money.

So if you’re feeling that the company is strong, this the time to remember growing—when everything is going well, this is the time to reach out and get more funding.

3. Your startup will get a better financing deal

This is good business and negotiations practice. When your company is strong, that is when you can really ask for investments and come from a place of non-neediness. You can be selective when it comes to which investors you want to deal with and how you want to structure the deal and the deal terms.

You will get better terms when the startup company is doing well. One of the items that many founders are concerned about is dilution, even though they don’t really understand it. See my article on dilution in order to learn more. You should raise money for your startup when it’s doing well so that it can get better terms on those types of terms. You won’t have to settle for some nonsensical liquidation preference.

Raising money when the startup isn’t doing well makes for more panicky deal making. You’ll get a better financing deal when things are going well than when things aren’t.

This is often a point that a lot of startup company founders don’t realize. The reach for raising money is often a panicky move that occurs when the company is in dire straits.

When the company is doing well, it can be more choosy about who it selects as investors. It can be more choosy with deal terms. It can be more choosy in nearly every facet. It can focus on bigger strategic points than simply getting some cash in. And of course, remember what I said before: always be thinking about what your investors can do beyond cash. You’ll be able to pick your investors when you raise at the right time.

What do you do if the startup is struggling and you need to raise money?

A very possible scenario is that your startup sucks. That’s okay. That just means your work is cut out for you. Here’s what you do:

1. Figure out exactly what would improve the startup

There is a massive difference between (a) needing money for survival; and (b) needing money to improve.

The difference is that the former is very limited in time. You never want to be in a case where you just need money to survive. Instead survival should always be a consequence of improving. In some situations, even if you give a struggling company $1,000,000 it will still fail. They’ll still tank because they don’t know what to do with that money. On the other hand, some struggling companies actually know what they will do with that money and how that money will help keep them afloat and thrive.

The only time startup investors want to invest in a dying business is when they believe they can help turn it around. Think about your startup. If it’s weak and even if you do get that cash, what will be accomplished? You need to have a robust plan for that money rather than to just keep operations going. Be able to show investors that the money will be used to improve certain aspects of the company.

A huge benefit of having a struggling company over a company that hasn’t gotten off its feet yet is that the struggling company has a lot of data points. Real data points that are very specific to your geography, industry, company, etc. are hard to come by. You can use those data points to help create the plan and figure out what exactly would help benefit the company. So even if your startup sucks, there’s still hope for improvement. Figure out what angle you can use to do so.

2. Understand startup financing deal terms

Fact: a weak company is poor at deal making.

This is because of two reasons: (i) the weak company is in a compromised position so isn’t able to command terms; and (ii) the individuals that are guiding that weak company may be inexperienced which is why the company is in that place to begin with.

Here’s how you nip those two reasons. You do your homework. That means you prepare an incredible amount. Pull out those spreadsheets. Understand your company better. Look at the numbers. Study them. Understand where exactly the company is weak and where things are going ok. Use that knowledge along with the information on this site.

Understand the deal terms better. The best way to do this is to read the relevant articles in the sidebar. Actually read and understand Phase 3 and the terms table.

Even if your company is not good, you may likely still get an investor to come on board. Don’t get fleeced. Understanding the terms and having done your homework will help you greatly.

3. Excel in one area

Not all companies can be strong in positive cashflow and have a huge growing user base and do well on other metrics. You may have to just focus on one or two aspects of the business and knock it out of the park on that one. If you’re able to show strong progress on one metric, an investor or someone who knows the industry well can help you with the other aspects.

If your company can’t be good in many ways, then just be good in one way. If you’re running a lemonade stand, and everything sucks—your location sucks, your price point sucks, your branding sucks, your service sucks, try to make the lemonade be the best damn tasting lemonade ever. If you can excel in one area, someone will help you.

What you’re actually doing by doing well on one metric is showing potential. The fact of the matter is that you can raise money if your company isn’t well if you show potential. If your startup is weak and there’s no potential then that’s a different problem.

So emphasize the potential and excel in at least one area. You’ll find what you’re looking for.

When should you do a financing round for your Houston or Dallas Startup?

The same as I’ve said before—you should raise money when your company is strong. However, I will make another comment that is particular to Texas startups. As I’ve said before, Texas has certain industries that it is stronger in than in others. That being the case, the important thing is to realize that if you’re not in the geographic area that your startup is strong in then you can still raise money, but it can take a longer amount of time to do so. Keep the course and keep an eye out for financing opportunities even if it’s not immediately necessary.

The best thing to do is to interface with investors and keep them in tune with what you’re doing. Investors have told me that they wish that entrepreneurs would keep them up to date with their progress. If you can show them the progress that you’re making, maybe one day they’ll jump on board.