How to Allocate Shares in a Startup: Equity Breakdown & Best Practices

Key Takeaways:

• Startups typically authorize 10,000,000 shares to facilitate easy distribution.
• Equity allocation should consider roles, expertise, risk, and contributions.
• A vesting schedule helps prevent premature departures from the startup.
• Standard equity distribution: Founders (50-70%), Investors (20-30%), Option Pool (10-20%).
• Different types of shares exist, including common stock, preferred stock, and restricted stock units (RSUs).
• Consider tax implications and Section 83(b) elections for equity ownership.
• Convertible notes and SAFEs are common investment structures in early-stage startups.
• Option pools should account for employees, advisors, and board members.
• Exit strategies, such as acquisitions or IPOs, affect equity distribution.

Wondering how to allocate shares in a startup? When your company initially incorporates, you'll authorize a specific number of shares. In general, startups typically authorize 10,000,000 shares of common stock. This amount is easily divisible and will enable you to distribute round numbers of shares. It's also common practice.

How you determine the allocation of equity will depend on many different factors. During your company's early stages, you won't have enough information to predict founders' contributions and added value. You won't have any objective data that might assist you in accurately predicting your company's potential. Thus, your equity agreement will be an estimation based on your company's best guess.

It's best to come to an agreement regarding founders' equity, and the respective amount of shares issued, as soon as possible after your company incorporates. Although this is an important decision, by necessity it must be made without much information.

Determining Founder Equity

Deciding how to distribute equity among co-founders depends on the unique circumstances of your startup. There is no one answer or specific formula that can produce the best answer for your situation.

To understand each founder's value, first determine the roles that each founder will play throughout your company's long-term development. Make sure to discern each founder's expertise and experience when it comes to determining their respective roles. For example, which founder is best suited to be a successful CEO? Roles may change as the company evolves, but it's helpful to begin with some role distinctions in mind.

Consider the level of risk that each founder is taking. Those taking higher risks should receive more equity.

Most importantly, don't avoid having these difficult conversations and simply decide that an equal amount of equity should go to each founder. If roles, responsibilities, and expectations are not defined early on, future conflict is more likely to arise. In addition, potential investors will question your motives if they are not rational and logical.

When calculating a founder's value, you can divide it into five categories: idea, commitment and risk, business plan development, domain expertise, and responsibilities. You can assign a value between 0 and 10, and then multiply by the founder's score in order to determine a weighted score.

Types of Startup Equity

Understanding the different types of startup equity is crucial for fair and strategic allocation. The three primary forms include:

• Common Stock: Typically issued to founders, employees, and early investors. It provides voting rights but is subordinate to preferred stock during liquidation.
• Preferred Stock: Issued mainly to investors, offering advantages like dividend preferences and priority in case of company liquidation.
• Restricted Stock Units (RSUs): Often granted to employees, these are subject to vesting schedules and do not require immediate purchase.

Additionally, founders and early employees should consider making a Section 83(b) election, which allows them to pay taxes on stock ownership upfront, potentially reducing long-term tax liabilities.

Vesting Schedules

Vesting schedules determine when an individual may exercise his or her stock options. Schedules are time-based, and will vary according to your startup. The most common vesting provisions usually include:

• A four-year vesting schedule.
• A one-year cliff.
• Single-trigger acceleration.

Most startups utilize vesting schedules, which are intended to discourage people from leaving the startup and reduce the risk of diluting equity. According to a four-year vesting schedule, each stockholder's equity will vest equally in 48 phases: once a month for four years. If the person leaves the startup before the first year has been completed, they relinquish all equity they have vested. On the other hand, if the startup leaves before all shares have vested, they all immediately vest by default.

In Silicon Valley, tech startup companies began routinely offering stock options to their employees, which soon became a trend. In California, state legislation cannot prohibit employees from leaving or being approached by competitors. Companies can only offer better incentives and more of a stake in developing an impactful business. As a result, employers are often granting "Evergreen" stock options, which are additional stock grants that typically activate after two and a half years. This avoids the situation in which employees no longer vest any equity after four years (or the company's vesting schedule).

Tax Considerations in Equity Allocation

Equity allocation has significant tax implications, which founders and employees should address early. Key considerations include:

• Section 83(b) Election: Filing within 30 days of receiving equity allows employees and founders to pay taxes on shares when granted, potentially reducing long-term tax burdens.
• Capital Gains Tax: Equity held for more than a year is taxed at lower long-term capital gains rates.
• AMT (Alternative Minimum Tax): Exercising incentive stock options (ISOs) could trigger AMT obligations, requiring careful planning.

Consulting a tax professional or startup-focused attorney can help navigate these complexities.

Dividing Equity

Dividing equity within a startup company can be broken down into five simple steps:

1. Divide equity within the organization.
2. Divide equity among company founders.
3. Allocate money to investors.
4. Divide the option pool into three groups: board of directors, advisors, and employees.
5. Create a vesting schedule.

The first step, dividing within the organization, is the most important. The total amount (100 percent) must be divided into three main groups: founders, investors, and option pool.

The standard distribution of equity to each of these groups is listed below. Keep in mind that these are guidelines and excellent starting points for discussion.

• Founders: 50 to 70 percent.
• Investors: 20 to 30 percent.
• Option pool: 10 to 20 percent.
• Total: 100 percent.

Convertible Notes and SAFEs

Startups often raise capital through convertible notes or Simple Agreements for Future Equity (SAFEs). These investment vehicles allow companies to secure funding without immediate valuation concerns.

• Convertible Notes: A short-term debt that converts into equity during a future funding round, often at a discount.
• SAFEs: A flexible instrument that provides investors with equity when a future priced funding round occurs, often used in early-stage fundraising.

Planning for an Exit Strategy

Equity allocation isn't just about the present—it also impacts future liquidity events such as acquisitions, IPOs, or mergers. Startups should plan for:

• Acquisition Scenarios: Ensure that vesting schedules align with potential acquisitions to prevent key personnel from leaving too early.
• Initial Public Offering (IPO): Equity distribution should anticipate future shareholder requirements and regulatory obligations.
• Equity Buybacks: In some cases, companies repurchase shares from employees or founders, impacting overall ownership distribution.

Frequently Asked Questions 

1. How do I determine the right equity split between co-founders?
   The equity split should reflect contributions in areas like expertise, time commitment, financial investment, and risk taken. A structured approach can prevent future disputes.
2. Why do startups issue 10 million shares initially?
   This large number allows for easy division and allocation of stock among founders, employees, and investors without creating fractional shares.
3. What is a good vesting schedule for startup founders?
   A four-year vesting schedule with a one-year cliff is standard, ensuring that founders remain committed before earning full equity.
4. Should early employees receive equity?
   Yes, providing equity incentivizes employees to stay long-term and align their goals with the company's success.
5. What happens to unvested shares if a founder leaves?
   Unvested shares typically return to the company, preventing early departures from holding disproportionate ownership.

A well-structured equity plan helps protect founders, employees, and investors as the company grows and potentially exits.

Both instruments impact equity allocation, as they determine how much ownership existing stakeholders retain after conversion.

If you need help understanding how to allocate shares in a startup, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.