Startup Equity: Cutting The Pie

You and your co-founder(s) have a killer startup idea and a plan for executing it. Now you’re ready to incorporate, but a big question looms: how do you allocate equity?

This question comes up initially in the context of considering how equity should be divided up among the founders, which is very important. But the question—and the implications of how it’s answered—is actually further reaching than this. The reason for this is that your company will likely choose not to issue a percentage of shares to anyone at the start. How you handle this will have an impact on equity ownership moving forward.

But before getting into the details, let’s talk about the basics.

As part of incorporating your startup, whether in Delaware, Washington, or another state, you will authorize a certain number of shares. Authorized shares means the number of shares the company can issue. You can think of authorized shares as the size of the pie. So, if you authorize 10 million shares of common stock (a common approach for startups), that means the company can issue up to 10 million shares of common stock. This number is a ceiling, not a floor. The fact that you’ve authorized 10 million shares of common stock does not mean the company has to issue that many shares.

Once you’ve incorporated, the company will issue certain shares to the founders. This is when you have to figure out how the pie should be divided among the founders. As a reminder, the size of the pie is 10 million shares of common stock. So let’s say your startup has 2 founders and you want to have a 50-50 equity split between the two of you. You decide to issue 4 million shares to each of you.

Related: 83(b) Election For Startup Founders

At this point, 80% of the pie has been divided between the two founders. But what happens to the other 20% of the pie?

The short answer, at least for most startups, is nothing, at least not for now. Startups will commonly set aside at least 10% of the initially authorized shares toward the “option pool.” This is where equity, usually in the form of stock options, will be issued to attract employees, contractors, advisors, and other service providers. If you like the pie analogy, you could think of the 20% slice being put in the refrigerator.

Related: What Type of equity To Give Startup Employees

Related: A Short Guide To Issuing Stock Options

If they don’t allocate all remaining authorized but unissued shares to the option pool, Startups may keep these shares back on an informal basis for other purposes. These could include offering to an additional co-founder, or perhaps a startup accelerator.

Tip: Founders may wonder whether authorized but unissued shares affect ownership, and the answer is no, assuming that ownership is being calculated based on issued shares. So, if the startup issues 80% of the authorized equity to the founders, the founders together own 100% of the startup. If ownership is being calculated on a “fully diluted basis” though, then shares reserved, say, for the option pool, will affect ownership.

Related: Startup Valuation and Fully-Diluted Capitalization

The details will differ startup to startup, but the basic structure usually remains the same, with most of the initially authorized shares being issued to the founders and the rest being allocated to the option pool and possibly reserved for an additional co-founder or accelerator.

At this point, you might wonder how the startup will issue equity to investors with most of the pie off the table altogether. The answer is that you can make the pie bigger. The startup will do this by amending its charter document to authorize additional shares.

As the pie grows bigger and other slices are given to investors, the founders’ percentage ownership will be diluted. But even a small slice of a very big pie is more than enough to justify the efforts required by startup founders to grow a successful venture and (hopefully) achieve liquidity.