Negotiating your equity stake is paramount to safeguarding your interests. When discussing a compensation package or invective stock options, it’s best if you come prepared to negotiate equity. This article will cover everything you need to know to negotiate equity, including a few recommendations to keep in mind before you sit at the table.
Defining equity compensation
The first thing to keep in mind is that equity is not cash. Instead, it typically takes the form of stock options or shares.
Counterintuitively, the founders of a startup or company do not automatically own any equity in it. They must purchase their shares (or founder stock options) from the company shortly after it’s incorporated. When this happens, the company will authorize some of the shares and issue them in return for labour or money.
It is in the founders’ interest to buy these stakes before any additional value is added to them because there will be little to no tax consequences when the price is low. Eventually, when a company is acquired, each equity owner will be compensated (usually in proportion to their interest) or the shares traded publically.
As a business grows, equity becomes more valuable. Founders then give up large percentages of their equity to match the risk their investors are taking. When VCs invest capital, they do so in exchange for equity. This process, which involves several steps of negotiating equity, forms a business relationship.
Negotiating equity
One thing is sure: The more firms interested in your early-stage startup, the more leverage you will have when negotiating an equity package. That’s why it’s always a good idea to leverage all your alternatives and ensure you agree only to the terms you find fair.
If you are a founder, you should always be weary of rushing into accepting an equity package solely because you need, for example, a cash injection. This is quite a common scenario but can severely restrict how much equity you will end up having.
Imagine, for example, that you discover you will run out of funds in three months. Fast-tracking a strategic partnership with a private company could help you pay your debts, but you might end up with a significant investment and a low valuation. The result of this negotiation could easily be that you end up with meager equity compensation as a founder.
Many startups have trouble forecasting their burn rate. If you are considering selling equity to solve a cash problem, it’s an excellent option to look into a bridge loan instead. Many founders have found, in time, that doing a larger-than-first-anticipated first round can pay off in the long run.
How to negotiate better equity compensation
When negotiating equity compensation (and whether you are doing it as a founder or as part of a job offer negotiation), a good rule of thumb is to focus not just on your options as a founder but understanding the interests of everyone involved.
What do we mean by this? You should always consider the financial risk, future success expectations, and other essential factors that make up the other party’s interests. Many negotiators want to maximise their leverage and focus too much on their options. If you understand a VC’s goals and long-term interests, you can find an approach that serves you both. Then, you will have some leverage even if there aren’t many alternatives for potential equity partners.
When negotiating equity compensation, it’s always best to understand what, among the things you bring to the table, has value to the other party. Of course, this is easier said than done. Negotiation is a complex craft. Good negotiators use specific tactics to achieve their goals, but a good deal usually tries to create a win-win scenario where new value is actually added.
Finding the value (and not just the valuation) of your business
Some negotiations are pretty straightforward. You don’t necessarily want to meet the buyer when buying a car or a house. Your priority tends to be the selling price. When you negotiate equity, however, what takes precedence is the relationship between the interested parties. If you only focus on the price, you might lose sight of the components that drive value (especially long-term deals).
When CVs and founders negotiate equity, they often focus too much on a company’s valuation. This is, after all, the number that will eventually be reported online and what your employees might toast to. However, there are other factors you should keep in mind, too – the main one being controlled. While getting a $5 million valuation sounds more attractive than a $4 million one, diminished control is something you won’t be able to change in the long run.
Most VCs won’t want to use their control rights to go against the wishes of management, but if a conflict occurs, you can find that, as a founder, you are constrained (or, worst case scenario, replaced). Valuations are essential, but identity, autonomy, and prestige go a long way.
Paying attention to the terms of the deal
In addition to the valuation, other provisions can impact the final amount of money you will get as a founder. One of them is liquidation; the other is participation.
The first means that, in the case of a liquidity event or point of sale, a VC firm can have the right to recoup its investment before the founder has a chance to take returns (liquidation preferences serve as a sort of insurance policy for VCs assuming risk). The second, participation, means that a VC might be entitled to share any remaining value once liquidation has been paid off (if a company performs spectacularly, participation can give GVs a huge windfall).
Both of these things are agreed upon when you negotiate equity. If you only focus on valuation, you might miss these other elements that, because they are designed to protect investments, can significantly impact wealth transfer.
Maximising trust and keeping your word
If your early-stage startup is facing trouble, it is always best, to be honest. Most VCs will appreciate being informed about the actual situation of your company. Being untrustworthy can derail negotiations, while fully disclosing any issues can help equity partners see you as a more reliable party.
It is okay to look for various offers so you can get the best equity compensation package – but not once you have reached an agreement. Remember that beneath the cash flow projections and term sheets, there is an agreement determining whether two parties want to associate for years to come. It’s just easier to build trust than rebuild it, so stick to your word and be open about the progress of your business.
Paying attention to the terms of the deal
In addition to the valuation, other provisions can impact the final amount of money you will get as a founder. One of them is liquidation; the other is participation.
The first means that, in the case of a liquidity event or point of sale, a VC firm can have the right to recoup its investment before the founder has a chance to take returns (liquidation preferences serve as a sort of insurance policy for VCs assuming risk). The second, participation, means that a VC might be entitled to share any remaining value once liquidation has been paid off (if a company performs spectacularly, participation can give GVs a huge windfall).
Both of these things are agreed upon when you negotiate equity. If you only focus on valuation, you might miss these other elements that, because they are designed to protect investments, can significantly impact wealth transfer.
Paying attention to the terms of the deal
A few more things you should consider when negotiating a better equity deal include:
- Diversify your options: Don’t just negotiate with one equity firm; explore alternatives and talk to other types of investors.
- Use an advisor: The process of selling equity tends to be quite complex; don’t hesitate to use a trustworthy growth funding company to embark on negotiations accompanied by experts.
- Conduct your own diligence: Make sure you vet your selected equity firm.
Negotiating equity: Summary
The mistakes you can make when negotiating equity are rarely apparent immediately. It usually takes months to see how the parties will face issues of control, power, and trust.
Both founders and VCs are looking to get a good deal that benefits the two. When deciding how much equity to share, the key is to truly understand what the other party wants, needs, and the value that motivates them.
Less experienced negotiators will try to outsmart those across the table. They will use clever tactics or focus on what they want to claim rather than the value that can be achieved in an equity negotiation process. Successful negotiators, on the other hand, will know that the key to mastering the practice is to develop rapport.
The same rules apply to any negotiation can incentivize stock options and equity compensations. Prepare ahead of time, create new value rather than distribute it, and establish openness and trust. To best negotiation outcomes if you genuinely interest the other party and their priorities.