You might have heard the term equity stake thrown around in business discussions or financial news.
And probably ask yourself the question: What is an equity stake? What does a 10% equity stake mean, or how much stake should I give to investors?
Equity stakes meaning
An equity stake is a pretty simple concept; an equity stake represents ownership in a company. When someone holds an equity stake in a company, they have control over its decisions and are entitled to profit but are also responsible for risk.
An individual, investor, company, or private equity fund can be an equity holder in a company. An equity stake typically refers to the percentage of the ownership interest, not the number of shares in the company.
The value of your equity stakes depends on the value of the company. Imagine the difference between owning a 1 percent of the equity stake in Apple versus a 1 percent of equity stake in the local grocery shop.
Share vs. equity stake?
Equity can be found across various business forms, such as proprietorships, partnerships, and corporations. On the other hand, shares are typically specific to companies.
In the context of companies, equity represents the overall ownership stake in the entity, whereas shares serve as a measure of an individual’sindividual’s ownership proportion within that particular business component.
In general, there are two types of shareholders. Minority shareholders own less than 50 percent of a corporation’s shares and lack majority control.
Contrarily, the majority shareholders hold more than 50 percent of the corporation’s shares, giving them majority control and decision-making power over the company.
A real-life example for equity stake
Imagine you and your friends starting a startup together. You all want to own a piece of the startup, right?
Well, that is where equity stake and share come into play. People might use them interchangeably, but they are different.
Consider the equity stake as your ownership slice in the startup. When you have equity, you are like a part-owner of the whole business. Your ownership volume depends on how much of the startup you own.
This is when the shares become relevant. Imagine the whole startup cut into 10,000 equal pieces, each representing a share. These shares are like little ownership certificates that show how much of the company everyone owns individually.
If you have 51,000 shares, you have a 51 percent equity stake in the company. As you own more than 50 percent of the equity, you have outright majority ownership over the startup.
One of your friends has 24,5 percent equity stakes, and the other has the same percentage, so they are minority shareholders.
How to calculate equity stake?
If you own 1,000 shares and there are 10,000 shares in a company, you have 10 percent of the equity stake in a company. It is as simple as that.
Does it mean you have 10 percent of the profit or voting rights?
Generally, yes, but not necessarily. There are different types of shares. You might have a common share A, and your co-founders have a common share B. Different classes can have various rights in terms of voting or dividend.
Furthermore, the third co-founder might have preferred stock or share. Preferred shares might have priority when receiving dividends or the right to return capital when the company is liquidated.
Comparing equity stakes and other forms of investment
First, owning equity is like owning a piece of a company, making you a part-owner of the business. On the other hand, other investment options usually involve debt, where you lend money that the borrower must repay with interest.
Now, here are some key differences to keep in mind:
Equity stakes are often considered riskier than other investment forms, such as loans. The reason behind this is relatively straightforward. The value of the equity is connected to the performance of the company. On the contrary, if you provide a loan to a business, you should expect to receive the principal amount and interest irrespectively of the company’s performance.
While the risk is higher in the case of equity stakes, the reward is also more substantial.
Profit entitlement is one of the most important factors when considering equity stake vs. other investment forms. If you decide to acquire an equity stake in a company, you become a part-owner and get a slice of the profit pie. How much you earn depends on the company’s future performance and the percentage of your equity stake.
However, it is essential to remember that the profits are not fixed, as they depend on the company’s performance. So, while you have the potential for significant gains, there is also a chance that the business might not do as well. On the flip side, most other investment options can offer a fixed profit level but with a lower return.
Once you have an equity stake in a company, you have a specific level of control over the company’s decisions. Although the level of control depends on the percentage of equity stake that you own, you can impact how the business runs.
Equity stakes in private companies may have lower liquidity than other investment options. Be aware that the equity stakes are generally not freely tradable in the market as it directly impacts the company’s holding.
Nevertheless, if you have publicly traded company shares, it is easily tradable through the stock exchange.
Taxes on capital gains
The capital gain you realize on equity stakes qualifies as taxable income. Nevertheless, the tax rate and implications might differ for equity stakes compared to other investment forms depending on the country. This aspect could also be vital when considering equity investments.
Now that we have a high-level picture of equity investments, let’s move on to the real deal.
Who gets equity stakes in a startup company?
The co-founder is the person who has the skill or specific resources that the founder needs to implement a business plan. It can be a technical skill, experience, and industry knowledge. A co-founder usually has an active and decisive role in the business, and the co-founder might be involved in a broad scope of duties.
A co-founder generally receives an equity stake depending on factors like skills, expertise, experience, and network the co-founder can bring into the business.
Let’s be honest; most of the startups have no money in the early phases. There might be cases when these startups give equity stakes to advisors as a form of payment. Long-term advisors working for the startups less than two days a month generally receive around 1% of the equity stake.
Private equity investors
Individuals and companies have multiple ways to invest in businesses, either by direct investments or through private equity firms. These firms have various types. The general approach for private equity investors, the more established the business, the lower the risk.
On the other hand, venture capital firms typically have an investment portfolio, including startup companies, which involves higher risk. Their investment strategy is simple: take higher risk for higher reward.
Equity stake is the currency of the startup world and part of the employment negotiation. Key employees at the executive level regularly receive between 1 and 2 percent equity compensation for taking the risk of working for a startup.
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How much equity stake should I give to investors?
This is a tricky question. It depends on numerous factors, including company value, funding stage, funding amount, and macroeconomic conditions.
The most important aspect is the valuation for most of the startup companies. A valuation provides the basis for determining the fair market value of your business. It is a strong reference point to how much equity you should give the venture capitalist.
When calculating valuation, you should consider factors like the company’s assets, financial performance, customer base, market conditions, and more.
Another critical factor is the funding round. While you might need to give up an equity stake between 5 and 10 percent during pre-seed funding, startup companies give more than 20 percent to investors during Series A and B.
|Funding Round||How much equity stake do investors ask?|
|Pre-Seed Funding||5 – 10 percent|
|Seed Funding||0 – 25 percent|
|Series A||20 – 35 percent|
|Series B||20 – 35 percent|
The investment size also influences the investor’s equity stake that they should receive. The average size of funding received for the equity stake also varies greatly in the US.
The average initial investment size during the pre-seed funding is approximately $500 thousand, while startup companies acquire $55 million during Series C.
How to negotiate equity stake?
First, you need to know how much your company is worth. This is the basis to determine how much equity you should give for the venture capital funding. Suppose you are in the early stages and have no revenue. In that case, there are some methodologies that you can use to value your startup company—for example, the scorecard, risk summation, or market approach methods.
Secondly, let the investors say the price first. As investors likely know the market better than you, it is easy to leave money on the table by setting prices too low for an equity stake.
Another crucial factor is that if you are in the early stages, you should try reaching milestones before equity investment. The higher the level of risk, the more significant the equity stake they ask for. Try to reduce milestones to reduce the investors’ risk and, therefore, the volume of equity stake they would ask for.
Lastly, you should pay extra attention to unfriendly terms like liquidation preference. There might be uncommon terms that can harm your equity and business.