The first day you create a company, three people put in $100 to each get 10,000 shares of the company at $0.01/share. The company has $300 in the bank account, and is worth $300, and each of you own 1/3rd of the equity. Everyone owns their shares outright, and there is no taxable event.
This represents the current ownership structure of the company. By no means is it a promise that the company will be forever owned by just those three people.
You start by doing all the work between the three of you, and then as the work grows, you turn to some contractors. One of the co-founders puts in $10,000 and takes a Note Payable from the company for the $10k (typically at 0% interest and with no actual terms but it will just sit as a liability) and now someone is managing a bunch of contractors on top of what they were already doing, and that person starts setting more and more of the direction by virtue of having more horsepower to get shit done.
Over the next few months, one of the 3 co-founders becomes less involved but because it's a remote team it's not like they stopped showing up to the office every day, it's just that emails are answered a bit slower, deliverables come through a bit later, etc. Then you see they've updated their LinkedIn and you call them to find out they are working somewhere else, but they promise they are still moonlighting with you.
By the end of the year you have either some revenue or some funding, and a couple of your contract employees are ready to come on full-time, and you need to make an option pool. Also, you met a VP in your exact industry who wants to jump ship and join your startup to take the place of the co-founder who is "moonlighting", and they need an offer from you in the next two weeks. An offer which will need to include a compelling potential ownership stake.
So, let's step back. First of all, it's very rare for a newly established company to get an option pool setup on day 1 - mostly because there's more important things to think about, but also because it's expensive to get all the legal docs written. Second, that option pool isn't going to contemplate a C-level hire who is essentially replacing one of your co-founders. Third, just because on Day 1 your $300 company was split evenly between 3 people, that doesn't mean each of those 3 people have an indelible claim to 1/3rd of the company in perpetuity.
In fact, if you're not able to authorize new shares to entice key future hires, your company will almost certainly fail, and all those shares will certainly be worth $0.
The way all of this is resolved, fairly, is to issue new shares. Our hypothetical company with 30,000 shares could issue 100,000 new shares, allocated 40,000 to an option pool, 20,000 each to the remaining co-founders, and 20,000 to offer to the VP coming in at the C-level. The new cap table would put the two remaining co-founders at 30,000 shares, the VP at 20,000 (vesting over 4 years), and an option pool of 40,000 "authorized but unissued" shares (which means they don't currently dilute ownership of the other shareholders, but you can safely assume they will ultimately be issued), and the drop-out co-Founder remains with their original 10,000 shares.
So in this example, assuming all the new shares are vesting over 4 years with a 1 year cliff, the drop-out Founder has 33% ownership which will fall to 11.1% over 4 years, and to 7.7% ownership once the option pool is fully issued and vested, i.e. over the next 6-8 years. This is probably overly generous to the Dropout IMO.
In order to issue these new shares, you have to take a Board Vote, and a Shareholder Vote. Your Articles of Incorporation will likely state that a simple majority is required in order to authorize or issue new shares. But since new grants are going un-evenly to existing shareholders, what you really want is Unanimous Shareholder Consent. This is important not just to protect against a future lawsuit, but also to help in future fundraising because a disgruntled early employee with a large initial stake who refuses to vote in favor of Corporate Motions is a big red flag.
From the drop-out co-founder's perspective, they paid $100 and a couple months of work to get a large early stake in a company worth basically nothing at the time. A group of people are now slaving away at that company to try to turn it into the Next Big Thing while Dropout has left to rake in the money at a FAANG and is contributing nothing to New Co. Their shares are completely illiquid and essentially worthless, but maybe they will be worth millions one day?
However, if 1/3rd of the company's equity is dead weight, a bunch of things happen; 1) you can't raise money, 2) you can't hire qualified employees, 3) the current shareholders are disincentivized to work on the company versus dropping it to start over with something new that they own more of.
So it's really in the Dropout's best interest to sign the Consent, keep their 10,000 shares, and if the company goes on to greatness without them, they got to essentially ride on the rocketship for free. But they might not see it that way initially. Hence Zuckerberg's email.
One thing which has always rubbed me the wrong way is that just because you are there on Day 1 that you are getting double-digit percentages of the company. Everyone who comes even just a few months later is getting Option Pool scraps. The way that illiquid startup shares are taxed makes it very hard (impossible) to do it any other way though.
This is a wonderful explanation. Thanks
Your explanation of the mechanics is excellent.
IMO, the current startup structures vastly overcompensate late employees who took no risk at the expense of early employees that take lots of risk.
That is why FAANG/established companies are getting the best employees and why startups are struggling to find talent
Thank you. It’s interesting that, even as a Founder of a few small startups that I feel differently.
Yes, I take a lot of risk by working without pay initially. But my early equity, even after dilution, means that once some funding has been raised and is being used to pay a bunch of employees, they are all essentially working for me and creating value for my shares.
Once there are hundreds of employees and millions of dollars at play (unfortunately not a scenario I’ve personally experienced), the early employees ride the rocketship and enjoy a 100x or maybe 1000x larger share of the profits than slightly later hires who are working just as hard every hour of the day.
I think a nice balance would be an option pool set at 6% with a full ratchet provision. The option pool could be established in such a way that any employee gets points toward the pull based on a formula* and no employee would need to exercise their options until their is a liquidity event that buys out the pool.
Formula could be something like: # of days from when startup was founded to liquidity event, that gives the equity per day.
Then divy up the equity per day by the number of employees that worked that day.
In a hypothetical example where the company had 3 people for the first year, those days would be worth a lot, but if it took 10 years to get to a huge exit, the people that put that first year in would get about:
6%/10 years/3 = 0.2% equity which at a very large exit would be something significant, but would also be somewhat fair because they did help get the thing launched, which is hard. There could also be provisions which eliminate or vastly reduce the value of equity earned for part-time employees or employees with other jobs. Say a .1 multiplier. Now you guy that goes to facebook after 3 months but moonlights for another 9 months gets:
(.06(90/360))/10/3 + (.06(270/360))/10/3).1) = 0.065%
The other 4% of the pool could be normal executive payouts that you need to make later, and other bonus allocations.