Equity in a startup: Mistakes to avoid

Equity management is one of the most vital considerations for startups. It holds the potential to either make or break startups, so effective management is imperative.

In this article, we’ll help you avoid some of the biggest mistakes startups tend to make when managing their equity by

• establishing the importance of equity management,
• shedding light on common equity management pitfalls startups fall into, and
• providing a free downloadable checklist.

Why equity management matters for startups

To understand why equity management is so important, you need to realize what you will miss out on with ineffective equity management. 

Equity financing is a powerful tool

Leveraging equity financing is a must for startups that want to raise capital from investors. By giving up a portion of equity, you can sell a percentage of your startup in exchange for funding, all without incurring debt or needing to pay interest as you would with loans. 

That said, equity financing is a tool that requires good equity management to execute. Without it, you could easily and unknowingly hurt your startup both in the short and long term.

Attracts and retains talent

Financial resources are always going to be stretched thin, regardless of how big your startup is. Accordingly, it’s important to consider equity compensation packages as a competitive form of compensation as they can level the playing field with competitors when hiring and retaining talent. 

This can also create a sense of loyalty and foster internal alignment within your startup. But like equity financing, this requires good equity management skills to ensure that your equity compensation packages are effective.

Boosts a startup’s reputation

A startup's reputation is its lifeblood. Effective equity management can enhance your startup’s credibility. For instance, a well-designed, transparent equity compensation plan can increase employee morale, boost productivity, and improve your work culture. 

This can lead to positive word-of-mouth promotion by employees and other shareholders, making your startup more appealing to potential hires and investors, and resulting in more opportunities for your startup.

6 common equity management pitfalls

Getting equity management wrong is dangerous because a tiny error now can snowball into an avalanche in the future. Here are some of the most common pitfalls startups of all sizes fall into:

#1 Having too many founders

Ever hear the saying too many chefs spoil the broth? The same holds true for startups, though spoilage would come from the excessive dilution of the metaphorical broth. 

While having more co-founders is merrier in terms of having a diverse range of perspectives and personalities, having too many opinions can lead to potential conflicts which can derail the startup’s direction and equity management. 

#2 Distributing equity recklessly amongst early founders 

Giving away equity like candy is a common recurrence for early-stage startups—though this applies to mature startups as well. When starting out, it’s easy to give out equity to co-founders without considering the long-term implications as it may seem like a low-cost solution. 

Not giving adequate thought to founder equity split is dangerous, as early equity is one of the most important assets your startup possesses, and giving it away too freely can rapidly decrease its future value. 

Remember, not everyone needs to be a founder as they may not have the required skillsets, experience, and business acumen necessary, and may be better suited as an employee.

#3 Issuing investors non-diluting shares without careful consideration 

Securing capital during fundraising can feel incredibly challenging. So, it might be tempting to do whatever is necessary to get potential investors on board, even if it means giving away large quantities of non-diluting shares (e.g., preferred shares).

While it might be appealing to give non-dilutive shares to investors, not understanding the full implications of doing so can spell disaster. 

Founders must be wary of how non-dilutive shares can 

• negatively impact the ownership percentages of existing founders, 
• lower the equity value held by shareholders such as employees, and 
• lower the equity amount available for future use (e.g., for fundraising), ultimately hindering the startup's growth.

#4 Giving too much to investors

Investors are meant to support your startup, not the other way around. Many startups forget this in their pursuit to secure as much capital as possible. There is absolutely such a thing as raising too much.

Giving away too much to investors can be detrimental to your startup's equity management. Not only would this affect existing ownership structures, but it would also lead to potential disputes on the startup's direction with so many investors on board, each with their own needs and wants. 

Furthermore, having too much capital may create confusion about how to optimally deploy it, resulting in inappropriate spending and the need to satisfy even higher expectations set by investors.

#5 Not consulting professional advice 

Startups often lack the necessary skills and expertise to avoid equity management-related pitfalls, which can lead to dire consequences such as regulatory violations. Managing equity is difficult, and seeking external advice from experts is crucial to mitigate these risks.

Accountants, certified financial advisors, and lawyers can all provide valuable guidance on equity-related activities, including tax implications of equity compensation, negotiating with investors, and developing well-designed equity plans. These are all potential areas of oversight that can be easily addressed with professional help.

#6 Neglecting to get an annual cap table health check-up

Cap tables provide readers with a clear record of a startup’s ownership structure and are used to inform equity-related decision-making, among other things. As startups go through funding rounds and expand in size, tracking equity becomes increasingly important yet more challenging.

For this reason, obtaining frequent cap table health check-ups is crucial to eliminate the risk of errors and discrepancies. Failing to do so can lead to poor equity management and regulatory scrutiny. 

Getting a check-up isn’t difficult though, provided you use a reputable equity management platform, which on top of its cap table-related features, also offers comprehensive annual cap table checkups to ensure both founders and equity managers avoid any equity-related problems.