Equity and Returns in Early Stage Startups: Structuring Investments and Partnership Agreements
When investing in a startup, the key question usually revolves around how much equity or returns you should ask for, especially if the other party is handling the technical operations while you bring in the necessary capital. This article will explore the nuances of structuring such investments and partnership agreements.
Understanding the Risk and Rewards
When you invest capital in a startup without assuming operational responsibilities, you bear all the risk. The other party can leave at any time with minimal financial impact while you are committed to the success of the venture. This arrangement effectively means you are running the business on your own, making the risk substantial.
Equity vs. Returns: The Fundamental Tradeoff
Equity represents ownership in a company, while returns refer to the financial rewards you receive from your investment. It is essential to strike a balance between these two to ensure a fair arrangement for all parties involved.
Alternative Scenarios
Scenario 1: Clearly Defined Roles and Responsibilities
In one scenario, the techie (who handles the technical operations) is paid a fixed salary, and the investor (who provides the capital) receives equity. If the techie is valued at $250,000 per year and the investor funds $1 million, a rough estimate might be that the techie receives $150,000 in shares annually. This approach ensures clarity and fairness in the partnership.
Scenario 2: Founder Equity Structures
In a venture-type startup, where the goal is to achieve billions in value over several years, the investor should be clear about their role. If you are simply an investor who provides capital, you are not a founder. This is especially true if you are not contributing any labor or operational effort. The usual structure is for investors to receive convertible notes, SAFE instruments, or other financial mechanisms that reflect their investment.
Participation and Incentives
If the techie has an exceptional invention or patent, it is reasonable to give them a percentage of the business while you provide the capital. However, the invention or patent should become the property of the company, and the techie should sign a non-compete agreement to prevent them from leaving and developing it elsewhere.
The Risk vs. Reward Equation
The decision on how much equity to seek is heavily dependent on the scenario. If the CEO has a unique ability that lacks financial resources, a lower equity stake might be appropriate to incentivize full effort. Conversely, if you are the CEO, you might want to include a ceiling on potential rewards, as business success is not guaranteed indefinitely.
Protections for Investors
While it is important to be flexible and fair, investors need protection. If the business fails, you do not want to legally own the company, but having enough equity to balance the risk can be beneficial. Typically, an equity stake between 20-40% might be reasonable, depending on the specific circumstances and the potential for future growth.
Paths to Fairness in Startup Financing
If one founder banksrolls the startup, the fairest and most reasonable approach is to treat the investing founder exactly as any other investor would be treated. This includes separating operational roles and defining founder ownership according to their contributions. For example, one founder could be the CEO while the other is the CTO, with a 50/50 or 60/40 ownership split.
Complications in Investor Structures
Investor structures are built under the assumption that investors are in a different position than founders, which impacts governance, voting rights, and other aspects. However, this basic approach provides a good starting point.
Conclusion
Investing in a startup requires careful consideration of the roles, responsibilities, and financial structures involved. Whether you are seeking equity, returns, or a combination of both, striking the right balance is crucial for a successful partnership. Understanding the risk vs. reward equation and ensuring fairness and protection for all parties will lead to a more sustainable and successful venture.
Beyond this, there are many resources available online, including Quora, books, blogs, and professional advisors, that can guide you through the complex process of structuring a startup investment.
Key Takeaways:
Investment and equity should be proportional to contributions and risks taken. Equity structures should reflect fair and reasonable terms between all parties. Consider protections for investors to mitigate risks. Flexibility and fairness are key to successful startup partnerships.By understanding and applying these principles, you can ensure that your investment in a startup aligns with your goals and the needs of the company.