How should a small business structure its equity? A lawyer's view
Many start-ups begin with a simple split of shares among the founders, but how that split is designed has a decisive effect on later financing rounds and on equity incentives for executives. Equal shareholdings are best avoided: contributions differ, and each financing round dilutes every shareholder by 10% to 20%, so the lead founder generally needs 60% or more to keep control. Allocation should follow capital, ability, professional background and contribution, and a founder who only puts in money might receive no more than 5%. Founders should also sign a shareholders' agreement and decide in good time on an option pool.
Small and medium-sized enterprises are, in China, medium, small and micro enterprises established within the territory in accordance with the law and determined by reference to specific classification standards. Many start-ups at the beginning of their growth have a simple shareholding structure, usually held jointly by the partners, and whether that structure is sensibly designed has a critical effect on bringing in investors later, once the company has matured, and on equity incentives, executive shareholdings and other reserved equity.
So how should a small or medium-sized enterprise structure its equity?
[Case]
A has worked in the education sector for many years and plans to start a business with four friends, running a tutoring institution for primary and secondary school courses. Of the five partners, A and two friends work full time, one friend works part time at first and will go full time later, and one friend only puts in money.
[The lawyer's analysis]
(1) Do not divide the equity equally
Equal shares mean that everyone plays the same part in the company, but in fact A and the other four differ in their roles and workloads and contribute unequally, and after the company has developed for a while equal shares bring a series of problems, such as the efficiency of development and the fairness of dividing the profits.
From the point of view of a public listing, a founding team generally goes through several rounds of financing between incorporation and listing, and each round dilutes the equity by 10% to 20%. Because every shareholder is diluted pro rata in each round, the majority shareholder generally needs to hold no less than 60% if the founder is to retain absolute control.
The lawyers therefore suggest that in this case the founding team should have no more than three shareholders: A as the majority shareholder with 60% to 70%, taking the decisions, and the two full-time friends with 30% to 40%, with some say and able to support A. The part-time partner and the one who only contributes money should not join for now. If their participation is genuinely needed, they can be brought in later by a targeted issue of new shares.
(2) Distribute the benefits sensibly
The allocation of equity should depend on the size of the capital contribution, working ability, professional background and the extent of the contribution.
For the key people indispensable to the establishment and growth of the company, more shares may be given to the founder responsible for sales in a sales-driven company, and more to the founder responsible for research and development in a product-driven company. As for a founder who only contributes money and does no work, his contribution may gradually decline as the company grows and his influence diminish, and at a certain stage he may hold the company back, so an assessment may be made and no more than 5% of the equity given to him.
(3) Sign a shareholders' agreement to prevent internal conflict
After a company has developed for a while, shareholders may fall to fighting for control or may lose trust in one another over the company's direction or over maximising their interests, so it is very necessary to set up a mechanism against conflict. The founding team is therefore advised to sign a shareholders' agreement setting out each party's rights and obligations and the way in which disputes are to be resolved.
(4) Offer equity incentives at the right time
An equity incentive is a long-term mechanism a company uses to motivate and retain its core talent. Once employees hold share options, if the value of the company keeps rising the incentive is very strong; if it does not, their enthusiasm is dampened and the options have no practical meaning.
In practice internet companies reserve part of the equity as an option pool at start-up, while companies of other kinds decide on equity incentives according to how they develop, that is, they create share options once the business can be expected to grow with certainty, so that the employees who receive options can actually feel the equity increasing as the company grows.
The above is our advice on equity structure for small and medium-sized enterprises, and in particular for start-up companies, from incorporation through to gradual growth.
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