How to Draw Up an Equity Agreement Between Two Parties
Equity is an important resource in business, especially if you’re in the early days. You may not be able to afford to pay top salaries for the best talent, but you can offer something that may become even more valuable: equity. Even as your business grows, you’ll likely find that equity is a viable option. At each point, you’ll need to draw up an equity agreement to solidify what you’re offering.
An equity agreement states the share of the business that each party owns. Generally established as part of a startup’s founding agreement, there are templates that can help.
Drawing Up Equity Investor Agreement
An equity agreement outlines the agreement between two parties. You’ll start your equity agreement by describing both parties in the agreement and then outlining the terms of the split. There are numerous equity agreement templates available online, but there are decisions you need to make before you get started.
The biggest challenge you’ll face in drawing up your equity agreement is how to split equity in a way that protects your own interests while also being valuable to the other person. If you’re splitting with a business partner, he might insist on a 50-50 split, while an employee you’re luring with equity as a perk may be satisfied with only 5 or 10 percent.
What Is an Equity Agreement?
If you look at a sample equity agreement, you’ll see that they account for many eventualities. It outlines what will happen if the business’s structure or ownership situation changes, the schedule at which the equity holder’s shares will vest, what happens with the shares if the owner dies and more.
An equity agreement is generally issued in exchange for something the equity holder will provide. In the case of employees, it’s a job perk, but if it’s a consultant, business partner or investor, most sample equity agreements state that in return for equity, the other party will provide something, whether cash, services or something else.
What Is a Founders’ Agreement?
Instead of a separate agreement, equity distribution is often outlined as part of a founders’ agreement, especially if the equity is being issued at the very start of a business. If there are multiple founders, this agreement will ensure you outline from the start how much you each own in the partnership. Your respective roles and responsibilities will also be described in this agreement and can play a role in how much equity you each get.
In addition to the sample equity agreement versions you can find online, you should be able to also track down founders’ agreement templates online. This will help you divide up each founder’s share, as well as all the other necessary information. In addition to details of shares and equity, your agreement should also discuss what will happen if one or more partners wants to exit the partnership.
Dilution of Shares
In many cases, founders want to set shares aside for future purposes. It may become a valuable job perk for employees, or they may simply want to plan for an equity share pool in the coming years. If that’s the case, the equity will be diluted, which simply means that the extra shares will reduce the amount of equity the owners have in the company.
Your equity agreement or founders’ agreement should state how this will be handled. You may want to put verbiage in that states that in such a case, each equity owner’s share will be diluted equally. Whatever you decide, having it in the initial agreement will avoid conflicts later.
Writing an Equity Agreement
Once you have the content of the letter down, you’ll need to know how to properly format it to make it official. It can help if you have an attorney draw it up for you or, at the very least, look it over to verify its legality. You may choose to sign in front of a notary to protect yourself against any future claims about the legitimacy of the signatures on the agreement.
The easiest way to write one of these documents is to find an equity agreement template and customize it to meet your needs. Your agreement should include:
- Valuation and equity split: This details the dollar valuation at the time the agreement is signed, as well as the stock shares and investment amount for each founder.
- Capital infusions: This section will discuss how things will be handled if the company needs to suddenly “call” an investment in.
- Vesting schedule: At what point will each founder’s shares vest? You should also consider what will happen to the shares in the event the business sells to a third party.
- Noncompete: You’ll need to have wording in your contract that prohibits equity holders from working with a competitor.
- Death or incapacitation: What happens to the shares if one or more equity holders dies or becomes incapacitated?
With the right equity investor agreement in place, you’ll have the peace of mind of knowing your shares are protected as you start your business.
Fighting for Your Share
If you’re lucky, the equity split decision will be amicable. Everyone will agree on the split, and you can sign the agreement and move forward. However, in some cases, the split discussion leads to a lengthy debate about just what each person is bringing to the table and how that should be reflected in equity shares.
Before you start this discussion, gather your facts and make sure you’re prepared to present the facts showing why your share should be equal to or higher than the other person’s. If you’ll be doing more of the day-to-day labor in building the business, you may feel that your share should be larger, and your partner may agree. Just beware of creating a permanent rift in your partnership over such arguments.
Distributing Shares After Acquisition
Your equity investor agreement will come into play if your partnership comes to an end. In that case, you’ll distribute equity shares as outlined in your equity agreement. But another event could affect the status of your shares. As your business grows, it may catch the eye of a third-party buyer who wants to buy your business.
Your equity agreement template should build in language for how equity shares will be distributed in the event of an acquisition. An acquisition happens when a company purchases more than 50 percent ownership in a business, at which point that company takes over ownership. That buyout agreement will include what will happen to the shares.
Distributing Shares After Merger
A merger happens when two companies of roughly equal size decide to come together to become a stronger single company. As with a merger, this action can be disruptive to the status quo, and many employees will have questions about the status of their jobs, as well as what will happen with the shares they own.
Unlike acquisitions, mergers happen on an all-stock basis, which means that every employee owns the same shares as before the merger. So, if the founders each hold $10,000 in stock in the previous company, they will each still hold $10,000 after the merger completes. Even if the number of shares changes, shareholders will still see the same value for those shares.
- Upcounsel: How to Structure Your Startup’s Equity Split Arrangement
- Docracy: Founders' Equity Agreement
- PandaDoc: Founders' Agreement Template
- Capshare Blog: 6 Equity Dilution Terms Every Founder Needs to Know
- FreeAdvice Legal: Does a Contract Have to Be Notarized?
- RocketSpace: How to Build a Startup Founder Equity Agreement
- ACQUISITION | definition in the Cambridge English Dictionary
- ALL-STOCK | definition in the Cambridge English Dictionary
Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a ghostwriter for a credit card processing service and has ghostwritten about finance for numerous marketing firms and entrepreneurs. Her work has appeared on The Motley Fool, MoneyGeek, Ecommerce Insiders, GoBankingRates, and ThriveBy30.