A startup is an entrepreneurial venture in the initial stage of its operations. Startups are typically young businesses aiming to grow quickly and meet a marketplace need by developing or offering an innovative product, process or service. The term "startup" has been popularized in the press and may also be used to refer to larger, more established technology companies which are still privately-held.
Differences between startups and small business
Startup companies may share a number of characteristics with small and medium-sized businesses. Especially at the earliest stages, startup companies may have small teams and limited revenues. Startups may be unprofitable in the beginning (and some remain unprofitable even at large scale). And they may operate in a relatively small geographic area or narrow segment of a particular market.
However, startups tend to share several characteristics which serve to distinguish them from small businesses:
- Innovation. Startup companies are typically built around a new idea, method, or product. While the products and services a startup may offer are enabled by technology, not all startups are rooted in unique, defensible intellectual property. They may offer a new type of business or service model (ex. app-based ride-hailing services vs. the traditional taxi industry) or a unique design or interaction model which sets them apart from established competitors.
- Risk. Startup companies often operate at the edge of a technical field or market for their product or service. Given their small size, limited resources, and often unproven demand for their commercial offerings, startup companies experience high rates of business failure. However, with high risk can come high reward.
- Scale. Almost by definition, startup companies start small. At launch, they may serve a small geographic area or a specific customer segment, sometimes referred to as a "beachhead market." However, from a management and economic standpoint, startups are designed to scale up beyond their initial markets and serve many, many customers. For startups, economic viability is often predicated on very large scale.
- Speed. Small team sizes and relatively flat organizational structures let startup teams make decisions and move quickly to seize upon a market opportunity. Limited available resources (see runway) and competitive pressure makes speed a necessity.
Collectively, these characteristics serve to create dynamic organizations and more flexible management styles than what might be found in the typical small business.
Equity and capital structure
Startups, like most types of companies, have a capital structure built around the creation and issuance of stock which can appreciate in value over time. Equity is the difference between the value of the assets/interest and the cost of the liabilities of something owned. In finance, it represents the total value of a company if its assets (which include tangible things like office furniture and computing equipment as well as intangible things like its intellectual property and its anticipated future revenues). Shares in a company's equity grant shareholders a claim to their proportional share of proceeds from a liquidation event, among other rights and privileges.
Startup companies are privately-held, meaning that there is not an open market for their shares. Accordingly, startup equity is an illiquid asset, which makes valuing its worth a challenge and selling startup equity for cash difficult before a company chooses to engage in an initial public offering (IPO) or is valuable enough for third-party investors to establish a secondary market for their shares. However, being privately held allows companies to operate with less oversight from securities regulators, and reduces the burden of corporate financial reporting imposed on publicly-traded companies.
Equity in a startup can be owned by an individual (such as a founder or an employee), by a company (like a venture capital fund), or by some other legal entity such as a trust. A startup's capital stock is originated at time of incorporation, and new stock may be created and issued over the course of a company's development as it takes on outside investors and grows its team. Creation of new shares dilutes the ownership stakes of existing shareholders. So long as the valuation of a company continues to rise, dilution does not directly affect the financial value of a shareholder's equity stake in a company.
How equity is distributed
Ownership of startup shares is tracked in a company's capitalization table (or "cap table"), which shows the full list of shareholders and the pool(s) of unallocated shares and what percentage of the company's stock each stockholder's shares represent. A well-structured capitalization table will typically distinguish between whether a shareholder is in possession of preferred stock—which may carry special rights and privileges outlined in a company's shareholder agreement—or ordinary common stock.
Stock may be sold to investors, awarded to key advisors (see Advisory shares), or may be granted to employees or contractors as part of their overall compensation package. Options to purchase stock, rather than direct issuance of stock, is the most common way for employees to receive equity in a company.
Allocations of equity may be issued in full, such as when an investor purchases shares, or distributed over time according to an agreed-upon schedule of stock vesting. Vesting schedules are a way to align interests between a startup and the person or entity to which stock is being vested. Issuing stock or stock options over time (typically 3-5 years, but there are exceptions) and/or only after a certain period of time has elapsed (called the "vesting cliff") ensures that employees and advisors maintain long-term engagement with the startup.
- Convertible note
- Founder preferred stock
- Restricted Stock Unit (RSUs)
- Restricted stock award
- Options pool
- Options pool shuffle
- Outstanding shares
- Liquidation overhang
- Liquidation preference
- Exercise options
- Exercise window
Acceleration and exercise
- Double Trigger Acceleration
- Phantom Stock
- Stock Appreciation Rights
- Incentive stock option (ISOs)
- Nonstatutory stock options
- Non-Qualified Stock Option (NSOs)
- Early exercise
- Cashless exercise
Individuals' roles and relationships in the startup ecosystem
Like all communities, the startup ecosystem consists of people which fulfill one or more roles.
Founders are the people who start organizations. One or more people may be counted as founders (or "co-founders") of an organization. It should be noted that, in the context of the startup community, organization types could include companies, entrepreneurial support organizations like incubators or technology community hubs, or investment companies like accelerators and venture capital firms.
As the name of the title may suggest, founders are responsible for establishing the foundational elements of an organization. In exchange for the high level of risk and workload they take on, founders are typically granted significant equity stakes in their companies, which may be issued as either founders shares or common stock. This serves to align incentives between co-founders, and later between the founding team and investors in the company.
Founders undertake disproportionate responsibility for defining the scope of their organizations; setting a vision and defining the mission of their organizations; designing, developing, and delivering the earliest versions of their organizations' product or service offerings; and other standard business leadership activities like recruiting a team, securing a source of funds (which could include their own personal assets or lines of credit, business revenue, or external funding from investors), generating "buzz" for their organizations, and fulfilling other administrative responsibilities.
Founders typically take top-level roles in their organizations. A co-founder with business experience and/or a compelling vision for the organization may serve as Chief Executive Officer (CEO); the co-founder with the strongest technical abilities, who might also shoulder most of the responsibility for developing core technology, may serve as Chief Technical Officer (CTO) for example. Though job titles may vary from organization to organization, especially at the earliest stages of formation and development, founding members typically go on to lead the parts of their organization that align with their experience and early contributions.
Founders may serve informal mentorship or formal advisory roles to other founders. Successful founders may make angel investments in other founders' companies, may join venture capital firms, or serve in advisory or mentorship roles to organizations serving the entrepreneurial community. It is rare for founders to start more than one organization simultaneously, but many go on to found other organizations later in their careers.
Startup employees are people who join organizations established by founders. Like employees of other organizations, they're responsible for managing or directly carrying out the functions of an organization. However, depending on the stage of a startup's lifecycle at which an employee joins, they may be exposed to more risk (but also more financial upside and professional opportunities) than employees performing similar roles at more established organizations.
Regulations vary between jurisdictions, but startup employees are typically granted the same rights as employees at other types of firms. In addition to salary and benefits (which can vary widely), employees may also receive a grant of equity or options to purchase equity shares in the startup, which is subject to the covenants and conditions outlined in a company's employee stock ownership plan (ESOP).
Startup employees who join a company early in its lifecycle are typically issued more equity or options than employees performing comparable duties who join the organization later in its lifecycle. Though management style and hiring strategy can vary between companies, it's typically the case that—relative to their counterparts at more established enterprises—startup employees have more responsibilities and more opportunities to rise through the ranks of an organization as it scales up its operations.
Startup advisors are people who provide advice to founders and executives about specific business needs. In exchange for their time, expertise, and other contributions to a startup, advisors may receive advisory shares in the company.
Advisors usually have experience, domain expertise, or a valuable personal or professional network that can help early-stage organizations set up new processes or grow their business or operations.
The relationship between companies and their advisors is often formalized in a startup advisory agreement. Advisors may work with founders and executives on an as-needed basis, or as part of a formal advisory board.
Unlike startup advisors, mentors typically have an informal, non-compensated role in supporting a company's founders and executives. They may contribute their time, expertise, and may help the company by making introductions to potential job candidates, investors, or service providers, but they typically do not receive equity (advisory shares) or cash compensation for their contributions. Relationships between founders and mentors is typically friendly, collegial, and informal.
Startup investment organizations like accelerators and support organizations like incubators and technology hubs may establish a structured mentorship program. This may involve pairing a founder (or co-founding team) with established service providers and people with prior founding or leadership experience who provide informal guidance and support throughout the duration of the accelerator or incubator program. Founders may opt to bring mentors on as formal advisors after the program concludes, but typically the relationship between founders and mentors remains informal or ends entirely.
Investors are people who commit capital in exchange for an equity share (or the promise of a future equity share) in a company, the rights or options to purchase equity in a company, an income stream from dividends paid out by a company, return of the principal plus interest of a loan made to a company, or some combination thereof.
Especially for earlier-stage companies, the investors they encounter typically fall into one of two categories: representatives of institutional investment funds (who invest other people's money) or individual "angel" investors (who invest their own money). People representing institutional investment funds may occasionally make startup investments using their personal capital if they have personal conviction in the founder(s) and their team, but the firm they work for passed on investing.
Besides providing capital, startup investors may fulfill similar roles to advisors and mentors. They may help make introductions to candidates for executive leadership positions, connect companies with customer leads, and generally act in the interest of their portfolio companies whenever and however they can.
In addition to mentorship and advisory functions, institutional investors may also perform governance and oversight functions as members or observers of a company's board of directors.
- Initial Public Offering
- Mergers & Acquisitions
- Internal Revenue Code section 409a
- Alternative Minimum Tax
- Ordinary Income tax
- Employment taxes
- Long-term capital gains
- Short-term capital gains
- 83(b) election
The Five Stages of Small Business Growth
Niel C. Churchill and Virginia L. Lewis
May 1, 1983
The Open Guide to Equity Compensation