One of the first hurdles of building a startup between you and your cofounder(s) is likely to be agreeing about a fair equity split.
It can trigger a lot of hard and difficult emotions, especially when co-founders have to discuss their potential, what they feel they are worth, and match that to an actual equity share. Therefore, it is important to take time with the process and consider certain things mentioned below before coming to a final decision. Even though it is a tricky and awkward conversation to have, don’t postpone it. Try to make it fair, clear and related to future performance early on in the startup to avoid issues further down the round.
Most commonly, avoidance, too much optimism, or lack of knowledge can lead to splitting the equity equally among the co-founders. However, according to Noah Wasserman, “A quick, even split suggests that the founders don’t have the business maturity to have a tough dialogue.” According to Wasserman’s research, co-founders that split their equity by default were found to have triple levels of unhappiness within their teams.
Things to consider while splitting equity
Idea or Execution
There are two ways to look at this situation while splitting equity among the founders.
The first is considering how the team was put together and what led to the idea of the startup. If it was a joint effort, then the equity should most likely be split equally. However, if one founder came up with the idea, which could have formal intellectual property to it. This idea should be worth a fair amount and the founder should get higher equity compared to other co-founders.
On the other hand, Martin Zwilling presented a different approach.
“The “idea person” insists that the idea is 90% of the value (and 90% of the equity). In the real world, the “idea” is a very small part of the overall equation. A startup is all about “execution”- meaning the equity should be allocated based on the value that each partner brings to the table.”
The idea is only a part of the equation of the startup. For example, Myspace and Facebook which are similar social networking sites executed their ideas differently. Facebook accomplished the execution into the social media space better, building a series of features that kept it dominant, whereas Myspace faded into obscurity.
Therefore, the second way allocates more equity to the founder executing the startup, making sure that the startup has the resources and capital to grow, and is able to execute on the idea.
In some situations, the answer to this dilemma could be that if a startup fails because the business was unable to execute the idea, 50% of nothing is zero.
Another consideration for splitting the equity fairly is taking into account the commitment level of the co-founders.
- What is everyone’s commitment?
- Is everyone in it for the long-haul?
- Will the founder work on this full-time or is this a side gig?
For example, some founders usually work full-time for the startup for no salary whilst others are working full-time for another organisation and only work for the startup in the evenings. The former portrays a large amount of commitment and deserves the vast majority of the equity being distributed, whilst the latter is simply buying an option to join the startup at a later stage and therefore deserves less equity.
A way to take into account these differences is by changing the percentage of options offered for however long the difference in commitment remains. For example, one of four co-founders works for a big enterprise for the first year because he has personal financial commitments to fulfil like a mortgage. On the other hand, the other three founders can afford a very small salary from the startup. Assume that the company was planning to distribute 20% of the entire founders options pool (the 2,000,000 options stated at the beginning) in the first year. In that case, the three founders working full-time for the startup may be entitled to their expected 500,000 options each for the year plus a quarter of the options of the founder that hasn’t joined full-time. In effect, this would result in each of the 3 full-time co-founders receiving 625,000 founder options while the other founder would take 125,000 options for that year. If in the second year the founder joined full-time, then the vesting of the options would become 500,000 founder options for all four co-founders for the year.
Tip: Clearly know each founder’s commitment level. Ensure that their equity shares vest over time, and how everyone will deliver on their commitment.
Another key question is: who is taking the most risk? A fundamental way to decide what is fair when distributing equity is to work out the risk for each of the founders. For example, one founder is giving up a full-time job to launch the new business. On the other hand, another founder still has a full-time job and is merely working on the new business in the evenings and weekends. In this case, the first founder is far more at risk than the second one if the business doesn’t work out. Therefore, the first founder should get a higher majority of the equity.
When dividing equity, a founder with previous experience in building a company should be given more weight. Building a startup is difficult work, and any prior experience fundraising, connections to investors, creating an MVP, or scaling a product are invaluable assets that increase the startup’s chances of success. For most first-time founders, this is a tough sell.
Consider the following questions while splitting the equity
- What is everyone bringing to the table?
- How will everyone contribute to the startup’s success?
- What skills are more valuable than others?
These questions can help determine the cash and non-cash contributions each founder is bringing to the startup. Depending on the founder team, these contributions will have a different weight. Consequently, the value of each of these contributions will help determine the level of commitment from each founder.
If a founder leaves
What happens to equity if commitment level increases, decreases, or if a founder leaves?
One of the founders could walk away as priorities change, and family and related expenses grow faster than the company. The founder departing should be entitled to keep the respective options for that year but no more. The remaining options should be split among the other co-founders in the following years. If the departure is amicable, the founder will most likely still be involved informally, providing advice on a regular basis. This is hugely valuable and there is a great advantage of having a co-founder looking in from the outside.
Sometimes different opinions lead to arguments, to the extent that it’s impossible to part ways in an amicable way. In this time, the value of having watertight, carefully thought out legal documents is realised and appreciated. Different people have different ways to react to unpleasant situations, so ensure that from the very start, you have a robust legal document prepared by a high-quality lawyer that asks all the right questions from the outset. If nothing goes wrong, the legal document won’t have much value. However, if it goes wrong, the legal document becomes your bible. Make sure the document covers many unpleasant situations, no matter how unlikely they feel at the beginning of the startup.
Regardless of the distribution you decide upon, ensure that the founder’s shares vest over a period of time (usually four years) and include clear guidelines within the partnership agreement for what happens to a founder’s share if they quit, are forced out, or leave voluntarily.
Tip: Create a partnership agreement that includes Rights of First Refusal, which is when the founders can buy back the equity shares if a founder leaves.
Equity for board members and advisors
An additional co-founder joins the startup
A formula to follow
Created by Frank Demmler, Founder’s Pie Calculator is one method for quantifying the various elements that go into the decision-making process of dividing equity. This formula incorporates all of the considerations regarding business acumen, value, and commitment into five distinct categories that the founders then have to adapt to their situation. It causes everyone to have a negotiation upfront as to how they value each other. Through this, everyone has the opportunity to test the founder relationship and come out equally satisfied at the end.
The following are the five elements in the Founder’s Pie Calculator
- Business Knowledge
- Domain Expertise
- Commitment and Risk
Each element may have a different weight apportioned to it (between 1 and 10) according to the industry that the startup is operating in. For example, the idea may be given more weight if the company is based upon new technology or the business execution may be given more weight if the startup needs considerable capital to launch the idea.
One common mistake is lack of reverse vesting (or a similar mechanism). This situation occurs when the equity is split and given to each founder without a clawback mechanism. For example, if the four co-founders split the equity 25% each without reverse vesting at the start of the company, one of the founders could disappear whilst keeping the same amount of equity as the other three, who may work for several years before the company is acquired.
A good way to tackle this is by including a mechanism whereby each founder gets a certain amount of the equity for each month they work for the company. Another solution is to mention clearly that if the founder leaves before a certain number of years, they will have to return the shares to the company.
For example, in the case of 4 founders with 25% equity each, they could receive 5% in options each for every year they work for the first 5 years. If one founder leaves by the end of the second year, they would keep 10% of the company. In this case, it’s important to have a clause stating the entirety of the options will vest immediately if the company has an exit before the end of the fifth year.
Fairness implies that everyone should leave the equity conversation valued. Giving everyone an equal ability to contribute, and making sure that the final equity decision you come up with makes everyone feel valued for what they are bringing to the table is important, even if that implies giving up a percentage point or two to get everyone there.
How the equity is split early-on will have a lasting impact on the co-founder dynamic and the company in the future. Considering the tips in this article will increase the startup’s chances of success.
Investocracy, a company focused on connecting startups from emerging markets with Japanese investors, produced this article.
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