You’re starting a new
company. Congratulations! Before preparing for your product launch or
talking to customers, however, you need to agree upon the allocation and terms
for the equity, or ownership, of the company among you and your
co-founders.
This is
one of the toughest decisions you’ll have as a founder, but it’s also one of
the most important to get right from the get-go. Even minor differences in
equity can mean a lot down the road, so starting off with everyone on the same
page (and feeling good about the agreement) will prevent big issues from coming
up in the future. So, how should you get started?
Dividing
the Pie
As with most things, there
are philosophical differences in the approach to founder equity. One camp believes
that founder equity should never be evenly split because it can result in
stalemates, which can kill a company fast. The other camp believes
that fairness should prevail and if an even split seems fair, then it’s
appropriate.
While
there’s no formula or one-size-fits-all approach, there are a number of factors
that are generally taken into consideration:
·
Whose idea was it? Unless someone is contributing patented technology, this
shouldn’t be a big factor—it’s widely accepted in the start-up community that
execution is more important than ideas. The founders of MySpace and other
social networking sites had an idea similar to Mark Zuckerberg’s, but failed to
execute on that idea as well as Facebook did. Instead, the founders who execute
on the idea deserve more equity.
·
Full-time versus part-time: If one co-founder is
quitting her job to dedicate herself full-time to the company and the other is
working part-time, the part-time founder deserves less equity because she’s
both taking on less risk and providing less value and time commitment to the company.
Typically, this person should get less than half of the equity that a full-time
founder is getting.
·
Salary: It’s not uncommon in the early days of a start-up for founders to
work for a reduced salary or forego it altogether. But, foregone salary should
not be “paid” in the form of equity, for a couple of reasons. It’s nearly
impossible to determine the right amount of equity for foregone salary, and
this practice can raise a host of difficult tax, withholding, and accounting
issues. The same advice goes if one founder contributes equipment, working
space, or other tangible things—pay for those with convertible debt or series
seed preferred.
·
Capital Contributions: One co-founder may be in a position to make a
significant capital contribution to the company, and you might think she could
just get additional founder shares in return. But, it’s typically better to
allocate founder equity based upon each person’s actual level of work
contribution (called “sweat equity”) and treat financial contributions from a
founder the same way you would that of a seed investor—by issuing convertible
debt or series seed preferred stock.
·
Future Roles: Consider each co-founder’s expected role in the company based on
her level of skill, capability, and the company’s needs. For example, if the
company requires significant technology innovation and one founder is a
world-class VP of engineering, she may deserve more equity. Just remember that
the needs of your company, and perhaps the roles of the founders, will change
significantly over time—don’t skew the equity split too much over a single
contribution or skill.
·
Future Employees: Similarly, it’s important to think about founder equity stakes
relative to the employees that get brought on
afterward. If a founder ends up as director of product marketing
with a huge equity stake, that will make it challenging to hire other senior
executives with smaller option grants. The allocation of equity should take
into account both past and future contributions to the company.
·
Control: Founder equity should not be allocated based upon how the company
should be controlled or managed—you should have a separate agreement that
specifies how important decisions get made. It’s also crucial to have rights of first
refusal (an agreement stating that if a founder wants to sell
her shares, she must first offer them to the company), so you don’t end up with
a partner you didn’t bargain for.
Vesting
No matter
how you divide the founder equity, those shares should be subject to vesting
restrictions, so that until the shares are “vested,” the founder does not fully
own them. This is important because it prevents a co-founder from leaving after
only a few months, and yet retaining a huge part of the company. The last thing
you (or an investor) will want is for someone to hold a lot of equity and no
longer be contributing to your success.
Under a
typical vesting schedule for employees, shares vest over a four-year period,
with 25% vesting at the end of the first year (called a “one-year cliff”),
which ensures employees stay around for a year before owning any of the
company. The remaining shares vest thereafter on a monthly or quarterly basis.
For founders, some shares
are typically vested up front (in our experience, 20% to 25%, though it can go
as high as 33.3%) [Editor's note: This is one perspective. As with all numbers
surrounding equity, multiple perspectives exist, and you should read more than
one source when making an important decision.].
Founders also often have provisions that accelerate vesting in the event
of a change of control (i.e., an acquisition) or a termination without cause.
Dilution
When founders launch a start-up,
they own the entire thing. But, it’s inevitable that your shares will be
diluted as the company grows in order to attract employees and investors, and
there are very few examples of successful founders owning 100% of their
companies at the time of a sale or IPO.
When you
raise Series A funding, you’ll issue additional shares of stock that will go to
your investors, and you can expect those investors to take anywhere from 25% to
50% of the company. In later funding rounds, they may take a smaller
percentage, though depending on the terms you negotiate, it can still be as
much as in your Series A. Each time, your shares will be diluted accordingly.
You’ll
also need to leave a pot of equity for future employees, particularly
early-stage ones. In general, when you’re setting up equity at the beginning,
it’s a good idea to leave between 10% to 20% in the pie for employees. If you
plan on raising funding at some point, your investors will require you to have
this—and if it’s already in place, you won’t have to dilute your shares further
to make room for it.
Every situation is
different, and there’s no right answer for splitting founder equity. But when
it’s all said and done, each co-founder should feel good about the equity
divide. If the agreed-upon split causes you angst, it’s probably not right.
Raise your concerns and iron out the details up front—it will only get harder
to ask for a bigger piece of the pie as your company
becomes successful and the equity increases in value, and it’s
well worth it to have these conversations finalized early on.
Good luck!
Munim Team
Your Personal Munim
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Rest Assured, We feel Your Concern !!
