How Startup Funding Works

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!

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Munim Team

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