Co-founder disputes are cited as the reason for around 65% of startup failures, according to research by Harvard Business Review. This makes the division of equity between co-founders a key decision that can make or break a startup.
Many co-founders decide on an equal split of equity early on in the life of their startup because it appears to be a simple solution that is easy to agree on. But this can lead to trouble down the line if one founder feels they are committing more time and money to the success of the startup without any corresponding reward in terms of ownership. That’s why it often makes sense for startup founders to agree on a division of equity that reflects their individual contributions to the business.
Equitable versus Equal
An equitable approach to dividing shares is based on the principle of fairness rather than equality. It may require some candid discussions about what each founder can deliver for the business in terms of value-added. But it does have the advantage of forcing founders to tackle difficult questions at the beginning of their entrepreneurial journey. Disagreements at an early stage have much lower potential costs than when the business has grown both in size and complexity.
Indeed, some angel investors and VC funds take a dim view of equal equity splits because it may be symptomatic of the startup team failing to address and successfully negotiate difficult issues. A survey of over 6000 startups published in Management Science found that 40% of founders spent less than a day considering their co-founder split of common equity stock. This would suggest that co-founders underestimate the importance of equity division to the long-term success of their startups.
It makes sense therefore for any startup co-founder to think hard about how they ought to divide up equity. They need to discuss it in detail with their business partners and investors, and then get it down in writing, however awkward this may feel on a personal level.
The first step on the road to agreeing on an equitable division of equity between co-founders is to establish the criteria that determine who gets how much. Standard criteria include the amount of time each individual commits to the business, how much money they are able to raise for the business, and what value their expertise and contacts can bring to the company’s future growth and profitability.
A commonly used method for setting out these criteria and then allocating a ‘weight’ to each of them is the so-called founder’s pie calculator. Its main virtue is the ability to quantify each element of the decision-making process. It brings transparency and logic to what is potentially an emotionally charged discussion.
One key criterion for equity allocation is who had the original idea and developed the business plan (although the execution is arguably more important). The second element of the pie calculator is to establish who has the most domain expertise, which is another way of saying who has the contacts and experience to reliably grow the startup. Any co-founder who devotes themselves full-time to the business and thereby takes a bigger risk is likely to command a higher score on commitment, which is the third element. Responsibility is the other main element to consider. The co-founder with the highest score for this is usually the individual who gets called up in the middle of the night when things go wrong.
Idea versus Execution
The relative importance of each element - which can themselves be changed to add to - depends both on the business and the sector in which it operates. A tech startup might attribute more relative weight to the intellectual property (IP) or ‘idea’ element than for example a hospitality business. But that same tech startup may also assign greater value to an individual who is able to turn that IP into revenue growth based on their contacts and commercial strategy. It all ultimately depends on the culture and preferences of the startup co-founders. Past, current and future contributions made by co-founders all have to be considered when making assessments of this kind.
In the pie calculator, each element is attributed a number from one to ten to reflect its importance or weight to the startup. Each founder is then measured against these criteria and given a number out of ten for each one. The co-founder’s evaluation numbers are then multiplied by each element’s weight number and summed. This provides a final ranking score for each co-founder, which determines their respective equity percentages. Remember however to hold a percentage of equity in reserve which can then be offered to key employees as an incentive.
A big concern for many co-founders is the risk of another founder or key employee departing the business (or getting fired) at an early stage, while retaining their shares. Retaining an equity stake allows them to maintain a degree of control over the business, as well as a share in potential rewards, long after they’ve left. To avoid this problem, a common feature of many equity division agreements is vesting.
Vesting is where you earn your agreed equity share on the basis of how long you work for the business. Meeting performance targets can also be a condition of vesting for employees. A typical vesting setup is to have 4 years of vesting with a one-year ‘cliff’. In effect, this means that you lose your agreed equity percentage (for example 50%) if you leave within the first year. After one year, you might get 25% equity. From there you might receive additional incremental percentages on a monthly basis until at the end of 4 years, you take entire possession of your allocated stock.
It is often said, only half in jest, that the best negotiations result in everyone emerging equally unhappy. A clearly written agreement at the beginning of the startup’s journey is the best way to avoid unnecessary conflict or misunderstandings as the startup grows and acquires investors. This is facilitated by applying a clear and logical equity allocation process that everyone understands and agrees to abide by, subject to sense-checking.
If you’re seeking funding, guidance and support for your early-stage start-up, get in touch with the Pitchdrive team today to get started.