Ever watched a movie where people are starting some business venture, and they blurt out how much of the profit they want? It sounds something like, “Ok, we’re going to split this 60-40”. If that seems too unlikely to work in real life, then you’re already ahead of the game. In our last blog, we talked about the most frequently asked question from founders, which is “How do my co-founders and I decide how much equity to take in the company?” Control, economics, and even status as a stakeholder in the company are all factors that weigh on this all-important decision. In this article, we’ll look at a couple of the ways co-founders come to a resolution on equity split.
The Data-Based Approach
Starting a company is hard work. In a perfect world, each co-founder would receive the amount of equity that perfectly corresponds with the number of hours worked and amount of effort, skills, or connections contributed. While an exact match of effort to equity is rare, some companies have tried to get close. Slicing Pie is an app which tracks co-founders’ time, as well as several other factors, and enters an equivalent amount of equity into a spreadsheet. Founders can then create a cap table based on this information. The biggest pro of the data-based approach is its apparent accuracy in helping to calculate the elusive effort-to-equity equation. While we appreciate the accuracy, however, using a tool like Slicing Pie does not resolve the fact that, for a variety of reasons, the founders need to purchase their shares of stock in the company as soon as they know how many shares they will receive. If the share issuance is delayed for too long because the founders are still trying to calculate more precise equity figures, it could be detrimental to both the company and the individual founders.
Apart from trying to calculate founder equity based on quantifiable metrics, there is another method which, while not as data-driven, is at least grounded in historical data. Based on many of the same categories used by Slicing Pie, organizations like Harvard Business School provide a less technical explanation of how and why cofounders choose to divide equity certain ways. But instead of meticulously categorizing each cofounder’s amount of effort and contribution to the company, this method involves analyzing several factors and deciding – as close as possible without crunching the numbers – how much each founder’s contribution is worth. Although it may be less precise, the benefit to this method is that it allows the founders to design a cap table and purchase their shares more quickly and create an initial cap table.
I like to think of this as the least-preferred method of dividing equity. There is a lot of guesswork involved in starting a company, mainly due to time constraints and limited information the founders have with which to make decisions. How to determine who receives what amount of equity should not be a total guess – at the very least, write up a chart which highlights each cofounder’s strengths and try to recreate the method used by online equity calculators. Most often, we see this method used when a company and its founders are in the “idea stage”, meaning the company is more of an unstructured vision than a cohesive team working towards its MVP. In many of these cases, it may be beneficial to pause corporate formalities (such as engaging a legal or accounting team) and focus on determining whether there is a market for the idea.
Equity Isn’t the Only Factor
When cash is scarce, everyone’s focus tends to turn to equity. But what happens when the company turns profitable? If cash becomes available, whether through an equity financing or simply generating revenue from sales, it’s a great opportunity to reward cofounders with a bonus or an increase in salary. Because ultimately, founders have to determine the length of their own personal runway, and equity alone won’t provide that runway regardless of how much it is. If a cofounder finds himself or herself with fewer shares than they would like, then negotiating for the purchase of stock options may be a way to bridge the gap.
What is the Real Reward?
Deciding the equity makeup of a company is a critical decision which cofounders should address as early as possible. That said, we have often seen it become a preoccupation – in more extreme cases, it has caused founders to simply walk away from an opportunity because the potential for reward doesn’t match the effort involved in starting a company. If discussions around equity become really contentious, it may be a sign that there are some underlying problems with the team dynamic, or possibly some doubts about the product or strategy, which need to be addressed before the company can become successful.
This article is for informational purposes only, and may not be considered legal advice.
Bob Baker is a founding partner of Peak Corporate Counsel. He has worked with numerous founders on a variety of issues specific to startups. When he’s not advising innovators, he can be found at networking events, playing rugby, or hiking with his kids.