It’s easy amongst friends to avoid the discussion on how to split equity amongst co-founders. Too many, this is an intimidating discussion. Still, there are plenty of cases where co-founders have regretted not having had this discussing early on.
I will shortly guide you on what needs to be discussed, and you should really put this in writing.
These are the three areas to agree and document in writing when you discuss how to split equity amongst co-founders:
- The base case is equal split of equity – discuss your different roles., think execution.
- When to alter an equal equity split – already achieved traction can be a reason to alter a later stage split of equity amongst co-founders.
- Vesting schedule – long-term involvement shall be compensated.
So, with that said, let’s shortly dive into each of these three areas. At the end of the article, I will also comment briefly on the effect on shareholding’s from future equity dilution.
Read more why market potential is key to valuation.
The base case is equal split of equity amongst co-founders
Steer the conversation so that you address what each co-founder bring to the table when you discuss how to split equity amongst co-founders, and put it in writing.
A great team is a team where members complement each other. Bringing different skills and resources to the company shall earn an equal split of equity amongst the co-founders. Simplified equal equity is deserved as:
- Idea equity – someone came up with the idea and made it’s first conceptual product.
- Money equity – maybe someone is contributing money to fund the first 1 – 2 years.
- Competence equity – execution is super important and scares competences earn equity.
- Sweat equity – someone expected to invest more hours than others on the venture earn equity.
How to split equity amongst co-founders is unique in most situations, but an equal split has many advantages. In particular if Founder A can’t execute the business without Founder B.
Importantly, you need to recognize that different skills and experiences are equally worth if they are important for the success of the company.
It may not be a good idea to partner up if you can’t acknowledge that everyone brings different but similar valued competences or resources to the table.
Some people believe that the person who had the original idea shall have the lion share of equity. Others believe that the success of a business has a lot to do with the execution of a business. Others fall in between these two extremes.
Competences and experiences vital to the success of the company deserve a chunky share of founder’s equity. The base case is equal split of equity amongst co-founders at the start of a new company.
When to alter an equal equity split
The concept of an equal equity split amongst founders may be altered if the company already have some traction. For example:
- A far gone prototype design.
- Rounds of previous funding.
- Existing sales and revenue.
Traction is worth something and early-stage founders should be compensated vis-a-vi later stage co-owners. Having said that, a pitch deck or talking to potential customers does not count as traction.
Intellectual property like an already made design or filed patents that are invested as an in-kind contribution has a value. So does informal intellectual property. Examples are relationship networks and key competences needed for company success and contributed by an incoming CTO or Board Member.
Unless everyone brings something unique to the company that is needed for company success, you may need to alter the equity split. Before going too extreme in different equity split however, please consider what future equity dilution may do to small shareholders.
Vesting schedule is used to compensate long term engagement
Long-term involvement shall be compensated vis-a-ví those who may not be engaged in the company for years to come. Initially all co-founders are in for the long run. It’s quite common thought that one or two co-founders leave the company pre-maturely.
Leaving the company early may be for personal reasons, for financial reasons or many other causes. Being a startup founder may also not be what you foresaw.
Someone might also disagree on the company direction. In particular if you don’t have a Founding Strategy document where you have agreed upfront on vision, strategy direction, operational principles, and preferred funding principles.
It really sucks if one or two early founders either fall behind in performance or leave his work entirely after one or two years. That person will still own a large part of the company.
This is where vesting comes in.
Founder vesting is an agreement on how the deliveries of shares shall be executed. It’s usually an appendix to the shareholder agreement.
A common startup founder vesting agreement can be made in two forms, although differences exists depending on what jurisdiction you operate within:
A 4-year vesting agreement amongst original co-founders
- The shares are split as agreed upon amongst the co-founders, the “Base Shares”.
- A new share issue is made with the company as a temporary owner. Alternatively the shares are put in escrow, in some jurisdictions.
- The new shares are then distributed to the co-founders on a monthly basis over 48 months, until all shares have been distributed. The originally agreed equity split amongst co-founders shall be kept throughout the share distribution period.
- Share distribution stops for the person that leaves the company during the 3-year vesting period.
Everyone is compensated during their involvement with the company. The once that leaves pre-maturely, during the 4-year vesting period, is only compensated for the period they have been with the company. Their remaining shares can then be used by the company in compensation packages for new hirings.
A 12-month cliff and a 4-year vesting agreement when you hire new co-owners
This is a simar vesting arrangement as above but used when somebody new is hired to the team a few years down the road. Someone that is entitled to co-ownership.
A 12-month earning period is used instead of an immediate distribution of Base Shares. This means that it’s only after 12 months that the new recruitment’s 48-month vesting period starts.
This 12-month period, the cliff, allows the partners to evaluate the new recruitment before starting the vesting period. Please note that the vesting period is assumed to be pre-agreed and will start automatically as soon as the first 12 months has passed.
You should engage a lawyer and an accountant to help sort out the vesting agreement. It’s not only to get the agreement right but also to make sure that you’re correct from a current and future tax perspective. Not least if you plan to invite outside investors to fund the company and the company value starts to grow.
Effect on shareholding from future equity dilution
Think ahead. Your funding strategy will have material effects on each co-founder’s shareholding. The funding strategy, in principle, is therefor worth agreeing upfront.
Most fast-growing startup’s will use 2 – 4 equity funding rounds to propell the company growth.
Alternative, traditional financing would be a much slower self-financed growth with a combination of cash flow and trade loans.
Current shareholder’s equity is diluted each time the company issue new equity to new investors. Your ownership percentage decreases when investors are invited as co-owners since the total number of shares is always 100%.
However, the value of the company usually increases with new investors, hence your smaller shareholder percentages becomes more valuable than before. Newly issued equity is acquired from the company with money that the company gets to finance its growth.
Startup valuation is a bit tricky when sustainable sales traction is still lacking. The enterprise value will be a result of capital raised divided with the share percentage the investor has negotiated for himself. Adding $2mn for a 25% share in the company means that the company post-valuation is $8mn ($2mn/25%).
Most founder’s struggle giving away ownership in their company. However, inviting equity investors to finance faster growth than internally generated cash flow and trade debts means that investors will become co-owners.
It’s like concept to split equity amongst co-founders: Investors add growth capital essential for company growth. Hence, they earn to become a shareholder.
The point of all this is to be aware that small initial co-founder equity stakes, say 5%, will be highly diluted in terms of value. Owning 5% of a business often leads to less than 1% after a series of equity funding rounds.
You now know to address split of equity amongst co-founders upfront
Be honest about how important each member’s contribution is to the execution:
- How important to the company’s success is the persons experience?
- How much would you have to pay outsiders to do the same work, and can you get the same result?
It may not be a good idea to partner up in a new venture if the team can’t acknowledge that everyone brings valued competences or resources to the table.
A start up need idea equity, money equity, competence equity and sweat equity., if you understand what I mean.
As awkward, as it may feel, you should agree and sign a shareholder agreement amongst the founders. You shall also attach a Founder’s Strategy Direction to you shareholder agreement where you lay out company direction and expectations.
What’s important though is that you and your co-founders is on the same page about it. That equity splitting and strategic plan has to be figured out and put in writing from the beginning.
I hope you enjoyed this short article on how to split equity amongst co-founders. Best of luck with your ventures.