March 6, 2011 19 Comments
So you and a few others have decided to take the leap and found a new start-up – congrats!! Now you just need to decide how to divvy up the equity ownership. Easy, right?
If you default to splitting it up equally among the founders, you maybe making a huge mistake, one with a long-term impact on your working relationship and therefore the success of your business.
All too often we see founding teams decide to divide the pie up evenly when they start. When we ask them why, they often admit they did not want to create a conflict and decided it would be easier to share equally. While there are certainly examples of successful companies where this is exactly how they handled it, we would respectfully suggest you take a different approach.
Instead of sharing ownership equally, agree this is a critical part of the decision in founding the company, then sit down to discuss it in detail. Let each person represent their personal opinion on how the pie (aka company) should be split and their reasoning for this. In the situation described above, if the person taking the CEO reins is expected to keep that role long-term, it is logical to expect they would own a larger share of the business, just as a VP Marketing would be expected to own a smaller piece. Yes, every situation is unique in some ways, but usually not so unique that you can justify an equal equity split between the CEO and VP Marketing, even if they are both founders.
So, how to deal with the conflict this can create and ensure you have a good working relationship from the start? We always have the same reply – if you are not comfortable disagreeing with your co-founders and dealing with the conflicts that a topic of this much importance, you should reconsider starting a company with this team. Odds are you will work together for a number of years and during that time you will run into countless situations where you do not agree on the best course of action, or are unhappy with one of your co-founders for some reason. What better time than right now to figure out if your team will be able to work through these situations together and come out the other side stronger for it?
For companies that have taken our advice and had the “hard” discussion on equity up front we have without fail heard positive results from the process (note: this does not mean all the companies succeeded in the end). Invariably the equity splits are not equal but each of the participants comes away comfortable with their ownership and the reasoning behind it.
Below is a framework you might consider using for this discussion. There are a few simple steps that require you to pull together a little bit of data (or ask us and we’ll see if we can give you what you need), and will require you to think about each of the individual founders, their role and long-term expected contributions.
Step One: Determine equity ownership for each person if they were not a founder
Figure out what an employee being hired into each of the respective founder roles would likely receive in terms of equity ownership. We recommend you think about this as a company that just closed a Series A financing round, and all these positions are being filled on the same day.
For the sake of this example, lets assume the middle of the range for a CEO hired in this situation would be a grant equal to seven percent, a CTO would receive three percent and a VP Marketing two percent. As shown in the sheet below, you have a ratio of 7% – 3% – 2%, or applied to a one hundred point scale (as in 100% of the company equity), 58.33% – 25.00% – 16.67%
Step Two: Make situational specific adjustments
Start with the 7% – 3% – 2% ratio and adjust as you think appropriate. There are a number of reasons you might adjust someone up or down, and you should think about these possible factors and then sit down to discuss them and agree on which are relevant and applicable. Possible factors to consider might include the prior experience of each founder including in the role they will be taking at the company, each person’s respective time and financial commitment to the concept before the founding of the business, and each person’s specific domain experience in the sector the business will be focused. For this example we’ll include the following factors:
(1) The CEO is a first time CEO, and while the founders think he/she is capable of filling the role over the long-term, this is not a certainty. If this person was hired into the role they’d get a lower equity grant to reflect this inexperience. In this case the founders agree it would be closer to 5.5% instead of 7%.
(2) The CTO is an experienced VP Engineering and is planning to fill a dual role for the first 12 months and then recruit a VP Engineering into the business. Given this dual role, but accounting for the 12 months they will hold it, the founders agree this person would get an extra 1% grant if they were hired in to fill these roles soon after a Series A closed.
(3) The VP, Marketing has good experience in this role and has some of the key contacts needed to launch the business. This person also played an important role in bringing the three founders together in the first place. The founders agree that these factors warrant a bump of 1.5% to 3.5%.
Making these changes you now have equity ownerships of 5.5% – 4.0% – 3.5%. Again, applying this to a 100% scale, the resulting equity ownership would be (rounded to the nearest full percentage point) 42.31% – 30.77% – 26.92%.
We recommend rounding the final results so you can start with a cleaner cap table. In this case the equity would round to 42%, 31% and 27%.
Step Three: Apply the Sniff Test
So you’ve gone through the process and come up with the following equity ownership for the three founders:
CTO – 31%
VP Marketing – 27%
Now think about it for a little while and get back together to review. Do these splits feel right? Does anyone feel slighted? Did you make the correct adjustments? If you need to tweak more, go for it, but if each of the three founders can look each other in the eye at this point and say they feel good about the outcome and are ready to get rolling, then congrats, you’ve cleared an important milestone.
We recommend that after this process is complete, the founder who ends up with the most equity take his/her co-founders out to a nice dinner to say thanks. If you don’t do this, and the business is a screaming success down the road, it is only fair that you will buy them each a sports car (or similarly priced trinket) when the company has a liquidity event.
Note: We have been asked how to account for things like the option pool and seed investments in setting founder equity. Our advice is to deal with these things AFTER setting the founders equity as above. The option pool should be added on after the fact so that it impacts each of the founders equally in terms of pro rata dilution. Seed financing should be handled the same way, unless it was raised prior to setting these amounts (in which case you should read some of our posts about working with the right attorneys, as this is a suboptimal sequence in terms of things like pricing founders shares and your personal taxes.