This post was contributed to VentureApp by Daniel Devoe, co-founder and director of marketing at LegalHero, which provides experienced, vetted attorneys at affordable, fixed prices.
When starting a new business with a friend, a former colleague, a classmate or even an acquaintance, it’s easy to get lost in the excitement of starting that business and avoid the awkward but necessary conversation about how to split equity among co-founders. As awkward as this conversation may feel at first, it’s not nearly as uncomfortable as having to deal from the fallout of a poorly structured, unfair, or, worst of all, non-existent equity agreement.
When you think about co-founders and equity, it’s helpful to separate the structuring conversation (things like vesting, repurchase rights, transfer restrictions, etc.) from the actual allocation. The structuring discussion should be easier and is at the end of this post. The allocation talk, however, is where things can get emotional and messy if not embarked upon with clear heads. Here’s how to do it.
What’s Wrong With 50/50?
There’s an ongoing debate out there about whether co-founders should split equity equally among themselves or unequally, according to a formula. In fact, most startup co-founders divide equity equally, even though we think this is (almost) always the wrong answer. Below are some of the more common reasons we hear for splitting equity equally, and why we think those reasons don’t hold water:
“I don’t want to have that awkward conversation…it could lead to a big argument and break up the band.”
The truth is, if you’re starting a business together, you’re going to have to learn how to have uncomfortable but critical conversations in a constructive manner. If you can’t have a productive discussion and come to an agreement on equity, chances are you’re not the right co-founder match.
“We’re all equals, so we all deserve an equal share.”
This is almost never true. Co-founders contribute different skill sets and resources to companies, and to suggest that all of these skill sets and resources are equally valuable is a bit silly. Instead, co-founders give careful consideration to what each co-founder is bringing to the table when determining the equity allocation.
“Splitting equity makes it simple so we can move on to important things.”
It may be the simple solution, but it’s not necessarily fair. And without having an honest conversation at the beginning, this “simple” solution can lead to resentment down the line when some co-founders are contributing more than others.
“We want to make every important decision together.”
That sounds idyllic, but can lead to company paralysis at critical decision points. Do you really want one co-founder to have the ability to effectively hold the company hostage at its most important (and perhaps hotly-contested) junctions?
So if you don’t split it equally, what should you do? If we can get only one point across, it’s this: what’s most important is that you and your co-founders agree to a framework that you can use to determine the allocation of equity. That framework should take into account the attributes, resources and skill-sets that you consider most important to the company, so that equity will be fairly, if not evenly, split among the co-founders.
Follow a Framework
To help guide that discussion, Legal Hero has developed a framework, which you can use or modify to your specific circumstances. In our framework, we separate “sweat equity” (what each co-founder contributes in terms of skills, resources and contacts) from direct contributions of capital (cold, hard cash), which should be treated as it would be from any third-party investor.
For the sweat equity components, each factor is assigned a range of points, and each co-founder is rated on that points scale for each factor. Each co-founder’s points are added up to achieve their “sweat equity” sum of points, and these are divided by the total number of sweat equity points, giving each co-founder a percentage “sweat equity share.” This sweat equity is then balanced against any direct contributions of capital by a particular co-founder to determine what the final equity split should be.
We consider a number of factors to be critical co-founder traits and have incorporated them into our framework. The beauty of our framework, though, is that you and your co-founders can agree on what’s most important to you and add and modify factors accordingly.
Here are the co-founder traits that we’ve already incorporated into our framework:
– What role will each co-founder have in the business? CEOs usually get more equity because of that role. Other co-founders fulfilling critical C-level roles should also receive additional equity for those roles.
– Who is working full-time on the business? Those co-founders who have made the early commitment and joined up full-time already should get more equity.
– Ideas are important! Usually, one co-founder brought the idea to other co-founders. That co-founder deserves some equity for generating the business idea.
– But so is execution! If a co-founder built a prototype or otherwise took first steps to validate the idea, that co-founder should get more equity. (Warning: Don’t make the rookie mistake of not having each co-founder contribute whatever IP or other materials they’ve developed to the company at the time equity is being distributed. Companies get into all sorts of trouble when they realize that they don’t actually own their own product.)
– Are you raising outside capital, and does one person have access to that capital? If so, that co-founder should get more equity.
– Are any of the co-founders experts? Having expertise in the industry is often critical to success and should therefore be rewarded with more equity.
– Does any co-founder have tons of contacts in the target industry? That’s crucial and deserves more equity.
– Who is critical to launching your product? That co-founder should get some equity for that.
– Who is critical to generating revenue? Turns out that all businesses need revenues, so that co-founder should get equity.
Interested in Part II of this series? Learn more: How to Structure Startup Equity After Allocation.
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