How Co-Founders Split Their Equity?
Beginning a startup can be quite an overwhelming process. This is because of the fact that founders need to make many significant decisions. They need to decide the markets which they intend to serve. Also, the product mix needs to be decided.
It is also important that a company chooses its financing and investors carefully. However, there is another important decision that forms the base of the entire company. This is the decision about how the equity needs to be split amongst the various cofounders. This is a strategic decision and can have a long-term impact on the future of the company.
A lot of the startups fail because the key members of the company are not able to amicably work with each other. Even companies like Facebook landed in court because of a dispute between founders Mark Zuckerberg and Eduardo Saverin about how the equity of the business needs to be split. Hence, it is important for the founders to make this decision after careful consideration.
Some of the points which need to be taken into account while making the changes are as follows:
Why do Equity Split Disputes Arise?
Whenever a business is created, founders have to contribute a lot of different things. Some founders contribute more capital. On the other hand, another founder could contribute more time. A third founder may have the expertise required to execute the project and it is possible that a fourth one has the contacts and network required to attract customers and investors. It is possible that these different roles may be split amongst the same founders.
In many cases, it is not easy to assign a monetary value to the contributions of the founders. Also, because of thinking bias, each founder assigns a higher mental value to their own contributions than they do for others. Also, these contributions can keep on changing over time and no one is actually keeping track.
As a result, all founders have very different perceptions of what all the other founders are contributing to the business. Since the founders have to work as a closely-knit team, these conversations can be considered to be offensive as well. This is the reason that, in the beginning, founders are not generally concerned with the distribution of equity. However, when the startup starts succeeding over the years, the amounts grow larger and this is when disputes arise.
Equal Vs Unequal Distribution
The first decision that co-founders need to make is whether they want to split the equity equally or in proportion to their efforts. Now, this decision is ideally personal and should have no impact on the growth of the company but it does have an impact.
Empirical studies have shown that startup companies in which the shares are equally split amongst the co-founders have a lesser chance of succeeding. This is because a lot of these companies are not professional and tend to include their friends and family as co-founders instead of finding the right man for the job. Also, it shows that the team has not carefully negotiated the share amongst each other which is perceived as a lack of negotiation skills.
Investors often avoid companies where the equity is equally split amongst founders. They want the co-founders to have the difficult conversation, iron out their differences, and be on the same page.
Ideally, an equal distribution would be unfair. Instead, the distribution should be equitable and based on the respective inputs that each co-founder brings to the table. This process begins by discussing with the co-founders and assigning a monetary value to each activity. For instance, if a founder is working 40 hour weeks whereas another is working a 10 hour week for the company, their contributions should be prorated monetarily. Once the input calculation is done, the allocation of equity can be done in the same proportion.
Time to Take the Decision
Another important factor to consider is the fact that decisions regarding equity distribution do not need to be taken immediately. Instead, they should be taken over a period of time. This is because, at the beginning of the process, the founders only intend to put in their efforts in the form of inputs. They should be rewarded with actual equity only after the efforts have been put in and results have been obtained.
It is common for startup companies to have a vesting schedule. This means that they start with a particular percentage of equity distribution amongst the co-founders. However, after a fixed period of time, the company issues more shares. These more shares are issued if predetermined parameters are met. This means that if the co-founder in charge of sales has executed his or her target, then they will get a higher percentage of shares that year. Now, since new shares are issued each year, the percentage of shares amongst co-founders can keep changing on a year or year basis. After a certain period of time, the vesting of additional shares can be stopped and the final distribution of equity amongst the co-founders can be obtained. This method allows the co-founders who put in maximum efforts to obtain maximum equity.
The bottom line is that the distribution of equity amongst co-founders is a strategic issue that is often downplayed in startups. Startups need to take cognizance of the fact that this is a crucial issue. They must create systems that allow them to scientifically allocate the equity amongst co-founders.
Authorship/Referencing - About the Author(s)
The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
- Seed Funding - Introduction
- Why is it Difficult to Raise Seed Funding?
- Documents Required for Startup Financing
- How Co-Founders Split Their Equity?
- Proof of Concept
- Minimum Viable Product
- What is Prototyping?
- Asset Light Business Model
- Advantages of Asset Light Business Model
- Disadvantages of Asset Light Business Models
- Cash Burn Rate: The Basics
- Managing the Cash Burn Rate
- Startup Financing and Term Sheets
- Key Terms and Conditions in a Term Sheet of Startup Funding
- Red Flags that Investors Need to Look out for in Term Sheet
- The True Cost of Owning a Property
- Valuation of Early-Stage Startups: The Mindset of Investors
- Pre Money and Post Money Valuation
- Start-Up Valuation: Advanced Concepts
- How Pre-Revenue Companies are Valued?
- Valuation Divergence - Meaning and its Importance
- How Do Option Pools Work?
- What are Capitalization Tables?
- Asset Sale vs. Stock Sale
- Financial Models for Startups
- Key Performance Indicators for Startups
- Restricted Stock Options (RSU’s)
- Veto Rights - Meaning and its Importance
- Financial Benefits of Incubators
- What are Unicorns?
- Why Startup Companies are Staying Private?
- Why Unicorn Companies Fail?
- Building a Startup Team
- Bootstrapping: Meaning and its Advantages
- Disadvantages of Bootstrapping
- Revenue Based Financing
- Convertible Notes and Startup Funding
- Pros and Cons of Convertible Notes
- Simple Agreement for Future Equity (SAFE)
- Keep It Simple Securities (KISS)
- Series A Funding
- Series B Funding
- Series C Financing
- Venture Debt in Startup Funding
- Pros and Cons of Venture Debt
- What is Venture Leasing?
- The Freemium Model - Different Types of Freemium Models
- Pros and Cons of Freemium Model
- Scalability and Startups
- Pros and Cons of Scalable Business Models
- Why Do Start-ups Fail After Receiving Funding?
- Start-ups and Arbitration
- What is a Revenue Model?
- Understanding Investor Focus on Burn Rate
- How Investors Evaluate Start-up Ideas?
- Government Regulations Which Impact Start-Ups
- What is a Start-up Accelerator?
- Managing the Operational Metrics of a Startup
- Different Types of Investors
- The Founder’s Dilemma
- Role of Social Media In Start-Up Funding
- Start-Ups and Public Relations
- Red Flags for Start-Up Investors
- IPO: An Exit Route for Start-Ups
- What is Acqui-Hire?
- How to Build a Start-Up that gets Acquired?
- Legal Issues Faced by Start-up Companies
- Corporate Venturing
- How Reverse Pitching Works?
- Aggregator Business Model
- Marketplace Business Model
- Difference between Aggregator and Marketplace Business Models
- Product as a Service (PaaS)
- Benefits of Product as a Service (PaaS) Model
- Disadvantages of Product as a Service (PaaS) Model
- The Co-Working Business Model
- How Co-Working Spaces Make Money?
- Peer to Peer (P2P) Business Model
- The Instacart Business Model
- The Goodleap Business Model
- The Twitter Story
- How Tesla Reinvented the Automobile Industry?
- How Epic Games Changed the Gaming Industry?
- The SpaceX Success Story
- The Stripe Business Model
- The TikTok Business Model
- Zillow Story - The Real Estate Marketplace
- How Business Cycles Affect Start-Up Companies
- Managing Start-ups During an Economic Downturn