How to split equity in a fair and efficient way?
Splitting equity is often a neglected topic and done at the last minute. However, it provides an important foundation for the success of your company, so I have asked myself if there is one formula that would allow everyone to get it right.
Even before splitting the equity, you want to make sure that you have the right people in the team. It is probably the single most important indicator for the success of your business and for getting funded. Equity can be a key motivator for people to participate in a Startup, but it can also be a reason to leave it. I am sure you know at least one of those stories where cofounders didn’t get along happily ever after. And if that happens, hopefully, you have defined how to handle such a situation. So you want to make sure to create the right foundation and keep your team motivated.
There are two main models that can be used to split equity, one is static, the other is dynamic. Before getting there let’s have a look at what aspects should be considered when splitting equity:
- Eligibility: Identify people for the core team, and differentiate between key employees and non-key employees. A (future) Org Chart can help here.
- Expectations: What are the individual goals. What functions are cofounders going to have and how much time are they planning to work?
- Contributions: Are cofounders investing cash or contributing other resources, networks, or IP?
- Importance: How important is their contribution to the success of your venture?
- Roles & Responsibilities: Who is going to do what? Who will be the CEO?
- Risk: What risk is everyone taking? What are the opportunity costs for everyone?
- Motivation & Fairness: What feels fair to the people individually and overall to the team.
- Investors: What impression would it make on investors? Is it comprehensible why you split the equity like that?
These considerations should definitely go into the decision-making process whatever the mechanism may be for splitting the equity. A value-benefit analysis can make this process more structured and faster, especially when using the static model. For the dynamic model, some of these factors are considered automatically. However, you might want to make adjustments before the equity becomes fixed, which will be the case at some point. When evaluating the methods to split equity one should think about the pros and cons before, during, and after splitting equity. The latter especially refers to cofounders who are leaving the ship prematurely.
Fixed Model (equal or unequal):
A fixed or static equity sharing model means that the cofounders must assign a certain percentage of the shares to each cofounder, which can be equal (e.g. 3 cofounders get one-third each) or unequal. In many cases, it is unlikely that each cofounder provides the same value to the Startup and will do so forever in the future. The main characteristic here is, that once it is agreed, the share ownership is fixed.
- Pro: Simple to set up.
- Con: Potentially tough negotiation and demotivated team members.
- Pro: No further activity is required (Milestones and Vesting should be in place).
- Con: A change in the scope of work will not be reflected in share ownership.
- Pro: Clearly defined ownership percentage (assumed proper vesting was in place).
- Con: Unjustified exit for cofounder (company valuation does not represent the fair value of contributions) or dead equity.
A dynamic model refers to the change of ownership percentage, which may go up or down over time. Typically, the equity will be split based on the value of contributions that everyone is making, such as money, assets, connections or IP. The main contribution is going to be time though. Hence, it makes sense to value the time of each cofounder and allocate the shares according to the value of the contributions. This model is especially applicable to bootstrapping companies.
- Pro: Clear rules and flexibility.
- Con: More difficult to understand, not well established yet.
- Pro: Always clear valuation of contributions. Provides transparency.
- Con: Effort to keep track of contributions. Events (e.g. incorporation) may trigger a fixed equity status and require additional considerations if bootstrapping continues.
- Pro: No negotiation about compensation of leaving cofounder, as the contributions are always valued.
- Con: None that I am aware of, as the effort for keeping track of contributions is now paying off.
These two models are not 100% mutually exclusive. There are certain events, such as the incorporation of your company, where you have to call the shots and make a decision on the ownership. Then a forecast or value-benefit analysis can be good practice to adjust the ownership. For each of the methods, it is equally important to have a proper cofounder’s agreement, including a vesting schedule based on milestones and/or time, potentially a cliff even for cofounders and a definition of bad and good leavers and how they are compensated, etc.
If I had to give a recommendation, I would choose the dynamic method as I believe it provides key benefits. It is fairer and less influenced by negotiation tactics. It provides transparency and active participation from everyone. Keeping track of the contributions can be a challenge, but online tools (such as bootstrpd.com) can facilitate that process and even provide additional benefits for the cofounders, like managing your time properly, handling expenses, compensating external supporters or even proving your commitment to investors.
Especially for early-stage companies, I believe tracking and valuing contributions is somewhat comparable to insurance. You hope you will never need it but in the worst case, it will be priceless to have it. Assuming your company has a valuation and you finally know how much that 5% of your leaving cofounder is worth, the valuation of companies often exceeds the value of contributions by far, even considering a risk premium. Hence, a payout based on the value of contributions including a risk multiple seems fairer for someone who is leaving at such an early stage.