One of the earliest challenges company founders face is on how to distribute equity in a startup. Getting the ownership structure right at the outset certainly doesn’t guarantee success, but making errors on something so fundamental as startup equity distribution can hinder the business in the future.
You will need to consider equity distribution strategies early on for employees, advisors, and investors, but the initial and potentially most awkward question to grapple with is how to divide equity among partners in a startup?
Generally, there are two schools of thought – go for an even divide or opt for a weighted split, with the latter approach awarding more equity to those deemed deserving of it, based on an agreed set of criteria. There’s no definitive right way to proceed on how to allocate equity in a startup, though it is certainly possible to get it wrong, and a misstep at this point can have far-reaching consequences.
Which direction do you go in?
So, how do you decide the best way forward? How do you settle on an approach for how to divide equity in a startup at the outset that will best set you up for the future?
If each co-founder contributes equally to the business and is expected to continue to do so into the future, then an even equity split is a no-brainer, but it won’t always be so straightforward. That being so, founders need to look with a dispassionate eye on how they each contribute to the business and how those roles may change in the future.
Also, while founders will begin their business journey together full of excitement and enthusiasm, it would be naïve to imagine that individual relationships will never break down or that no founder will ever leave the company. That being the case, it is also important at the outset, when considering how to negotiate equity in a startup, to put in place provisions and clauses that will protect the company in the event of conflict and/or departures.
That being the case, when looking at the equity split and the rules around it, we need to think in terms of personal considerations between the founders – relationships, roles, and performance – and also how to protect the company in the future.
Against that backdrop, the following are some of the key points to be considered:
How much of the load are the founders willing to carry to grow the business?
Has one or more of the founders been more committed to getting the business off the ground?
Early on, there may be little or no money available for salaries, and depending upon the circumstances of the individuals involved, it is not unusual to have one or more of the devoting all their time to the project, while others might still have a full-time job elsewhere and focus on the new start-up in the evenings.
Without dismissing the efforts of those who also work elsewhere, it is clear there are two different levels of commitment in this scenario and some commentators maintain that that should be reflected in the equity split, at least until such time as the imbalance is addressed.
Is someone taking more risk?
This is related to the point above but is worth addressing separately. Basically, you need to be clear on who is taking on more risk at the outset. Is one founder quitting their job to devote themselves 100% to the new endeavour? Is another holding on to a full-time position and putting in their work on the new business outside those hours?
It doesn’t necessarily follow that factors like these should dictate the equity split, but it is a relevant consideration for the conversation.
Who had the initial idea for the business and how should that be acknowledged in the equity split?
At first glance, the initial idea might seem to be the most important element of all, and while it is true to say that without an idea you have nothing, it is also true that an idea is just the beginning. Once the idea has been voiced, the focus will very quickly shift to delivery and execution, and without those two things even the best ideas will struggle to come to fruition.
So, again, it’s about balance and awareness. How did the idea come about? Was it a product of group brainstorming? Did one individual think of it in the first instance? Are there intellectual property implications
These are some of the questions that need to be asked.
Will individual roles change over time?
The role an individual founder plays today may change over time, and perhaps that role will be less vital in the future. Of course, the opposite may also be true – the skills and talents of one founder may become more relevant over time, as opposed to at the outset. The key point here is that it is important not to base decisions on how to allocate equity on the early state of the company. As the company develops and grows, the internal dynamic will shift, with the skill sets of individual founders coming more to the fore at different times.
So, just because one individual might be the key performer in the early days, it does not necessarily follow that they should receive a bigger slice of the equity.
Considerations when looking to protect the business
Having a clear exit plan is important even if you're not planning to exit
As stated above, relationships can turn sour. This can happen for any number of reasons, and it won’t necessarily be anyone’s fault. Sometimes personalities simply prove to be incompatible and when that happens someone may ultimately decide it is best for them to leave the company.
At that point, things can get a little messy on the equity front, unless you had the foresight on day one to make provisions for just such an eventuality. There are several different approaches you can take when drafting an initial shareholders agreement to protect the business when a founder departs.
Have a selling restriction
The idea of a founder trying to sell their equity on the secondary market would be unwelcome to their fellow founders for any number of reasons, not least of which being they might find themselves having to work with someone that they don’t know or don’t want to work with.
One way to avoid this is to have a formal selling restriction in place. This would prevent a co-founder from “going rogue” and doing as they please with their equity. In practical terms, this kind of restriction can take two forms – a right of first refusal, which would give the company the right to match any offer made by another party, and a blanket transfer restriction, whereby the company would need to offer its consent for any equity transfer.
While the right of first refusal protects the company, in practice it is not the ideal option. Depending upon where the company is at the time in terms of growth, it may not be practical or desirable to buy out a co-founder. On a simple level, the company might not be able to afford to do so.
With a blanket transfer restriction, such a provision would need to be put in place early in the life of the company, as it would be difficult to go to shareholders later on and effectively ask them to give away their right to sell.
Use reverse vesting
Under reverse vesting, a founder who leaves the company within a set timeframe will be obligated to sell their shares to the other founders. Typically, the reverse vesting provision will be in place for the first 3-4 years of a company’s existence. This provides certainty, in that the founders know they will not be facing serious equity-related upheaval at a point when the business is still finding its feet, and neither is it too restrictive on the individuals in that they are only obligated to sell to other founders for an agreed period of time.
There is a wealth of information available online on splitting equity, and you owe it yourself to take the time to examine it. In some respects, the area of founders and equity splits is a lot like entering a marriage with a pre-nuptial agreement. It’s more practical than romantic, but it doesn’t mean you care about each other any less.
Here at Global Shares, we know the most important advice for companies looking to launch their own equity compensation plans because we've helped so many to do it. From startups to public companies, we can help. If you're interested in equity compensation, and want to make sure your equity is in good hands, contact us for a free demo today.