When you’re 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 and structure equity among co-founders. As awkward as a conversation about this 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.
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 they are rarely equally valuable. Co-founders should 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 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 we don’t split it equally, what should we do? What’s most important is that you and your co-founders agree and commit 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.
To help guide that discussion, we have 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 traits that we’ve 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. (And don’t forget to make sure that intellectual property is transferred to the company and not solely owned by one co-founder.)
- 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.
Without further ado, here’s our proposed framework, which you can use and modify to help guide your equity split discussion. [DOWNLOAD EXCEL SPREADSHEET/CALCULATOR]
How To Structure The Split
While determining the actual equity split is critical, many co-founders make the mistake of ignoring important structuring considerations. In the best-case scenarios, not thinking through how to structure co-founder equity can lead to resentment. In the worst-case scenarios, not thinking this structuring through can lead to company failure and lawsuits. Structuring should be the easy part on which all co-founders can agree without emotions and egos coming into play.
Most co-founders of businesses would never consider issuing options to an employee without attaching some sort of vesting schedule, but so many issue themselves stock outright with no vesting. This is a huge risk, because it creates the possibility that a co-founder who works on the company for a very short period of time walks away with a massive chunk of equity. To understand this (unfortunately not uncommon) phenomenon, we first have to understand what vesting is.
Vesting is the process by which a founder accrues non-forfeitable rights over stock. Vesting generally conforms to a schedule, which defines the time period over which the stock will vest in installments. For example, if stock vests on a monthly basis over a 4 year period, then that means that, each month over the course of the 4 years, 1/48th of the total stock grant will vest, so that 100% of the stock is vested after 4 years. Sometimes, there is a “cliff” attached to the vesting schedule, which is the time period that must pass before any of the stock vests. Using the example above, if we add a one year cliff, then 25% of the stock will vest after one year (the cliff), and then 1/48th of the stock will vest during each month for the remaining 3 years.
Without vesting, all co-founders receive their full grant of equity on the date of the grant. That means that, even if a co-founder changes her mind the very next day and decides she doesn’t want to devote herself full-time to the business, she still owns her fully-allotted share of equity. I think we can all agree that that’s a horrible position to put yourself in, so why do so many co-founders resist vesting anyway? The answer is simple: many co-founders want to avoid imposing those same vesting provisions on themselves, and they can’t ask their co-founders to do something they themselves won’t do.
There are a couple of reasons we think this avoidance doesn’t make a ton of sense. First, if you’re raising venture money, your investors will want to see that you’re subject to vesting and will often require it. Second, if you’re worried about not being fully vested at the time of a liquidity event or when you leave the company, you can address these concerns with accelerated vesting provisions that cause your stock to become fully vested upon certain events. For example, you may provide that you and your co-founders’ stock immediately becomes fully vested upon an acquisition, so that you can enjoy the fruits of your hard work! Or, if you’re worried about being fired for no reason, you can provide for acceleration upon firing without cause.
In any private company, owners like to have a say over who owns the stock, because nobody wants a stranger out there controlling a significant stake in the company. Founders’ and Restricted Stock Agreements often contain transfer restrictions, which prevent any co-founder from transferring stock to any third party except for certain enumerated cases (such as to heirs in the case of death).
Rights of First Refusal (ROFRs)
Rights of First Refusal, or ROFRs, give other co-founders the right to buy stock that’s being transferred to a third party. It works by giving the non-selling co-founders the right to match the price that’s being offered by the third party buyer.
Repurchase rights give the company the right to buy back any vested and unvested stock from a departing co-founder. Usually, barring unusual circumstances (like being fired for cause), vested stock is re-purchased at fair market value, while unvested stock is re-purchased at cost.
Starting a business should be an exciting time. And even though it’s stressful, it shouldn’t be stressful because of bickering over equity. Approaching that conversation with some knowledge, thoughtfulness, and trust can make the process of structuring and splitting equity fast, easy and, most importantly, fair, so that you can focus on building your business and actually making that equity worth something!
* If you've found this information valubale be sure to check out Legal Hero's free ebook: 26 Legal Issues Every Entrepreneur Must Know.
Annie Webber is CEO of Legal Hero. You can find related content on the Legal Hero Blog, follow Annie on Twitter @AnnieFWebber and the company @LegalHeroInc.