Every entrepreneur needs to address this question at some point. Figuring out how to best divide equity in a new venture is one of the most critical decisions to take early on, as it has the longest lasting implications.
Fundamentally, equity means ownership. And in any venture, ownership matters. I believe that in my career thus far I’ve managed to get it wrong and get it right, and sometimes end up somewhere in between. This post stems purely from my personal lessons learned, along with some external observations to round out my recommendations.
When dividing equity among co-founders, two key questions must be addressed:
- How much equity does each person get?
- What happens if somebody doesn’t pull their weight, or abandons the project?
I will delve into each question separately.
How much equity does each person get?
I believe that the amount of equity that each partner receives should directly reflect the size of their contribution to the venture. Contributions (or value add) can be made in three main ways, namely:
- Operational skill
- Time and energy
Operational skill covers the role played by the particular co-founders. For example, in a tech startup, key roles could be sales and marketing, software development, and product design. Or in a restaurant, there would be a chef and a manager. In many startups, people have to take on multiple roles at the same time.
So to determine the value of the operational skills being added, the partners should assess the intended roles of each party as well as their skill level, and predict the impact that this would have on the venture. For example, a salesperson may be crucial to landing key deals, or a developer may be crucial in building an initial prototype to sell. The size and nature of the value add per person will vary from project to project. This would need to be thrashed out internally until a common view is developed.
A premium (i.e. increased equity stake) should definitely be added for the person fulfilling the role of Project Leader or CEO, and every venture needs a leading CEO character. A startup where this role is not clearly defined and supported by all parties is risking it’s future for a number of reasons to lengthy to get into in this post.
Time and energy refers to the physical time commitment of each co-founder to the project. Often, this is not as easy as “we will all do this full-time”, nice as that may sound. It’s possible that one partner would work on the project after work, or only on weekends, while the other(s) may be doing it full-time.
The time investment to be made by each partner (as well as when that could change) should be defined up-front, and factored into the equity split. For example, a highly experienced salesperson founder would naturally receive a large equity stake in a business, however, if they are involved on a part-time basis while there is a software developer involved on a full-time basis, the developer’s stake should probably be greater. And vice versa.
Money can be contributed to the venture in two very simple ways. The first is that a co-founder is making a cash investment in the project. When a commitment to invest money is being made, I believe that the co-founder investing the money should propose the terms and valuation that he believes is fair, and the other partners can hammer out the negotiation. To keep everybody honest and the deal feeling fair, all parties should be allowed to invest at that decided valuation at that point in time.
The second way that money can be contributed to a venture is when a co-founder is saving the project cash by working for no salary. This situation should only affect the partner’s stake when they are doing this while working substantial hours (e.g. 18+ hours per week), not for part-time involvement as that contribution can be assessed based on skilled value add only.
The final area that can affect how co-founders divide equity is the concept of who was there first. This topic always comes up, and it can take on two different forms, specifically:
- It was my idea.
- I have made progress on my own but need to bring in partners.
People who try to push the “it was my idea” line of reasoning as a means to get a larger stake in a venture need to be avoided. There is very, very little value in an idea on its own. The blood, sweat, tears and ultimate rewards come from execution. If the originator of the idea is bringing special domain knowledge to the project, then their contribution can be assessed under the basis of operational skill, as discussed earlier. Nobody should ever receive a founding equity premium (i.e. a larger stake) on the basis of coming up with an idea first.
On the other hand, if somebody had an idea and tried to start executing on it on their own before deciding to approach partners, that is a different story. In these cases, the co-founders should asses how much progress that partner achieved and where that puts the project in terms of traction and momentum. If the project has indeed progressed beyond ground zero and is out of the starting blocks, then it would be fair that the original founding partner receive some sort of premium for that effort.
Now that we have a decision framework for determining value add by each co-founder and dividing equity in the venture, we need to address the elephant in the room that is often ignored by co-founders starting out: what if a partner is no good, or if a partner quits?
Both of these fears regularly become a reality for new ventures! And it far more common among people that have never worked closely together for a meaningful period of time before (which happens more often than not).
This is where the concept of the “golden handcuff” becomes very useful. Co-founders should be “handcuffed” to their ventures, i.e. there should be a strong incentive to keep them fully involved. A good mechanism to manage this process is founder vesting. Basically, vesting means that partners need to earn their equity over a period of time, and stand to lose their equity if they leave the venture. Generally speaking, all vesting structures in new ventures should allow for accelerated vesting if the venture is sold before the partners’ vesting periods are up (i.e. they get to reap the value of selling their entire stake at time of sale).
Vesting structures can be pretty simple or extremely complicated.
A basic structure could be: 50% vested up-front and 50% vested in total at the end of 4 years, so if the partner left before 4 years they would lose half their stake.
I believe in taking a more nuanced approach to better manage the risks associated in dealing with co-founders. Here is my proposed vesting structure for a new project, fully explained:
- Vesting period: 36 months (3 years is adequate time for partners to prove their commitment).
- Up-front vesting: 10-25% of total stake (this gives each partner a strong sense of ownership in the beginning, which is important in motivating them to make the venture succeed, and it also recognizes their willingness to seriously commit to a new project).
- Vesting method for remaining equity: 1/36th of partner equity vested every month (this is a fair way to incentivize continued commitment with continued reward, as opposed to an all or nothing approach).
- Probation period before up-front vesting is recognized: 3 months. (The 3 month period provides the co-founders enough time to work together to get a sense of team dynamics, commitment and value being added).
The last point around the “probation period” requires more explanation, as it links back to the question I posed earlier: “What if a partner is no good?”. A partner can be no good for a venture for a number of reasons, such as:
- They are difficult to work with.
- They are not putting in the hours/pulling their weight.
- They are not as skilled as the co-founders initially believed and cannot deliver the productivity and results expected when the project was started.
As in hiring new employees, the operational value and viability of a partner in a startup can be assessed fairly quickly.
Then why do so many co-founders charge into equity splits and end up with partners holding on to stakes that they (the other partners) are not happy with, you ask? Well, I believe it’s because co-founders are often blinded by the romance and enthusiasm of a new project and see the world through rose tinted lenses, and as such would rather avoid these painful “what if” discussions with their partners.
The inclusion of a probation period takes this significant risk into account. At the end of the 3 month probation period (or sooner), a decision can be made as to whether every co-founder will proceed in their envisioned roles, or if somebody needs to be cut from the team, and not receive any equity at all (except if they have invested cash already, in which case the cash should either be returned or the co-founder should receive the pro-rata amount of equity deserved for the investment to date). Unfortunately, this is a lousy thing for the person that is dropped (if such an event happens), but all founders must take this risk, and it ensures fairness and alignment among the team, placing the best interests of the venture at heart.
If the co-founders feel that a partner is not living up to expectations, the manner in which I propose that the decision be made is by a simple majority vote. Specifically, if more than say, 50% (exact amount can change depending on number of partners) of the venture’s owners (by equity value, not number) vote a partner out before the end of the probation period, then that person must leave.
I further believe that this system should remain in place even after the probation period has ended, i.e. the majority shareholders should be able to vote a co-founder out of the business, however, that co-founder would be entitled to keep (or sell) their equity vested up to that point. This additional mechanism ensures that co-founders keep pulling their weight and adding the expected amount of value to the venture on an ongoing basis. Remember, without such a clause in place the alternative for the remaining co-founders when faced with a non-performing partner would be to fire them but have them entitled to hold on to all or most of their equity in the venture.
If a partner is forced to exit the venture, the leftover equity, now unassigned, can be dealt with in a variety of ways, such as being earmarked for a new partner or an employee share pool, however the easiest method is for the leftover equity to be split pro-rata among the remaining active partners.
In teams of two where equity is divided 50/50 (a split I don’t often recommend) then voting somebody off the team so to speak does not make any sense. In this scenario, the unhappy party should have enough guts and sense to realize quickly that the partnership isn’t going to work out, and abandon the project completely or restart it on their own.
I realize that this is a sobering view on how to divide equity among co-founders in new ventures, but it is the product of years of experience and many lessons learned. When applied properly, this system would be very fair for all co-founders, leading to better alignment and increasing a venture’s chances of success.
I hope that this post was helpful. As always, I’m interested to hear your thoughts on this topic.