Co-Founder Equity Split: How To Split Equity Among Co-Founders?
The first and the most significant deal of all the deals in a startup is typically the one that determines how to split equity among co-founders? The significance of this deal lies in the fact that it has the power to negatively impact all the subsequent deals in a startup.
Noam Wasserman in his book titled, “The Founder’s Dilemmas”, claims that startup founders often describe their equity-split negotiations as “war,” “exasperating,” or “stressful”. In fact, as per his research, 65% of startups fail due to problems within the management team.
Now, one of the major dilemmas that contributes to the problems within the management team in a startup is the manner in which the co-founder equity split must take place.
As per research, startups consider a minimum of three important dimensions when dividing equity between founders. These include the timing of the equity split (early vs. late in the evolution of the startup), the amount of time spent negotiating the split, and the degree of equaling vs. inequality in the founders’ equity stakes.
For instance, the founders of Zipcar adopted a 50/50 split model after founding the company. However, later they realized that the quick negotiation had negatively impacted the long-term effectiveness of the team.
On the contrary, the co-founders of Ockam had decided to spiky equity unequally. This was because one of the co-founders worked as a junior under the other for 7 years before both of them decided to build their startup.
Since the contribution of each of the co-founders towards the startup was different, the decision of splitting equity among founders unequally was quite reasonable.
It is clear that there is no one-size-fits-all approach that founders rely on for dividing equity in a startup. Founders across different startup teams consider a wide range of negotiation processes and outcomes before they decide to spilt equity among themselves.
In this article, we are going to talk about what is founder equity and the factors that founders consider to split equity amongst themselves. Besides this, we will also discuss the founder equity split process.
What is Startup Equity?
Startup Equity refers to the right or share of a team’s founding members on the future profits of the company if there are any. It is a promise and not the actual remuneration for the founders to have control and a share in the company profits.
The control and equity share that each of the founders has in the company profits depend on their contribution, performance, and actual time spent working on the project. This means that founder equity grows along with the company’s growth.
But, at times, founder equity may be subject to vesting. Now, what is vesting? Vesting refers to the time period for which a founder needs to stay with the company in order to earn the share of equity assigned to them.
The process of vesting prevents the founders who are no more interested in the project from leaving the startup. Thus, the concept of vesting is good for those founders who work hard and want to stay with the firm.
Michael Seibel, the CEO of Y-Combinator’s Accelerator Program says that “the equity share that your founders get would motivate them to stay with your company through the years it takes to build the company. As a CEO, you need to think about what your founders want even if they themselves do not think about their long-term interests at the moment.”
Siebel further says that “the biggest falsies that I hear from the founders is that we came up with this equity split based on the negotiation. As a CEO, you need not split equity based on negotiation but you should do it based on what would maximize the motivation of your co-founders.”
Besides this, Siebel suggests that startup founders can use the Vesting and Cliff schedules as a safety net against the danger of co-founders leaving early. “Vesting and cliff can be your primary mechanism of safety. This is your hedge. On the flip side, you have to be more generous in giving equity to the founders. You need to understand that equity is going to motivate your co-founders to stick with the company for a long period of time.”
Taking this into consideration, the following are the major approaches to co-founder equity split.
Major Approaches to Co-Founder Equity Split
Primarily, the following are the two approaches that the co-founders while dividing equity in a startup. These include equal equity split and dynamic equity split.
1. Equal Equity Split
The Equal Equity Split approach is the one in which the founders of a startup divide the shares equally among themselves. Say for instance if there are ‘n’ number of founders in a startup, the equal equity split would be allocating 1/n shares to each of the ‘n’ founders.
The experts who promote equal equity split believe that giving a low equity share to a co-founder indicates that the team does not value the co-founder’s contribution. This can ruin the relationship among the co-founders.
As per research, the co-founders can consider different trade-offs in the negotiation process to determine whether to split the equity equally. Two of the most important aspects of such a process can be the timing of negotiations and the time taken to get to an agreement.
a. Timing of Negotiations
The timing of negotiations may include the earliest date and the latest date. The earliest date of negotiation can be at the beginning of the project. Whereas, the latest date of negotiation can be when outsiders buy ownership in the venture.
The major advantage of late contracting is that it helps to resolve the uncertainty involved with early contracting. This is because late contracting may allow the founders of a startup to understand the skill sets and the contributions of each of the co-founders.
Also, founders who are confident about their relative contribution may prefer late contracting. This is because they have the fear of being undervalued at present and believe that they can attract a good deal in the near future.
On the other hand, the major benefit of the early negotiation is that the founders are able to protect themselves against the opportunity being stolen away. Besides this, founders who do not want any sort of confusion will certainly prefer early negotiation.
Additionally, an equal equity split agreed upon in an early negotiation is more likely to be associated with poor venture performance. This is because the uncertainty about knowing the skill sets of the individual founders is extremely high.
However, an equal equity split agreed upon in a late negotiation is more likely to indicate proper team understanding.
b. Time Taken For An Agreement
The equity split negotiation process involves some time in reaching an agreement. This is because founders take time in understanding the skill sets of each of the co-founders, the importance of different skills, and tasks performed by the co-founders. In addition to this, they also consider if they require any outside help, all of which takes time.
Now, there can be two possibilities with regards to the time taken to reach the founders’ agreement. The negotiation process can be quick where the founders spend minimum time negotiating the terms of the agreement. Thus, in such a scenario, the team can start working on the core tasks of the venture.
However, a quick handshake agreement can also be an indicator that the founders lack the ability to resolve the conflicts. This may also result in poor negotiation outcomes with suppliers and buyers. Hence, poor negotiation may negatively impact the performance of the venture.
Besides this, quick negotiation is less likely to be well-structured that further impacts the venture performance.
On the other hand, the negotiation process can be slow where the founders spend more time negotiating and communicating the terms before reaching the final agreement. This may help the founders in understanding each other in a better way.
Benefits of Equal Equity Split
- An equal division of shares does not consider the relative rankings of the co-founders.
- Further, it does not demand the co-founders to resolve any potential difficult points of disagreement.
- In addition to this, some founders believe that an equal equity split may promote team cohesion as the rewards would be distributed equally among themselves.
Downsides of Equal Equity Split
- Some founders may turn out to be less productive over time on account of the inability to upgrade skills or losing commitment towards the venture.
- Equal equity distribution may create a lack of hierarchy, a leadership vacuum, and possibly a voting deadlock.
Impact of Equal Equity Split
- Equal Equity Split may be an indicator of hidden fundamentals like insufficient negotiation skills on the part of founders. Further, it may also reflect a lack of founder confidence on account of lower venture performance or less entrepreneurial endurance.
- It may negatively impact the performance of a startup as the incentives are not sufficient enough to motivate the founders to stick with the startup for a longer term.
- An equal equity split may result in a deadlock kind of a situation when making decisions. Michael Seibel suggests that in order to prevent a leadership vacuum or a voting deadlock, CEOs can resort to having a proper vesting or cliff schedule in place. This can be the primary mechanism of safety for founders.
2. Dynamic Equity Split
The second approach that founders adopt while dividing equity among themselves is the dynamic approach. The dynamic approach of equity split is the one in which the founders evaluate the individual co-founder’s contribution towards the startup in terms of resources he gets on the table. Such resources may include:
- Founder experience
- Contribution to the founding idea
- Contribution in terms of financial investments in the venture
- Time invested in the startup venture
- Roles and responsibilities of a co-founder in a startup
Thus, in a dynamic equity split, the co-founders determine the value of each of the inputs and divide equity among themselves according to each co-founder’s share in the whole pie.
Further, an individual co-founder’s share changes over time to ensure that each co-founder always has exactly what each of them deserves to have.
Also, in the case of the dynamic equity split model, the co-founder has to give away his share in case he leaves the startup or is fired.
In other words, the equity is divided unequally among co-founders in the case of a dynamic equity split. That is, the dynamic equity split approach is performance-based.
Benefits of Dynamic Equity Split
- It ensures the fairest equity split possible and maintains fairness even as things change.
- Each co-founder gets exactly what he deserves to get.
- The Dynamic Equity Split also tells the co-founders what to do when someone leaves the company.
Downsides of Dynamic Equity Split
- The weights assigned to values are questionable.
Impact of Dynamic Equity Split
- As per research, more-experienced founders are less likely to split the equity equally. Further, founders bringing varied financial investments and contributing differently towards the founding idea are also less likely to split the equity equally among themselves.
- In addition to this, entrepreneurial teams having more co-founders do not agree to an equal equity split. Also, such teams are less likely to negotiate quickly.
- Considering the performance of a startup in terms of employment, startups in which founders negotiate early and quickly have relatively fewer employees. And considering the startup performance in terms of the capacity to raise funds, startups adopting an equal equity split are less likely to obtain venture capital.
It is important for the founders of a startup to understand the long-term implications of allocating equity before dividing equity in a startup. Thus, the startup founders must choose an approach that suits their personal beliefs and matches the company culture.
They should create a plan to determine the individual contribution of each of the co-founders towards the startup growth.