5 Ground Rules from a 5x Entrepreneur To Figure Out Founder Equity Split
Listen to the episode!
Read The Blog Post!
The following is an excerpt from The Startup Playbook, co-authored by Will Herman and Rajat Bhargava
The Value Dilemma – Splitting Equity Between Founders
Once you’ve assembled your founding team, determining how to share ownership of a company is one of the most difficult conversations you’ll have with your fellow founders. It’s also a discussion that may happen multiple times throughout the life of a company. Often, complicating this conversation is the discussion of cash compensation and founders taking below-market salaries. The initial equity ownership conversation needs to cover these topics and create alignment in the founding team.
That’s easier said than done.
Too often, we see founders choose the path of least resistance and opt for a simple solution: split the company equally. This is almost always a bad approach and frequently leads to major relationship issues down the road. It’s far better for you and your co-founders to have the discussion, or debate, up front about who will get what percentage of the company and why. If you find your team heading down the path of equal ownership because it seems easier, then that may be a sign your team isn’t able to discuss and hash out difficult issues—a major red flag for the future success of your company.
Founders aren’t created equal. Someone always takes the lead and becomes the de facto, or elected, CEO. When founders objectively look at their team, they know deep down that some members will have a bigger impact than others on the relative success of the venture going forward. This is, of course, assuming they’ve done their due diligence in assessing each founder’s strengths and weaknesses.
There are any number of approaches you can use to decide who gets what percentage ownership of the company. There is no right or wrong model to use, but as a team, you should agree on the one you want. Part of figuring out your model includes figuring out a structure based on your philosophy for overall compensation to each founder, which can include equity, salary, and potential investment.
Before you figure out your structure, we advocate creating a few ground rules to help you get to a fair result. The following ground rules are some of the ones that we’ve used in the past, and can help to give you an idea of the types of rules you should set too.
Ground Rule #1. Separate the equity a founder receives for the role they play from any equity they receive because they are forgoing salary—
that is, equity they receive in exchange for taking a reduced salary. This approach creates clarity for what founders are being granted equity for. When you mix conversations, it becomes very difficult to understand what a person was given equity for and why. Separate them out, and it will make the conversation a lot easier both now and later.
Ground Rule #2. Consider how valuable the idea is versus the ongoing execution of the startup—
often, the idea is given too much credit as part of the equity discussion. Our view is that the idea holds relatively little value and shouldn’t be credited with much, if any, additional equity. The ability to execute your business plan, however, is worth much more.
Ground Rule #3. A cash investment into the company should be treated separately from founder equity—
similar to the first ground rule, if a founder puts in some cash to help the company initially, the value of the cash should be calculated separately from their value as a founder.
Ground Rule #4. Equity will be vested—
vesting is a process in which a person earns their equity over time. That means they must remain at the company and continue to contribute. If somebody doesn’t work out, vesting is a mechanism that protects the other founders from giving somebody equity disproportionate to their contributions.
Ground Rule #5. Equity may be adjusted up or down based on contribution or role—
this may be more controversial and harder to implement, but founders play different roles over time, and building a startup is a long-term endeavor. If one of the founders turns into a shining star over time and adds far greater value than their anticipated contributions, it may be reasonable to reevaluate that person’s equity relative to others.
After you’ve built some ground rules with your founders on how you will think about splitting the equity, you’ll need to dive in and do it. Hopefully, these ground rules make it easier, but in general, we’ve found this is a difficult conversation regardless of the preparations. Keep in mind, no matter how much logic you use in splitting the equity, there is sure to be a negotiation that ensues.
One simple approach to splitting the pie is to try imagining the company four or five years in the future. Ask yourself, in this scenario, “Who from the co-founding team will have contributed the most to the company? What roles will each person be playing? How critical is that role to the success of the business?”
Another approach might be to structure the equity split around the role that each person is playing today and then figure out what that is worth relative to the other roles. Many positions in a startup have general equity ranges for the role that the person plays at an early stage. These are numbers that are widely available and can be validated through compensation surveys. You can find some compensation surveys online, but even better is to participate in one. To encourage you to do so, the resulting data is usually shared with you for free. Essentially, the idea is to pick a comparative benchmark and then allocate the appropriate amount of equity to each person to create relative ownership among the individuals.
Let’s look at an example of a founding team with a CEO, VP of Engineering (VPE), lead developer, and business development person. This is a likely founding team for a technology startup. A simple model might be to give the CEO 50 percent of the equity, then the other 50 percent is split between the other three founders. The VPE gets half of the CEO’s cut (25 percent). The lead developer gets two-thirds of the VPE (16.75 percent). And, the business development founder gets the remaining equity (8.25 percent). The key here is thinking about the relative value among the co-founders. Using that starting point, you can make adjustments based on standards in your specific market.
Remember, there is no perfect method to allocating equity to the co-founding team. The final decision is based on the value of each person in the context of the startup. That can be a harsh reality for some. For others who may not handle the conversation delicately, they can offend their fellow founders. More than a few companies have stalled at this stage, and many more have had founders depart because they’ve failed to navigate this difficult discussion
Full Episode Audio Transcript
*Note: Transcript generated automatically. Our apologies for any spelling or grammatical errors. But we wanted to at least get you the gist of the episode.