Splitting equity among co-founders can be a complicated process. It's important to take the time to hash out the details in order to avoid misunderstandings, reward work fairly, and operate your startup in a way that your team is comfortable with.
In this article, we’ll cover the basic factors to consider when discussing how to divide equity in a startup — including the process of dividing equity among founders — as well as common pitfalls to avoid.
Factors to consider when dividing equity
When it comes to splitting equity among founders, an even split might sound like the most logical option. That said, there are number of additional factors tp consider that might influence how you choose to split your company's equity.
1. Experience and expertise
An important factor you might consider when dividing equity is a founder's expertise — including the years of experience they have in the industry or related industries — and the skills they bring to the table.
Let’s say you’re starting a health insurance technology company. If a member of the founding team has worked at a major health insurance firm for several years, they might have unique insights about the future of the industry. Perhaps these insights have a significant impact on who you approach as prospective clients, where you target marketing efforts, or simply on your company's overall strategy. In a case like this, you might decide that this founder deserves a higher share of the equity.
However, it’s important to remember that expertise isn’t a totally obvious reason to give a founder more equity. Let’s say another founder has never worked in insurance but has been involved in a personal situation that has led her to research the health insurance landscape in depth. As a result, she might have a better idea of what customers are looking for and might bring new ideas, creative approaches, and out-of-the-box solutions to the table.
2. Capital investment
Founders contribute two common types of capital to a venture: monetary capital and sweat equity. Monetary capital means that a founder has contributed cash to help kickstart and grow a business. It’s fairly straightforward to calculate the value that monetary capital adds to a business.
Sweat equity is a little more difficult to define, although it can be equally as important. Generally speaking, sweat equity refers to labor and time invested into the company. Consider these questions:
- How many hours is a founder investing into the company in a given week, month, or quarter?
- Are their contributions something that no one else — or only a few others in the company — can offer?
- Can you establish metrics to track their sweat equity?
One way to determine the worth of sweat equity is to assign a founder’s hourly rate to the various roles and duties they occupy. Another method is to establish a flat rate and track progress by project milestones. This metric can be especially useful when calculating equity for founders offering both capital and sweat equity.
3. Level of involvement
Some founders like to get involved in the daily operations of a company, like managing the product development team. This can impact the amount of equity they receive.
Let's say a co-founder was closely involved with the product from the get-go. They helped set the product’s vision, built out its roadmap, and hired the initial team to execute these plans. In that case, they might get a larger share of equity than a co-founder who was away from the company for the first year and contributed to the product later on.
4. Ideas and intellectual property
It’s often assumed that the founder who came up with the original idea behind the business deserves the larger share of equity, but that's not necessarily the case. An idea that isn’t executed never goes anywhere. If another founder has contributed a valuable skill set that actually gets the company off the ground, their contributions might be just as important.
Of course, if a founder is bringing ideas to your company that they developed on their own or at a previous venture, these ideas can be considered intellectual property. Intellectual property is an important factor to consider when determining what a fair equity split will look like.
5. Salary and other compensation
Often a founder will take a smaller salary — or no salary at all — in exchange for more equity. A founder may also take a larger salary with less equity for a few months, then shift to receiving only equity. Whatever the arrangement is, hone in on a formula that feels fair and is agreed upon by all founders. Then, stick to it.
What is a dynamic equity split?
In a dynamic equity split, the amount of equity each co-founder gets depends on the amount of capital or time they invest into the company. That amount resets monthly and there's a predetermined formula used to decide how the equity should be doled out.
Businesses are often works in progress. As a company's direction, needs, and goals evolve, the roles and depth of involvement of each founder will change too. A dynamic equity split recognizes these shifts and allows founders to split shares according to the value that they add to the company at any given time.
Equity vesting schedules
You may be familiar with a vesting schedule if you’ve ever worked for an employer that offered vesting schedules for retirement contributions or other company benefits.
An equity vesting schedule works similarly. It lays out a timeline for founders to commit to their involvement in the company and ensures they don't walk away from the company too early.
An example timeframe for an equity vesting schedule is four years. After a year, a founder is entitled to 25% of their equity. This first portion is known as the cliff. Once they hit the four-year mark, they can swoop into 100% of their equity. A common caveat is that the founder receives no equity if they split before the one-year mark.
Another way to slice it: Each founder gets 25% after a year of involvement in the company, and the remaining 75% can be doled out in 25% chunks at the end of each year for the following three years.
Common mistakes when splitting equity
Although each situation is unique, there are a few common stumbling blocks founders encounter when deciding on startup equity splits.
- Making assumptions: Assuming one founder is entitled to a certain share of equity because of a certain contribution — for example, if the founder came up with the idea for the company — can lead to disagreements down the road. Keep your assumptions in check by talking things out and be cognizant of the fact that each founder weighs contributions differently. Try to create a metric upon which all founders can be measured equally.
- Not getting it in writing: You'll want to make sure that the equity split you decided on is spelled out in a written agreement. A seasoned attorney who specializes in startups can help you lay out terms, address everyone’s concerns, and inform you of any potential issues that might pop up.
- Mixing business with friendship: There’s nothing wrong with starting a company with friends, former colleagues, family, or significant others, but don’t let the external factors in these relationships cloud your judgment. Be as objective as possible when negotiating for equity.
- Being hasty in your decision-making: Deciding how to split equity is a major decision and it can often be permanent. Act in haste and you run the risk of making a decision that you’ll regret. Take a step back, make sure you have all the information you need, and play around with different scenarios and equity splits before making a decision.
The process of dividing equity among co-founders
Let's walk through the process for how equity deals are reached.
1. Start with a discussion
Before you make formal decisions, hash things out verbally with your co-founders. There are many details that might not be easy to get down on paper and carving out time to talk lets you air your concerns and better understand each founder's perspective. Investing the time to have these discussions comes with another benefit: It shows members that their opinions are valued.
The discussion phase is also the best time to figure out if and how to divide equity to startup founders, advisors, and employees. Flesh out details like whether only full-time employees will be eligible to get equity, how much each employee will receive, what their roles and duties are, and what milestones they need to hit to earn their share of the equity.
Once all founders have had a chance to air their concerns verbally, it's time to put on your negotiation caps and decide how equity will be split up.
If you're feeling stumped about how to iron things out, consider using one of the many founder equity calculators available for free on the internet. These calculators can provide numbers that can help you figure out what to factor in when negotiating.
3. Put it in writing
Now that you have the terms hashed out, it’s time to create a founders' agreement. This legal contract will cover the various equity splits and can be referred to as the company grows.
It’s also your source of truth. From the start, all agreed-upon terms should be outlined in this agreement. This ensures that the best interests of all parties are protected. And if you feel that these terms might change as the company evolves, you can add a clause indicating that certain terms will be reassessed on a monthly or yearly basis.
Don't rush the process of figuring out how to split equity. If you strike the right balance, you can help ensure that your co-founders feel rewarded for their work and stick around for the long run.