Startup Founders: Should You Divide Equity Equally?

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Startup Founders: Should You Divide Equity Equally?

 


I get this question fairly often from new startup teams.  Often the teams consist of founders that were classmates, colleagues at a prior job, etc.  The question is: 

Should we divide the equity in our startup equally?
 
The short answer to this is:  No.

The longer answer is of course, slightly more interesting. 

Here are some of the reasons I get for founders wanting to do this.  I will assume there are two founders, but all points apply equally well to three or more founders.

Why Founders Argue For Equal Equity
  1. It’s Simple:  It avoids the need to have complicated discussions and negotiations.  In my opinion, there are definitely complexities and debates you should avoid in the early days of a startup.  This is not one of them.  The initial equity allocation is an important factor in the future success (and sanity) of the company.  The issue should not be skirted.

  1. We’re All Equal:  This is kind of the philosophical argument.  The premise is that all of the founders are equally qualified, will equally contribute, etc.  So, the argument goes, we should divide the equity equally.  I’ll argue that this is rarely ever the right answer.  Deeper inspection will reveal that one or more founders are deserving of more early equity than others.  The founders all have different (even if similar) experiences, different opportunity costs, different relevance for the new startup, etc.  It’s hard to convince me that it just so happens that two people came together and that they just so happen to have identical value to the new startup.  Even if you were born as twins, not separated at birth and lived identical lives, chances are, you’re not “equal” in this given context.

  1. There’s No Right Answer, So Might As Well Divide Equally:  This one is starting to get at the heart of the real issue.  The thinking here is, in the absence of sufficient data to justify otherwise, it’s easier and better just to divide equally and get started building/running the company.  This is a very tempting argument, but also not a good one.  I think it’s possible to pick a couple of “dominant variables” to use as an objective benchmark.  

  1. We Want Equal “Skin In The Game”:  This argument proposes that to ensure all parties have an equal vested interest in the successful outcome, they should have an equal number of shares.  I think this is a weak argument.  The reason is that “skin in the game” is a situational measure (not an absolute one).  How people perceive risk, and how that impacts their behavior (in terms of incentives) varies from person to person and situation to situation.

  1. The Debate Over Equity Will Kill The Company:  This is a troubling argument (but I’ve heard it a few times).  The thinking here is that trying to figure out the “right” answer is filled with too much emotion and anxiety and rather than kill the startup before it even really gets started, it’s better to just push past this and create something of value.  I’m troubled by this argument when I hear it, because it is usually a sign of trouble to come.  If you can’t talk about hard issues (like equity distribution), amongst the founders right now – how will you have the other hard conversations later?  Startups are replete with difficult and often emotional decisions.  Trying to ignore the early issues in the hopes that “things will get better later” is asking for trouble.


Of course, the obvious question is, if you shouldn’t divide it equally, how should you divide it?  I don’t have a magical formula for this, but will give you some points that might influence your thinking so you can objectively “triangulate” to an answer:

1.  Is there pre-existing IP and/or effort?  (i.e. did one founder actually start the company before the others joined)?
2.  Fair market value vs. actual compensation for all founders.  So, if one founder makes a larger sacrifice (in terms of cash comp.) this might raise her equity stake.
3.  Focus of the company:  Is the company technology, marketing or sales focused?  If so, this might impact which founders will presumably bring the most value.
4.  Cash investment: by a founder:  This should be treated separately from the equity allocation (and the founder in this case is also an investor).
5.  Degree of commitment:  Is one founder keeping their day job for a little while?  If so, it might warrant lower equity.

Note that this article does not cover the also interesting topic of why you don’t want to divide equity equally (yes, there are downsides).  Purpose of this article is to make the case that thought and effort should be put into this and you shouldn’t just “revert to the default”.

Summary of My Point:  The issue of equity allocation amongst the founders is just one in a series of difficult decisions that need to be made with a minimal of data and objective criteria.  I’d advise getting outside help (legal counsel, potential investors, startup advisors) etc. as they may be able to provide experience and more importantly, an unbiased view that the entire team can trust.  But, the answer is almost always never “split it equally”.

Posted by Dharmesh Shah on Fri, Jun 23, 2006

COMMENTS

I am right in the middle of this now. Taking a 100k investment. One thing that is incredibly helpful is to use a LLC instead of an S-Corp. The flexibilty of dividing profits, responsibilites, etc., is enabling agreement. And you don't need a lawyer!!!!

posted on Friday, June 23, 2006 at 12:54 PM by stacy



You might find this an interesting read as well. It goes one step further and gives frmewrk that hellps to be more objective.
http://www.andrew.cmu.edu/user/fd0n/35%20Founders'%20Pie%20Calculator.htm

here is another interesting link
http://www.sfu.ca/~mvolker/biz/structur.htm


Rajan

posted on Friday, June 23, 2006 at 1:49 PM by Rajan


I've always treated co-founders with the respect and reward each deserves (per the the value they add to the company) but my style is such that I run the company as the founder with others coming on board with option grants, using a Stock Options Agreement that is in line the industry standard for high-tech/software startups, and not common stock, which is reserved to the founder/enabler/starter.

I agree with Dharmesh regarding the obvious foundational flaw in dividing equity on equal basis. I find that the only position to be in is not to "argue" for equity but to negotiate bringing people on board under fair terms.

:)

Marc

posted on Friday, June 23, 2006 at 7:55 PM by


There is a flipside to this topic. I recently (actually the same day this article was written) had to walk away after a year with a company that my business partner and I founded because we could not agree on equal equity. In the beginning we had divided the equity 75/25 because he already had a business plan and was talking to investors and needed me to quit my job and join him to build a prototype and put together an engineering plan. After a few months it was evident that the idea would not get funded. We decided to stick with it and gradually (over one year) came up with a new business plan, new product, new investors and new customers. This idea does look like it is fundable, but everything was the joint effort of both founders; however, the original founder is adamant about not giving up any more of his equity (based almost solely on the belief that as CEO he deserves almost all the equity). I went through analysis of what a fair equity division would be (even using the pie calculater mentioned by Rajan), talked to almost every founder/entrepreneur I met about this topic, and came to the conclusion that there was strong justification for this to be a 50/50 partnership.

Maybe there will be something to salvage here, but I am preparing my self to learn about the transition out of a partnership which could be complicated since he hopes to secure funding from investors that I made the introduction to. I have no idea where this will lead - there are several legal issues to address if we do dissolve.

I learned three important lessons, though. The first, choose your business partners very carefully. In some situations I may have considered forging ahead but I learned a lot about this person through this experience that raised other questions than just the equity. Trust is critical between founders. There should be trust that if contributions change significantly, then equity may be redistributed. I don't believe this should be done lightly; however, there need to be thresholds set where you will agree to reallocate if they are exceeded. We actually did set these, but they were not honored.

Second, don't get emotionally attached. I believe in the idea we have created; however, I do not believe the opportunity cost of going forward in the current relationship versus exploring something new is worth it. It would definitely require 3-5 years (or longer) to reach an exit from this venture. There are enough ideas out there that I can take what I have learned in the past year and apply it to a different venture.

The last lesson is to consider everything a learning experience. Even though this did not work out, I do not regret the last year. Everything I learned will be helpful towards my next venture and I certainly had more fun in the past 15 months than in any "job" I have ever had.

posted on Saturday, June 24, 2006 at 1:15 PM by David


My first experience was the opposite of Dharmesh's post, but over time I have come to realize that it was a fluke.

A high school buddy and I formed a software company with 50/50 split, we spent seven years building it, even raised some VC money (they didn't like the 50/50 split at all). In the whole time, we never had an argument or major disagreement. We sold out to a public company 11 years ago, and we still meet for lunch once or twice a month.

Since then I've been involved with numerous startups and have seen the above-mentioned problems with 50/50 or 33/33/33.

Despite my one very good experience with 50/50, I would definitely agree with this post.

posted on Friday, July 07, 2006 at 5:20 PM by Roy Smith


why determine all % from beginning?
it's near impossible to guess what will happen which is why I created this google spreadsheet (still somehwat rough)
http://spreadsheets.google.com/ccc?key=phOOkNUCAg0K2JCkXVvTgNA
just save a copy to play with it
it's pretty straightforward and requires there be one "decider" who is kept in check by a rule that he not be payed more than a predetermined rate.
It ensures fairness no matter what happens to the company - investment, purchase, hiring, firing, quitting etc.
It could be made much more sophisticated, it's just a start.

I named it "friend keeper" for obvious reasons.

posted on Thursday, November 16, 2006 at 8:02 PM by Jeff Krupman


Control over the company goes hand in hand with this too. If someone has more equity (more risk) wrapped up in an endeavor, they are naturally going to demand more control over decisions. And deservedly so. 
 

posted on Tuesday, July 29, 2008 at 2:09 PM by jquaglia


i was stupid enough to trust my partners to be fair and not negociate a management contract in a 50/50%company. they put an initial investment of 30,000euros..and out of that after 4 years made 4 shops, invoiced 500,000euros,.recuperated losses , made profit...never got a salary.any money at all!!!!..and now they claim they had as much input as myself in the company and that my claims for a misery salary of 1200,euros are unfounded.legally they are in the right .NEVER AGAIN anyone want to buy???

posted on Thursday, March 26, 2009 at 2:13 AM by dahlia


This could be a series of articles on common issues faced by founders of startups. Honestly, many of my ideas for projects/ventures have languished mainly because I did not have a good grasp of what would be the "right" amount of equity to offer people when I could not afford to simply pay for their services. Would love to see this topic expanded.

posted on Tuesday, April 21, 2009 at 12:33 AM by Tariq Nisar Ahmed


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