Legal Services for Entrepreneurs in Colorado

How Should I Split Equity in My Startup?

Splitting Equity

If you are trying to split equity in your startup it can start with some third grade math. Add your equity to your co-founders’ and get to 100%, right?

Not so fast.

Consider the following scenario. You and another co-founder have quit your full-time jobs to work on a company. There are also four other people who have joined the company, a tech developer, an industry expert, a high-powered sales guru, and a CFO-type. They haven’t quit their 9 to 5s, but still provide value. And you know, after talking to advisors and lawyers, that you’re supposed to leave aside a certain percentage of stock ownership as an “option pool” for future employees.

How do you split the pie?

What seemed like an easy math problem is something more complicated. Splitting equity, like many things, is simple, but it ain’t easy. It’s a delicate calculus that has a mathematical and a human component. Like everything about your business, it requires careful consideration.

To start, founder equity should always come with a vesting schedule[1].

This means you have to stay with the company for a certain period of time before you receive unfettered ownership of your portion of the equity. Without a vesting schedule, if three co-founders divide equity evenly among themselves and one quits after a month, the departed co-founder takes off with a third of the company with them. Or you have to buy them out. You do not want that.

The standard vesting schedule is structured like this. After a year, you are entitled to 25% of your equity, but if you leave the company before a year has passed, you are entitled to nothing. This is referred to as the “one-year cliff.” For each subsequent month, you earn an additional fraction, until four years’ time with the company at which point you will have earned all of your equity.

Of course, there are variables in this equation. What if you sell the company after two years? Do you forfeit half of your equity? The answer is it depends on how you structure your documents. If you have “single-trigger acceleration” then you don’t, but there are alternatives that may not provide for full vesting. This is something you should consider with your co-founders, your lawyer, and then may have to negotiate with investors.

And what if a co-founder resigns after 10 months due to a cancer diagnosis? Shouldn’t she be entitled to some portion of her equity?  In theory, the documents say the co-founder is entitled to nothing. And while some lawyers may argue that that is a fair result, if it were my company, I would want to come to a compromise position that rewards the departing co-founder for her time.

The next thing to take into consideration is the options pool.

If you’re like most startups, it’s going to take years for your company to grow into what you want it to be. This means that you haven’t met or hired some of the people who will eventually contribute to your company’s success. This is why companies have an options pool, which sets aside a percentage of the equity to incentivize future employees. Depending on the company, this may range from 10-20%. I usually recommend 15% — though this may vary depending on the size of the founding team and the company’s stage of development.

Many founders want to leave aside some of the initial equity for investors. I think this is a mistake, for a number of reasons. I don’t think that startups should have an equity raise at the very beginning. Startups should raise capital initially with a convertible note, a SAFE, or a similar instrument, one that does not trigger either an initial valuation or require an immediate sale of stock. When startups do sell equity in their company, they will usually be selling their investors “preferred equity,” which comes with rights and privileges that must be specified and enunciated in the formation documents of the company. Until you negotiate these terms with investors, you can’t know what the rights and privileges will be. Best to wait until you cross that bridge to set up that class of stock. And when you do cross it, all founders will be diluted equally.

Okay, now that we’ve got the basics out of the way, it’s time to get into the nitty-gritty of your company. And here’s how I propose that founders do it: Founders should create an excel spreadsheet or google doc and create two columns for each founder, one with past contributions and one with expected future contributions.  Past contributions may include the idea, the building of the team, the name, some intellectual property, or any number of other considerations. Expected future considerations will vary tremendously, but the founders should do their best to figure out who is going to take the company from nothing to something of value, and reward the ones who are going to contribute the bulk of the value to the company.

Often, one co-founder is more experienced, has more connections, and works harder. The other just has the idea. In these situations, it is important to consider each founder’s contribution. Who has the capital, who has developed the intellectual property, who has put in the most time? Opportunity cost. Should someone who quits their gig at Goldman Sachs get more equity than the guy who was waiting tables? Probably. But only if investment banker boy is contributing more to the future value of the company.

There isn’t just third-grade math involved but people’s feelings as well, which are always hard to manage. But this is part of the business of running a company, and if you’re not equipped to handle the equity conversation, you will probably also struggle with many other hard conversations. Like I said, it’s not easy. But, in the world of startups, if there’s one universal truth, it’s that things are almost never as easy as the initially appear.

[1] Do not try this at home. I’ve had many founders come to me after they put together their own founders’ documents, and they universally get it wrong. Be smart. Include professionals in your process.

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