One of the first tough decisions that startup founders have to make is how to allocate the equity among co-founders. A seemingly easy solution to this problem would be to split it equally among all co-founders, since there is minimal value at that point but this is usually the worst possible decision, and often results in a later startup failure due to an obvious inequity.
An equally problematic response to the situation is to overly value the “idea person,” believing that the idea is 90% of the value (and thus 90% of the equity). In reality, the idea represents only a very small part of the overall equation. A startup will thrive only if the execution of the idea is successful, which means that the equity should be allocated based on the value that each partner brings to the table in each of these dominant variables:
- Experience running a startup business. Running a new business starts with building a solid and credible business plan, working the investor funding process, and building an organization from nothing with minimal resources. Successful Fortune 500 executives are often not the best candidates for this role because most would not have experience with any of these tasks.
- Domain expertise and connections. Individuals who are recognized as experts in the business area of your startup who have a good reputation, and who know all the key vendors and customers represent a significant value to the startup. Building a product it is important but it also needs to be distributed and sold through a variety of kinds of expertise, including marketing, technical, financial, or sales.
- Pre-existing intellectual property. Ideas become intellectual property only once they have been converted into patents, trade secrets, trademarks, or copyrights. In many cases, one founder has a longer history with the company, providing an important completed piece of work to the startup and thus can have great value.
- Sacrifice and time commitment. The level of commitment on the part of founders also represents a way to evaluate one’s contribution: A part-time commitment and a full-time executive role should be valued differently, especially if the cash compensation is nonexistent, deferred, or at high risk.
- Funding. Providing the major funding source for an early-stage startup ordinarily entitles the contributor to a significant degree of equity. For purposes of commitment and business decision making, it is best if execution partners retain control of at least 50% of the equity.
One possible approach to factoring equity rationally would be to assign each of the above five items as 20% of the total, and allocate equity based on each partner’s relative contribution to each. For example, if an individual is providing all the initial funding, but has no active business role, it might be smart to offer him a 20% of the total equity.
Equity allocation is usually the first point in a startup where outside help should be considered. This may include seeking help from legal counsel, potential investors, or startup advisors as they may be able to provide experience and more importantly, an unbiased view that the entire team can trust.
It is of utmost importance that the discussion is addressed to right away, and that an agreement is reached quickly, which is then written down. If you and your potential partners can’t get through this conversation in a timely fashion and come to some consensus, then it’s unlikely that your startup can ultimately survive anyway. Startup decisions will only become more challenging later in the process.
Regardless of how the initial equity is split, it is important to consider vesting your founders’ shares over at least two years. This means they will be meted out month-by-month so that a partner who changes his mind or defects early will not walk away with half the company.
The next big challenge for a multi-partner startup is the allocation of roles, including how to assign the roles of CEO, CFO, and CTO. Many of the same variables apply as when considering allocation of equity, but here skills and experience are paramount. The inventor who has the key patent in hand is not necessarily best suited for the role of CEO. Of course, holding key assets and money always provide leverage to management rights as well as economic rights.
All partners should remember that their allocated shares are only the beginning, and will be diluted proportionately when outside funding is later required from angels or venture capitalists. Even if investors diminish the overall percentage of equity, that smaller percentage is still worth more than having 100% equity of a company that fails. The same logic applies to splitting equity with co-founders.