Once you’ve decided upon the number of co-founders your startup needs, it is high time to think about the benefits these people will receive. As a rule, founders who join the project mainly rely on the startup idea and successful future. However, this is not enough to fully motivate them for maximum efforts. After all, the idea alone will not feed their families – money always matters and you should keep this in mind. Since at the early stages startups sometimes don’t even have enough revenue to pay salaries, one of the most common ways to inspire and support co-founders is a startup equity split.
Why Allocate Equity among Startup Co-founders?
The answer is quite simple – to boost loyalty. An equity split is the distribution of one’s degree of ownership in an entity. This is the most expensive yet valuable asset. If a co-founder owns some shares of your company, he/she is automatically given some authority in decision-making processes. This elevates co-founders’ enthusiasm while showing your gratitude and respect to them. Equity distribution only underlines the importance of the contribution made by each team member to the company, that motivates your partners to do their best.
Note: Investors pay special attention to the way co-founders allocate equity because it tells them a lot about engagement and solidarity inside the team. If for example, in a team of three co-founders, one person owns 80% of startup shares and the other two people only 10%, investors are likely to doubt trust in this team.
Who Gets Startup Equity
When thinking about how to allocate equity in a startup, the first question should be: who is going to be involved. Very often not only co-founders, but also other people like investors, key employees, or advisors take part in the startup equity split. There are several levels of the priority list. Co-founders go first, then the interests of investors are considered. If you have an advisor or a professor who contributes to the startup project, put this person before your first employees.
As a rule, independent startup advisors get up to 5% of shares (or no equity at all). Investors claim 20-30% of startup shares, while founders should have over 60% in total. You may also leave some available pool (5%), but don’t forget to allocate 10% to employees. Based on the most outstanding skills of co-founders, define your roles clearly within the company and assign job titles. It is important to mention that while distributing the responsibilities, startuppers should think about their long-term expectations. It means that you all need to understand the future of your career and potential responsibilities & risks. Leave all uncertainties behind and open up to the team.
Co-founder vs First Employees
Before splitting founders shares, you need to understand who is who. It’s important to realize the difference between the first employees and co-founders. This will enable you to build a clear hierarchy in the company and avoid inner disagreements.
First and foremost, an employee works by an employment contract. They have a fixed salary and working hours. An employee does not take any huge risks working for you – and from your side, it’s easier to lay off and replace this person. De facto, you may find it difficult to let them go, but de jure it’s quicker and less painful. As a rule, first employees join the company only after it has received initial funding and grown to 5+ people.
By contrast, a co-founder does not have a monthly salary but owns a part of your company’s shares due to the equity agreement startup offers to sign. This person plays an active role in decision making and demonstrates high commitment. Co-founders may work either “24/7” or just a few hours per week as a part-time job. Their primary motivation is the idea, and that’s why co-founders tend to think in the long term and are good at strategy planning. These people join your startup before the initial funding and work on the project from scratch.
Nevertheless, if one co-founder suddenly leaves the company, this affects the whole team and business. Legally the founders shares will stay with this person, and this creates a headache for the startup team. Unless otherwise provided by the startup employment contract equity shares are wasted. That’s why you should think clearly when putting together the co-founding contract and initial agreements.
Employee Stock Options
It is worth mentioning that dedicated employees can also get a small percentage of equity shares, the so-called employee stock option. Simply put, a stock option is a right given to an employee to buy a certain number of shares in the company’s stock. Private companies, and especially startups, frequently use a stock option plan to reward their key employees. You might consider 10% of your startup equity for the most dedicated employees.
Employee stock options typically fall into two categories: outright award and performance-based award. The latter is also referred to as an incentive award. Companies either grant outright awards of stock options (upfront) or on a vesting schedule, i.e. they grant incentive stock options per the achievement of specific targets.
In case a startup wants to expand offshore, employee stock options are also applicable to offshore teams. At their growth stage, startups look to alternative opportunities and find IT talents in other nearshoring countries. Having a product-oriented mindset, the local tech specialists are highly interested in contributing to the success of their startup company (even if they work remotely). For instance, with the help of Alcor, several US tech companies have made use of stock options for their Ukrainian software development teams, and this practice is going to continue.
Stock Option Plans for Offshore Developers
In Ukraine, there are many offshore software development teams that work for US-based startups. Employed as independent contractors, developers are thought to have no access to the startup bonus system. On the contrary, local software engineers feel a part of the startup team and contribute as much. Naturally, co-founders consider rewarding their offshore employees with stock options. According to the new regulation of 2017, it’s become easier for Ukrainian independent contractors to invest money abroad and keep assets in other countries. Thus, employee stock options from foreign companies have become available in Ukraine.
In Ukraine, a developer is obliged to pay taxes right after signing the employee stock option agreement and then once more after receiving stocks. This situation makes companies opt for another kind of stock options called phantom stock plans.
In essence, phantom stock is a benefit given to selected employees without the real ownership of equity shares. The value of phantom shares follows the market price of the real equity stock of the startup. Having met certain criteria, an employee is rewarded. The company pays the difference between the initial price of shares and the current one (as if the employee has sold his/her shares).
Depending on the mechanism of bonus calculation, two types of phantom options are distinguished:
- “fully paid” (after “selling” their phantom shares, the employee is paid the current market price of his/her shares;
- “appreciation only” (an employer calculates the difference between the value of the shares at the time of the stock option agreement and the current value of the shares).
The “appreciation only” option is close to a classic option with the sale of shares. Even though it doesn’t work like true stock option plans, the phantom stock looks very attractive to employers and employees. While an employer can include this money as a bonus into the salary, employees pay no additional taxes. Having the desire to engage their fellow engineers in Ukraine, startuppers can benefit from lower taxation burdens.
Stock Option in Startups Can Be Risky
The most important thing is to understand that an option is not equity or stock in the startup company. Stock option plans only give employees the right to buy the startup shares. Stock options are useful when a startup company cannot offer a competitive salary. In this way, employers balance out lower wages. However, startuppers should keep in mind that this bonus is quite risky. On the one hand, if the company will be doing well, owners of stock options will be able to buy a pre-determined number of shares. Since you agree upon the fixed price, chances are the price on shares will raise and you will get a good bargain. On the other hand, if the company fails the stock option and shares will have no value.
For employees, it is vital to understand the percentage of their ownership. It seems that 10,000 stock options are a really good number, but it doesn’t mean anything unless you understand their percentage. For instance, 10,000 can be 10% (10,000 of 100,000) or 1% (10,000 of 1,000,000) of the overall stock. For this reason, get more information on the recent round of investment and the market value of your company.
How to Split Equity among Founders
First of all, you need to have deep discussions with your co-founders to ascertain what each of them is bringing to the table. For the most part, the contribution of co-founders is fairly equal and the main task is to define any gaps and present them in numbers (percentages). For example, one business partner looks for investors, arranges business processes and does marketing, while another co-founder codes and leads all product development. At first sight, it seems to be a fair 50/50 split – but what if the latter works only part-time, and the former umpteen hours per day? As can be seen, time and engagement can make a significant difference, so while splitting equity you should take into account the following:
- Experience and expertise
- Time and commitment
- Business plan preparation
- Responsibilities and risks
- Money invested
Startup Idea in Equity Allocation
It is a common misbelief that the idea is everything. The idea alone isn’t an asset until it is brought to life. There are dozens of examples when promising startups with brilliant business ideas failed due to inefficient management. That’s why make sure you don’t overestimate “the idea guy” in your team of co-founders. What really matters are expertise and time – because they make the business move. The more committed a founder is, the more result he/she brings. It goes without saying that previous experience can be a game-changer. The knowledge and expertise of co-founders may keep your startup distanced from many troubles. This is also connected to responsibilities and duties because the level of responsibility presupposes more skills, workload, and stress.
When evaluating the risks each of you is exposed to, try to include both personal and financial factors. For instance, one of the founders has to leave their job to start up with you, and another invests the largest amount of cash. After that, add points to those who participated in the creation of your business plan. The following template demonstrates the major points for consideration when discussing startup equity allocation with co-founders. It’s still up to you to decide which type of contribution deserves the priority.
On this account, you could discuss a percentage ratio. If your team of founders consists of only two people, you can divide equity equally – 50/50 – and although this is a common practice many startup advisors do not recommend it.
A Fair Split Doesn’t Work
The investor and entrepreneur Mike Moyer states that equal-stake founders follow their blind guesses about the future in terms of company value and individual contributions. According to him, start-uppers should be very specific and precise while dividing equity in advance of actual work. On the one hand, both co-founders are financially balanced and secured. On the other hand, it can scare investors away. They usually find a 50/50 split impractical and immature as if you are not ready to talk about money seriously. Startup decisions will only become more complicated later on, so you need to come up with clear agreements from the get-go.
“A quick, even split suggests that the founders don’t have the business maturity to have a tough dialogue,” says Noah Wasser, Harvard Business Professor.
From your perspective, a 20/80% equity split seems to be a better percentage ratio for startups with several founders. It shows investors that your team is actually in agreement and has one prominent decision-maker. To have a strong leader is good unless there are only two of you in a startup.
In the case of only two people, when one co-founder owns over 70-80% of company shares, the other partner may feel underestimated. His/her 20% will be diluted to 14-10% of shares after investors come in with their 20-30%. Consequently, your partner will be left with almost nothing and become demotivated.
The win-win solution for two co-founders is 45/50. This model includes everything: leadership, responsibilities, risk, and expertise. Give the 5% to the “idea man” in the startup or your CEO for his/her key business acumen. The figures can fluctuate around 45/50, giving preference to the most distinguished contribution point. Anyway, be ready with some explanation of such allocations in front of investors.
How to Divide Equity to Startup Founders, Advisors and Employees
If your startup comprises of three co-founders, the most suitable startup equity split is 30/30/40 – investors will not make a big fuss and your company still has a decision-maker. It’s also possible to go for other options like 15/15/70, 20/20/60, or 25/25/50. However, in this situation, your co-founders receive less than 30% of company shares, which will dilute even more in the end. If you are serious about working together with your team for years, express it with the help of numbers!
Taking into account the above mentioned, the equity allocation in a startup can look in the following way:
Pitfalls to Consider
Never forget about venture or angel investors and their interests in your business. At the seed stage of funding, they usually ask for 20-30% (not more than 33%) of ownership in your startup. As a result, your shares will be diluted proportionally. As mentioned above, it means that if initially, you had, for example, a 20/80 split and the investor received 30%, your percentage ratio of startup equity would fall to around 14/56. It may be unpleasant to admit that the investor now owns more of your startup than one of its co-founders. You can hardly do business without investments, yet make sure you take care of your partners and provide them with enough ownership at the beginning.
Unfortunately, one cannot be 100% sure in their partners. To secure oneself, it is highly recommended to put co-founders on a vesting schedule. Normally, sensible start-uppers sign a vesting agreement according to which co-founders will get their equity shares only over 4 years with a one-year “cliff” period. It means that in the first 12 months the person wouldn’t receive anything (even if he/she decided to leave the company). After this period, the agreed ownership percentage is transferred to the partner every quarter (or monthly) over the next four years. A vesting schedule helps to ensure that founders are a nice fit – and if you happen to have problems while working together, there’s a year to fix them with no losses.
It is advisable to think about what would happen if one of your shareholders decided to leave the business and sell his/her shares. To avoid letting unwanted people into your company, consider the priority right for other shareholders to buy these shares (and include this point in the shareholder’s agreement). In addition to this, keep in mind that your former co-founder could become a “competitor” to your startup business and, what is more, headhunt your key employees. To be on the safe side, consult IT lawyers and work out a well-built shareholder’s agreement.
No one would ever say that starting up a business is easy. Co-founders encounter the most crucial difficulties at the very start of their work, and startup equity allocation is one of them. This article shows that equal or close-to-equal splits of startup equity among co-founders are the most reasonable choice. Of course, you can allocate shares in a different way based on what value each of them brings to the project. The main thing is to keep the right people in your team and work out the execution of your idea!