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, in itself this is not often 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 both inspire and support co-founders is via an 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, they are 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 shares and the other two people only 10%, investors are likely to doubt trust in this team.
Co-founder vs First Employees
Before giving away your startup equity to newcomers, you need to understand who should be involved. It’s important to realize the difference between 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 (more or less) defined 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. 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 is 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, as legally the company shares will stay with this person (unless otherwise provided by the contract) and in the long run can create a real headache for other partners. That is 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 the right given to an employee to buy a certain number of shares in the company’s stock. Private companies (especially startups) frequently use a stock option plan to reward their key employees. You might consider, say, 10% of your company’s 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.
How to Divide Equity among 2 or 3 Co-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 (or with little distinctions) 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
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. For example, 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.
If your startup comprises of three co-founders, the most suitable 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!
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.
- Shareholder’s agreement
It is advisable to think over 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 (and success) of your idea!