Pass me the knife – how to agree on the equity split amongst cofounders
Splitting the equity in your startup usually sounds like a straightforward task. You incorporate a business, create share capital, give it a nominal value and split the shares equally. If you use a good accountant or online provider, creating the shares is simple enough. The hard and underestimated challenge is precisely how to divide up the equity.
There are circumstances where a 50/50 or equal split will be appropriate. The conditions for this are where the cofounders are equally experienced, skilled, and committed. In addition, everyone is also putting the same amount of cash, time and effort into the venture. There are a lot of variables in that list, which means that in reality, when it comes to shares, some founders are more equal than others.
You might think not splitting the pie equally sounds a bit mean-spirited. "Sure, nobody is the same, but we are all in this together.” As good as this sounds, take note of startup guru Prof. Noam Westerman, who said:
"A quick, even split suggests that the founders don't have the business maturity to have a tough dialogue."
Ouch.
The reason for the tough love is if you don't make the right equity split at the start, it can come back and bite and causes real grief for the team and the business. The most common issue is that a founder feels they are not getting an appropriate reward for their efforts and the value they have created. When this happens, the results are often unreconcilable resentment and acrimony.
Having a larger slice of equity normally means more decision-making power; you all need to be comfortable with this, whether you have a larger or a smaller piece. Finally, in some cases, getting the initial cap table wrong can also mean the business becomes uninvestable.
“A quick, even split suggests that the founders don’t have the business maturity to have a tough dialogue.”
So how do you get it right?
There are a few ways to tackle this. One way is to use a tool to help you work this out. A couple of useful resources to look at is the Founder's Pie Calculator and this online tool. They are helpful as they guide you through a more systematic approach to working out who gets what, including acknowledging the person who came up with the original idea.
The Founder's Pie calculator does not discriminate on what type of skills a founder brings to the table. Instead, it asks you to evaluate how much domain expertise each founder can bring to the venture. Ideally, cofounders will have complementary skills that will bring different value to the project over time. For example, in a tech startup at an early stage, the technical founder will probably add the most value as the product gets built. Once you are ready to launch, the marketing focused founder takes centre stage, and then when the revenue starts coming in, the operationally minded founder may become most important. These changes, over time, show how reliant you are on each other for your long-term success.
The Founder's Pie also bunches commitment into one broad term. Commitment could be time spent on the business, money invested or even the opportunity cost of doing this over something else. It is quite hard to assess, so we would recommend you focus primarily on time invested and the seed capital each founder is prepared to put into the business as the primary inputs into this metric.
The last thing to consider once you have put in all the inputs and have calculated an answer is whether the equity split seems fair. What’s more, you need to check that it is sufficiently motivating for everybody. For example, if a three-founder team calculated a division of 60%/30%/10%, is the founder who is only getting 10% going to be suitably motivated to put their all into the business? If the answer is no, then you will need to look at ways to address this. Also to be remembered is that your shareholding will be diluted down to an even smaller share of the overall equity pot if you gain any outside investment.
Adding a safety net
Even with a rigorous systematic approach, it is still possible to get this wrong. Sometimes we misjudge each other's intentions, misvalue our networks, experience and skill and, more often than not, forget that our circumstances change. For example, one of your founding team could move abroad, receive a job offer too good to turn down, have changes in their home life, or simply become disinterested. When this happens, it can be unfair to the rest of the founding team. An excellent way to protect yourself from getting derailed by the unforeseen is to use cliffs and vesting periods. A cliff means shares are only awarded after an agreed event (usually a period of time or a specified deliverable). A vesting period means that the founders are gradually awarded shares over an agreed time horizon. Cliffs and vesting periods mean if something goes wrong during the vesting period, the founder, who does not do what they originally set out to do, must give or sell some or all of their shares back. [For further reading, see this Seedlegals guide].
Our recommendation to founding teams is to use a systematic approach, and The Founder's Pie is a great place to start. Look at what the tool is telling you, and then double-check your input assumptions to be satisfied that the allocation is fair. Split the shares accordingly and then use the safety net of vesting periods (potentially with cliffs) to ensure the amount of equity a founder ends up with is ultimately equitable with the value they each bring.