Splitting the Pie
- An early decision that can often trip up founders is how to divide the initial equity issued by the startup. While there is no cookie cutter approach to this question, the following are some general principles founders should follow:
Future Effort– The vast majority of the equity awarded to founders should be based on the likely future effort needed to make the company a success. Founders often over-value their contributions to the initial intellectual property upon which the founders are basing the company. A general rule of thumb is that the founders’ equity granted in exchange for existing intellectual property being assigned into the company should be less than 10% (across all contributors), and often significantly less.
Aligning Interests & Properly Incentivizing – Don’t get too hung up on trying to precisely nail each founder’s value. Instead, think about aligning each participant’s interests with those of the company. To do this, you need to incentivize each participant to work their tails off to build a great company. The right question is: how much equity is needed to properly incentivize exceptional effort from all involved?
Multi-stage Transaction – Founders should also recognize that taking a startup from concept to commercial success is a multi-stage transaction. Investment rounds will often serve to correct any misalignments of interests between founders, the company, and investors. For example, if a technical founder has 15% of the equity in a startup, but his or her role has become more important to the company than originally anticipated, investors will recognize the need for that founder to have a larger share of the company in order to be adequately incentivized. The investors may require a reapportionment of the founders’ equity as a condition to investment.
Keep it Simple and Follow Established Models to Address Future Changes – Founders (especially student founders) are often concerned about the difficulty of allocating equity when the future time commitments of founders is up in the air. Founders may be tempted to try to create an equity allocation that adjusts periodically based on the contributions of founders during that period of time. This is unnecessary, can be unhealthy to team dynamics, and can cause tax complications.
Fortunately, there is an industry accepted model for aligning the interests of founders with the company and giving the company the flexibility to adjust its relationship with founders that are not living up to their end of the bargain. This model includes:
- establishing a “reverse vesting” schedule for each founder that grants the company a repurchase option in the founder’s unvested equity if the founder’s service to the company ends;
- providing the company the ability to terminate a founder’s service at will (either through termination at will provisions in the employment offer letters or service contracts, or as a provision in the restricted equity agreement).
Accordingly, if a founder is not contributing the expected value to the startup, the startup can seek to adjust that founder’s equity split to something more appropriate. If the founder acts unreasonably and is not willing to adjust his or her equity, the startup has the ability to terminate the founder’s service and stopping the founder’s stock from vesting. This threat will either incentivize the founder to act reasonably and agree to an equity adjustment, or provides the company the ability to end its relationship with that founder without the founder leaving with equity that he or she did not truly earn.