You started a company with a couple of your good friends. Some have put in more money or time than others, but you feel like you can trust each other. That’s why when it’s time to formalize the business and raise money, you all come to the non-confrontational answer of how to split up the equity: equal ownership for everyone. It’s simple, seems fair, and avoids any awkward debates. But does it really make sense?
The answer is likely to be “no”, although it’s what many startups do. While splitting equity evenly is a good way to avoid an awkward discussion today, it may set you up for failure further down the road — when the stakes are higher.
The Dangers of Splitting Up Equity Equally
Prospective investors will be skeptical when they hear that there’s an even-split. They will want the equity split to determine each team member’s level of contributions and commitment. If the split doesn’t match the respective contributions and commitment, the team is not going to be incentivized appropriately to get the job done. Investors are especially wary of uncommitted founders that try to exert a disproportionate influence but don’t meaningfully contribute to the startup’s success.
It may reflect upon the team’s ability to run an effective startup, as well. Investors may be inclined to think the founders are not sophisticated enough to know what type and level of contribution it will take by each member, based on his or her role, to grow the business. Worse, they may just write off the startup as being unprepared to discuss the question of equity, chalking it up to the founders being hesitant to tackle tough issues.
At the very least, if you’ve decided to go with an even-steven split, you should be prepared to explain your reasoning (read on for guidance on that).
The other reason the split should be more thoughtful is more obvious: things can (and will) change. Your co-founders may already have insight into their respective future commitments and how much effort they can realistically put into the startup’s success. The startup may require more work than one of the co-founders wants to put in, leading them to tap out early. At that point, a tense conversation may ensue and it will likely be harder to change the split – leading to legal headaches, tax issues, and strained relationships.
How to Split Up Equity
There’s no one magic formula to get this right. The best strategy is to have an honest discussion up front about what each of you bring to the table. The evaluation should cover the following:
Equity splits should take into account background experience relevant to the startup that will be essential to its success going forward. Also, more senior members may have a larger founders’ equity percentage than more junior co-founders, since they’ve put in more time before others joined at later stages. This leads us to….
- Sweat Equity
In return for helping to start the company, co-founders might forgo salary early on to earn an additional share of “sweat” equity. The split should reflect how much time and effort a co-founder has (and will) put in, and what the monetary value of that effort looks like relative to other team members.
- Capital Investment
Founders may have put in capital to fund the startup. Those who put in more than others may be compensated by receiving a larger portion of founders’ common equity as a result, rather than structuring their investment as debt or some type of separate investment instrument, like preferred equity (making them akin to venture capital investors). This factor should be closely assessed with future commitment to the company.
- Future Commitment / Role
The equity split should reflect the on-going involvement of the co-founders in the company. One or more of the co-founders won’t be involved on a full-time basis going forward. Those co-founders that are there for the long haul and working full-time should have a multiple-times larger chunk of equity.
Note that earning equity as a co-founder should always be contingent upon staying with the company for a certain amount of time – called a vesting period – typically four years. This incentivizes co-founders to stay on and build out the startup. If they depart early, they’ll only get whatever equity they have earned up until that time
- Role in Ideation
The ones who came up with the idea and / or created the IP behind the startup may request more equity. However, it may be wiser to value execution of the business over the initial idea. That’s why we recommend focusing more on sweat equity and future commitment; that being said, most discussions will involve how to make sure the person who came up with the idea gets a fair share.
It’s OK to split up equity evenly – so long as there is sound reasoning behind doing so. It’s not necessarily one of the first decisions you must make, although earlier is better. If you still need time to figure out how the above criteria will pan out, think about putting a stake in the ground with a rough estimate of equity splits (or even equal split), but also set aside an equity “pool” (say, 25%) to allocate down the road if things change or to correct an inequity that might happen should one of the founders underperform or excel beyond the others.
- Check out this piece at Quartz on the Slicing Pie model for splitting equity
- Consider the equity calculators on Gust and Foundrs.com, or the spreadsheet from Founder Institute. These tools help you determine how to split up equity based on several factors (commitment, ideation, pay, etc.)
- The Zell Lurie Institute at the University of Michigan Ross School of Business has experienced faculty and staff members who can help if you’re a student entrepreneur. You can request an appointment to speak to a representative here.