WHEN TO SPLIT EQUITY:
As soon as possible.
WHY TO SPLIT EQUITY:
1. To motivate the co-founders for the long-run. Equity is always about long-term motivation. The more motivated the founders, the higher the chance of success. Getting a larger piece of the equity pie is worth nothing if the lack of motivation on your founding team leads to failure. It takes 7 to 10 years to build a company of great value.
2. To get better evaluation and chances to be funded. If you don’t value your co-founders, neither will VC. Investors look at founder equity split as a cue on how the CEO values his/her co-founders. The quality of the team is often one of the top reasons why an investor will or won’t invest. If you only give a co-founder 1-10%, others will either think they aren’t very good or aren’t going to be very impactful in your business. Don't communicate to investors that you have a team that you don’t highly value.
HOW MANY CO-FOUNDERS:
Most startups have one or two co-founders, total. A few have three. Usually, when a startup declares 4, 5, 6 or more co-founders, it's a sign that the CEO is weak and not willing to make the hard decisions. It’s dubious that all 6 potential co-founders are critical to the success of the company. Your co-founders should complement your competencies, not copy them. Try to be honest and separate the real co-founders from the friends who are happy to join for the ride.
You should treat founders who put significant cash separately. Consider them as co-founders by time they are investing, not by the cash contribution. If most of their contribution is cash, they are not really co-founders, either they are investors who want to tell you how to run your business, or you are their cheap employee. Once you figured out how much equity their work deserves, do projections for a normal round of funding and see how much their cash would be worth.
HOW TO SPLIT EQUITY:
Considering you have 2-3 co-founders, the thumb rules are:
1. Equity should be split equally or close to that because all the work is ahead of you. If you aren’t willing to give your partner an equal share, then perhaps you are choosing the wrong partner.
2. The shares of time you’re going to contribute to your startup for the coming four years. Startups are about execution, not about ideas.
3. However, you should evade 50/50% split between two co-founders. From a legal perspective, it can be problematic due to control/deadlock issues (e.g., the stockholders elect the Board, and the Board appoints the CEO).
4. It’s alright to warrant a 3-15 higher percentage for the founder that either contributes cash and/or intellectual property to the venture, or will have greater responsibility, or will be adding more value going forward than the other founders (e.g. due to domain expertise).
5. Four years of vesting with a one year “cliff.” This is a typical setup of the vesting schedule in the Valley to cover the situation when you have to break up with a co-founder. In other words, while you might own 50% of the company on paper, if you leave or get fired within a year you walk away with nothing. After the one-year point you get 25% of your stock. Every month after that you get an additional 1/48th of your total stock. You only earn all of your stock at the end of four years. This ensures that founders are a good fit for the long haul - and if there is a problem you can fix it without harm in year one.
6. Holding a board seat only for the CEO/co-founder before a significant equity fundraise as another good contingency measure. That will prevent board disputes during tough decisions, such as in the unlikely event that the CEO has to fire a co-founder.
THE MOST TYPICAL SPLIT MISTAKES:
1. Founders postpone the decision of the equity split. Aka:
• Let’s consider that later...
• We’ll definitely sore this out fairly after the funding...
2. Founders make an oral agreement without capturing it on paper or e-mail. Aka:
• But I thought we agreed to...
• As far as I remember, we agreed to...
3. Founders tend to make the mistake of splitting equity based on early work, not on future work. Aka:
• I came up with the idea for the company...
• I started working n months before my co-founder...
• My co-founder took a salary for n months and I didn’t...
• I started working full time n months before my co-founder...
• I am older/more experienced than my co-founder...
• I brought on my co-founder after raising n thousands of dollars...
• I brought on my co-founder after launching my MVP...
• It’s a CEO’s job is to think of how to come up with an equity split that will maximize the motivation of your Team. So before filling out a VC/accelerator application, your CEO should analyze carefully your equity split.
• The fact that a founder has been working on the project for significantly longer than others (one year or more) is not justification in itself for more equity. Instead, consider adjusting the vesting schedule.
• Do not sign up a co-founder until you have worked with them long enough to know it’s going to work out. Long enough should be 1-3 months. If you need to incorporate early with a co-founder you don’t really know, then a 3-month cliff makes sense. Just think of it as a trial period, and be upfront about it to your co-founder.
• An 83(b) election must be filed with the IRS within 30 days after the grant or purchase date of the restricted stock. The 83(b) election is a provision under the Internal Revenue Code (IRC) that gives an employee, or startup founder, the option to pay taxes on the total fair market value of restricted stock at the time of granting. Please note that Section 83(b) elections are applicable only for stock that is subject to vesting, since grants of fully vested stock will be taxed at the time of the grant.
• Consider around 10% of your startup equity to be put aside toward your "options pool" - the portion of company equity that is reserved for future employees. Most Series A/B startups usually grant options of 0.1-2% of the total diluted equity amount per C-level Executives (e.g. COO, CTO, CFO, CMO, but no more than 3 true non-founding C-level Execs). When assigning equity options to members outside the executive team: Heads may get assigned 0.5-1% of total company equity, Leads/Managers and other key functions 0.2-0.7%, and all others employees 0.0-0.2%.
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