Monday, April 1, 2013

Lesson #139: How to Calculate Equity Split Between Founders in Startups

Posted By: George Deeb - 4/01/2013

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The other day, I got asked a question about how best to divide up the equity stake in a new startup, between the founders.  I told him that was a very big question, with lots of variables that go into to calculating a fair equity split.  So, it inspired me to write this post on the topic, to document my answer for all of you.

To me, the key variables that need to be considered here, include: (i) whose original business idea was it; (ii) who is funding the business; (iii) how important is this person's role within the company; and (iv) is this person taking a salary, or deferring compensation.  Let's tackle each of these points below.

In my opinion, there should be a big premium placed on being the originator of the idea.  With all other things equal, that means that a 50/50 split between two co-founders, could be 66/33 based on the premium for coming up with the original idea, and for starting the initial development efforts and sourcing the original team.

If people are funding the business, they should get a premium, because at the end of the day, cash funding founders are acting no different than a seed stage investor.  That means a 50/50 split, with all other things equal, would need to be adjusted for the cash investment.  So, let's say that one founder puts in $100,000 in seed capital, that could be worth 20% of a seed stage company's valuation.  So, a fair split, would be closer to 60/40 in favor of the funding founder, when diluted for the cash.  Calculated as follows:  original 50/50 diluted down 20% to 40/40 for the financing, and then the one founder gets that 20%.

Key executives should get a premium stake over non-key executives.  So, a CEO or CTO, would get a much higher stake than an office manager or a graphic designer, as an example.  So, in this case, I would take your total ownership and divide it up by employee tiers.  Maybe something like 10% each for five C-level executives; 2.5% each for  10 VP level executives and 1% each for 25 director/manager level staff (adding up to a total of 100%, with all other things being equal).  Understand that not all of this will be granted day one, with everyone having higher stakes in the short run, but you will have an equity cushion to play with as the employee base scales.

People that are not taking a salary, should also get a premium stake.  To me, that is no different than financing the business.  So, if someone is deferring a $100,000 per year salary, this is like a 20% stake in a brand new startup.  So, with all other things equal, a 50/50 split, would be closer to a 60/40 split, with the same calculation and logic we used in the cash investor example.

And, please notice, I kept saying "with all others things equal" in each paragraph.  You need to collectively take all four paragraphs into consideration, in calculating a fair equity split between the founders.  And, keep in mind, there may be additional considerations to take into account, like contributing patents, sourcing investors or other value to the startup.  So, make sure to take a wholistic view of what a founder is bringing to the table, across the board.

But, splitting up the pie is only half of the exercise.  This lesson should be read in conjunction with Lesson #124 on Vesting of Founder's Stock.  So, in the event the founders split ways, there are mechanisms in place to get any unearned equity back into the hands of the company.

For future posts, please follow me at:  www.twitter.com/georgedeeb.

3 comments:

Sharon Duffy said...

George, thanks much. This is very helpful way to think about it. As I read it I couldn't help remembering "1 share for going down the hill, 1 share for having a car, 1 share for everyone in the car...." And you still had to find that Big W!! From a Mad, Mad World, one of the great examples of a lack of cooperation and collaboration. Thanks again. Sharon

Matt said...

Hello George!

This is insightful article.

My situation is a bit more complex. Around 8 months ago I've started working on a project with a friend. We are both techinical but he was fully focused on building back-end of our platform where I was doing We made a mistake and did not discuss finances/equity as we were thinking "we will get into it once this start making revenue". At that time he had no any job so agreed to help almost like being full time, without receiving any compensation. Initially I wanted to pay him a % of profit until we incorporate and if that happen this would change to shares.

2 months later (so that's around 6 months ago) we soft launched first version that started generaticing revenue from the first days.
Things changed a bit when 2 months ago he decided to get a full time work in a company that was hiring that time. He stopped contributing to the project and although I kept growing revenue based on what we already have, the development of improvements and new features has stopped, in first month after he joined he had no time at all to sit to our project as he was busy in his new role at the company that hired him (completely understandable). Recently he mentioned that if we want to move forward with it, we need to find a way I will be paying him out.

Now the complex part is the fact that he is not involved in this full time anymore. Yes, he contributed a lot at the beginning and built most of the platform so the past is pretty clear to me. The question mark is what now and what in the future?

Since we did not incorporate yet (I am waiting till we hit first 10K in MRR) I offered him that for now I will be paying him out 10% of month's profit + 25USD/hour of his work.
Why hourly rate? Because he is not involved in this full time, this is the only way I can reward him for the amount of time input he add.
Why 10% of profit? He declared he is able to work on this around 40 hours a month which would be around 1/4 of the full-time (assuming full time is 160 hours a month). The 10% of profit each month is what he gets no matter whether he work or not, this is to repay the past he was working without being paid. In future, once the company is formed, this will be replaced by shares.

He is not happy with my offer and demands more.

Of course, that's a bottleneck now for this project because development has stopped, clients are waiting for enhancements and we need to figure out how to move forward.

What would you do in this situation?



George Deeb said...

Matt, it is all a function of what was agreed to upfront (which sounds like not much), and then adjusted for the new learnings of his less than expected going forward involvement. One suggestion--value his economic contribution of initial tech development (e.g., two months of work worth $25,000), and give him that equity stake in the business. So, if business worth $500,000 as a piece of paper idea in a seed stage investment, that gets him 5% stake, on top of his going forward hourly rate or rev share you agree for the future. Talk to a good startup lawyer to help you here, as you need this contracted in the right way, to make sure he doesn't hold copyright claims to the work he created.

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