How to Distribute Startup Equity
Equity distribution is hard to do because it has second-order consequences.
Imagine you want to lose weight. If you eat a cheesecake today, you will get some pleasure, but you probably won’t lose weight. If you refrain from eating cheesecake, in the long run, you will probably lose weight. Not eating a cheesecake today has a second-order consequence - namely, you won’t put on weight and will likely lose weight.
You can distribute your startup equity in a simple manner like 50/50 or 33/33/33 or explore other opportunities. Exploring other opportunities can mitigate negative second-order consequences. I have failed a couple of times due to second-order consequences of equity distribution. Unfortunately, there is No Silver Bullet.
“When Bill Gates and Paul Allen co-founded Microsoft, they split the company 64% to 36%. Google’s co-founders, Larry Page and Sergey Brin, went 50%-50%. Which model should you follow? It depends.” ~ DeMarcus Williams
The topic can be very complex and I will focus on a pre-seed stage and try to answer two questions:
- How to distribute equity in a startup?
- How to exit a startup?
I have chosen these two questions because if both are clearly defined, equity distribution will be an implementation detail. In computer science, the implementation often doesn’t matter, what matters are the interfaces. These two questions are the interfaces (input information) for a successful business.
How to distribute equity
Don’t avoid this topic and don’t default to equal splitting of equity. Spend time to discuss it with your partners. While there is “No Silver Bullet” when it comes to distributing equity, there are a few questions that can help you to define the equity split.
- Who is the CEO?
- Which founders are coding most of the app?
- Who had the original idea?
- Which founders are working part-time and which founders are working full-time?
- Who is doing the marketing?
My suggestion is to use the foundrs and gust calculators. These calculators will help to start a discussion among the founders. The calculators will also help to define clear roles. Role definition is important for accountability. Beyond the “hard” skills, discuss your personal goals with your partners. Discuss each person’s:
- Risk profile
- Personal circumstances
- Personal goals 3-5 years
Think broadly and after talking about “hard” and personal goals, start with the discussion on how to split the equity. What are the possibilities here?
1. Equal split
“Equal splits remain the most common type of arrangement among startup founders. But that means that almost half are not.” ~ Scott Dettmer, a Silicon Valley-based lawyer
2. Unequal split
The reason for an unequal split is where one founder stands apart from the rest. For example, the founder is the originator of the idea, is an engineer, or a product specialist. All other founders will get between 5 and 20%.
3. Controlling Partner
Another option is where one of the partners has more equity than others. The so-called controlling partner with 51-49, 60-40, 40-30-30. In this scenario, the controlling partner usually has the idea and takes on the CEO role.
Someone who takes on the CEO role usually receives more as they have greater responsibility.
“The equity split should be on value creation. At a certain point, your best friend, who owns 33 percent of the company, stops working so hard. Then what?” he asks. The CEO never stops working.” ~ Pham CEO of BillShrink acquired by Mastercard
“Professor Wasserman studied more than 6,000 startups over fifteen years and reported that startups who chose an even split by default, bypassing difficult but important discussions, were three times more likely to have unhappy founding team members.”
Now you should have enough information to start a discussion with your partners.
How to exit a startup
There are two main reasons for an exit of a partner. The first reason is a person is not performing to expectations. The second reason is everything else! If a person doesn’t spend time/energy working on the startup there are two things you can do:
Speak with the person openly about the issue. My recommendation is to use the DESC method. The DESC method should help your partner to change his/her behavior.
If your partner doesn’t change their behavior, it may be time to start the exit procedure. I call it the forceful exit but try to do it in a respectful way.
The forceful exit
There are four options for a forceful exit:
Follow the procedure set out in your operating agreement. If you have the majority, you can make it happen without your partner’s agreement. Define an “exit clause” and option to buy-out shares from exiting partner/s.
Negotiate a different deal. What are the shares worth? You can always suggest your own evaluation of the equity he/she owns. For example, if your partner has invested $20,000 and the business has yet to grow, you can offer a 50% buyout or even less.
Close the company. In early-stage startup when no brand or serious business is existing and no revenue has been generated, consider cutting your losses and walk away.
Go to court. You can take legal action and let the court do what your operating agreement would have done.
Usually, the ownership of a business has no direct relevance on how much your partner works on the business. These two things are disconnected from each other and can be “mutually exclusive”. If you expect a person to work on a business, you need to define explicitly the baseline performance in your operating agreement. Define the operational metrics, and in case of continuous underperformance the “exit clause” should trigger the forceful exit procedure. Remain open to investing/divesting opportunities. For example, if your partners are underdelivering for any reason they can compensate their underperformance with cash investment or reduce their shares.
The golden rule here is to create a legal document/operating agreement. An operating agreement should include:
- The baseline performance metrics
- The option to purchase shares from an exiting partner
- An outline of who keeps the proprietary technology or information
- A definition for when should the exit clause should kick in, and how to trigger the forceful exit
- How to divest
- Evaluation criteria for a buy-out
Start a discussion regarding the equity distribution. A simple rule of thumb: who creates the most value, gets the most shares. Based on the equity distribution create an operating agreement. Always consult your lawyer.
This is a living document, from time to time I will update the content.
Feedback received: “always do a vesting agreement, standard is 4 years, with a one year cliff; but 3 or 5 years is not unheard of. even founders should have vesting agreements. Had (2) of 4 leave current company, it really protected us.”
Founder’s stock basics: https://www.cooleygo.com/founder-basics-founders-stock/