Recently, I had a friend reach out to me for advice as he considered joining a startup as a co-founder. Most of his questions were around negotiating for equity – slicing the hypothetical pie of startup ownership. It’s certainly not the first time the topic has come up. And so, this first post in the series is about the levers used to split startup equity amongst the founding team and how to negotiate on them.
Since there are two different perspectives when negotiating terms on a founders agreement – of the founder, and the founding team member coming on board, I’ll cover these topics as a series. This initial article gives an overview of the different ways to slice the pie, control ownership of startups, and what scenarios each handles best.
Why the 50-50 split doesn’t work
As you can guess, what initially sounds like a fair split between equals, is anything but that. Even in the scenario where two founders come-up with an idea over lunch, complete with the quintessential napkin sketch, it’s doubtful, they will contribute equally to building the startup in the future.
There’s always one founder who goes beyond the rest, by choice or by circumstance. It won’t be long before this founder feels undervalued for, say, providing critical expertise, bringing in a key partner, or taking on more risk by committing to the startup full-time.
There’s one thing I’ve learned through such negotiations in the past – there is no perfect formula that, when applied generally, incentivizes all founders.
That said, there are enough proven frameworks out there to build a model that works for a given scenario. In the simplest sense, you can either predefine how you will split the equity up-front (predefined path) or intentionally postpone it till a significant funding milestone (dynamic approach).
1. The Predefined Path: Splitting Startup Equity Upfront
Each founding team member comes in with preconceived and often strong opinions on what they bring to the table. So, there’s real value in discussing equity distribution upfront, even if you feel uncomfortable. Most often, startups will predefine the equity split amongst their founding team.
The pitfall of this standard approach is that equity is distributed based on a prediction of the future. It’s ironic because what defines a startup is unpredictability. The founding team anticipates the capabilities they need. There’s an inherent asymmetry of information about your strengths or weaknesses compared to the rest of the founding team. Also, each founder assumes the extent of their participation in building a successful startup. The inevitable uncertainty that comes with any startup is ignored.
In the worst-case scenario, one or more co-founders’ contribution isn’t in line with their pre-determined equity share. You can intervene and bring the founding team back on track. But, not always. To avoid this scenario, founders use two ways to control predefined equity distribution – based on time or milestones. Let’s look at each –
i. Time-based Approach
“Vesting” equity is one of the simplest ways for founders to control the ownership of their venture. When vesting over a duration, the founding team earns a portion of its equity at predefined regular points in time. A four-year graded vesting period has become the norm on founder agreements.
A vesting schedule protects the startup’s liability during its riskiest phases – the early stage. It also incentivizes the long-term retention of founders and employees. Suppose the founding team is working with each other for the first time. In that case, a “cliff” is another useful lever – a cliff period builds-in time to validate working structure and relationships before vesting kicks in.
Now, there is an assumption that the founding team will achieve certain milestones during those four years to “earn” their equity. Due to many reasons, that might not happen. This assumption is the pitfall of time-based startup equity split. So let’s consider an alternative, a milestone-based approach to distributing equity.
ii. Milestone-based Approach
Equity can also be distributed or earned as and when the founding team meets predefined milestones. The key here is to define milestones that can be measured, say with deliverables. We’re all familiar with SMART goals, and it’s a great checklist to run your predefined milestones through.
Also, include milestones that you know you will have to meet regardless of the path you take to launch your startup. We know that there will be changes in strategy and detours along the way. Suppose you defined milestones strongly coupled with your current plan. They could become obsolete over time, and you will need to redefine your milestones for equity distribution. No one wants to have that discussion again. Certainly not at this stage when blood, sweat, and tears have already gone into building the startup thus far.
2. The Dynamic Route: Splitting the equity based on effort
Both time-based and milestone-based approaches split the equity upfront before the founding team has worked significantly on their new venture. Everything is uncertain in the early stages. One way to alleviate this risk of uncertainty is to postpone the equity split intentionally. In this case, the founding team will split equity further down the road according to the efforts already contributed. They can usually wait to divvy up equity based on effort till the startup seeks funds from a VC or a sophisticated Angel Investor.
One necessity for this strategy is to have a system to measure and translate the founders’ efforts into a contribution percentage. You don’t have to get distracted from building your startup to design such a system – there are several options out there. One of the most popular systems, developed by the entrepreneur Mike Moyer, is the Slicing Pie Model.
Now, it seems fair and foolproof to reward startup equity based on each founder’s contribution. However, it has its challenges, and there are things to watch out for. Not having had the conversation about equity split, founders can feel anxious about their involvement with the startup. Also, there might be a tendency to constantly make one’s contributions visible to the rest of the team or guard their territory. This behavior detracts the team from doing whatever needs to be done to launch the startup successfully.
What’s next?
As I mentioned at the start of this article, there is no perfect formula to split startup equity. That said, by reviewing each methodology and its relevance to your situation, you can define the most practical framework for your startup. Also, by having open conversations about the pitfalls the team needs to watch out for, there’s a sense of transparency and accountability. It brings the team together.
I hope this article provided an overview of the approaches to split equity and the considerations when adopting them. The next couple of posts will cover negotiating terms with any of these approaches – either as a founder or a founding team member.
What has your experience been with using these approaches? Is there something you’ve learned that I haven’t talked about in this article? Share in the comments section below.
