Legal Services for Startups & Savvy Businesses in Colorado

How to Split Equity in Your Startup (updated)

Splitting Equity

Most startup founders have a pretty basic understanding of how to split equity in their startup.

“I want to split equity 70-30” or “I want to split it 50-50.”

That’s an okay starting point, but it doesn’t get you all the way there. To get it right, you need to understand the little nuances. And you need to ask the right questions:

  • Do you have additional people, beyond the founders, that you will want to offer ownership to in the business—such as consultants, employees, etc.? (You’ll most likely need an options pool, and need to set aside shares now to allow for that.)
  • How will your business operate before you allocate capital to founders?
  • How do you intend to raise capital?
  • How will you raise capital with sophisticated investors? (Based upon this answer, you may not need to set aside shares now for those investors.)
  • How will an options pool fit into your initial allocation?
  • If your plans require an options pool, did you set up your business correctly? (For example, there is no such thing as an options plan for LLC’s.)
  • Do you fully understand the mechanics of shares and equity? (For example, you’ll need to fully understand the difference between authorized, issued, and outstanding shares.)

Of course, if you never plan to raise capital or issue additional equity after the first moment you start your business, then you can disregard most of the above. But it’s important to know what you need to, and don’t need to, know.

Ultimately, the question of how to split equity depends on the nature of the business you plan to create. Structures and approaches vary. You may be a small to moderately-sized startup that earns a decent amount of money for the founders; a business that’s looking to raise a lot of capital and hit a grand slam exit, or a smaller operation looking to formalize to gain limited liability protection while enjoying consistent revenue.

I’m not a fan of “one-size-fits-all” solutions, particularly here. But there are a few guidelines that apply to most startups. Here’s what I have found:

Approach the Problem with Granularity

Let’s imagine this scenario: You and another co-founder have quit your full-time jobs to work on the startup. There are also four other people who have joined the company: a tech developer, an industry expert, a high-powered sales guru, and a CFO-type. They haven’t quit their 9 to 5s, whereas you have. The sales guru is a superstar, but you have concerns that the tech developer isn’t the best.

Given all this information, what do you do?

I recommend that startup founders create an excel spreadsheet or a Google Doc (or a Lotus spreadsheet – if you’re over 70) and really dig into the details of who are going to be the drivers of the business’s success. Go into real detail about the past contributions of who got the business to the point where it is now and the expected future contributions of who is going to get the business where it needs to be. If the business doesn’t yet have revenue or customers, you should heavily weigh future contributions over past contributions. Past contributions may include the idea, the building of the team, the name, and perhaps some intellectual property. Expected future considerations will vary tremendously, but the founders should do their best to figure out who is going to take the company from nothing to something of value, and reward the ones who are going to contribute the bulk of the value to the company.

Making a startup succeed is really hard, especially if you’re planning to do the friends and family, then angel, then VC route. It’ll probably take many years to become the best business in the world at what you do. Make sure that you allocate the equity to the persons who will be doing the heavy lifting to get you there.

Deal with Sensitive Issues Early

Whenever you see a company that issues equity to all co-founders equally, there’s a good chance that the CEO of the company is afraid to confront tough problems. When you look at the contributions of multiple co-founders by looking specifically at their individual contributions, which is the most likely scenario: that each of the co-founders is contributing exactly as much as the others, or that the company just hasn’t had a hard conversation yet?

In most cases, it’s the latter. Unhealthy startups and unhealthy marriages share the same issue: problems that aren’t dealt with early tend to fester and get worse over time. If a founder feels that he or she has not been treated fairly at the beginning of the process, then it is unlikely that he or she will work the late nights and tolerate the inevitable ups and downs that follow with the creation of any new business.

Deal with sensitive issues early, or be ready to confront them over and over again.

She Who Commits Most Should Get the Most

A team of smart, hard-working, committed founders will eventually succeed, as long as they stick with each other long enough to find the right business opportunities.

But most businesses fail because most startup teams eventually give up. Who is the person who will deal with the problem when the server crashes at 1 in the morning and all of your users are irate? Who will be there to handle the angry customer service call on a Sunday? When the fecal matter gets caught in the ventilator, who will be there to clean it up?

To me, that’s the founder who should always get the most equity. Because that’s the founder who will serve as the last line of defense against failure. It is in every founder’s best interest to make sure that person is rewarded for her or his commitment. If the most committed founder is not rewarded for that commitment, the startup will always be one crisis away from failure.

Vesting Schedules Are a Must for Most[1]

Without a vesting schedule, if three co-founders divide equity evenly among themselves and one quits after a month, the departing co-founder takes a third of the company with them. Or the remaining founders have to buy them out. You do not want that.

Vesting schedules require all founders to stay with the company for a certain period of time before they receive unfettered ownership of their equity.

The standard vesting schedule is structured like this: After a year, you are entitled to 25% of your equity, but if you leave the company before a year has passed, you are entitled to nothing. This is referred to as the “one-year cliff.” For each subsequent month, you earn an additional fraction. After four years’ time with the company, you will have earned all of your equity.

Of course, there are variables in this equation. If the company sells before the founders reach their milestones, the founders may or may not retain their equity. And if you set up your documents correctly, you’ll get to make that decision.

And what if a co-founder resigns after 10 months due to a cancer diagnosis? Shouldn’t she be entitled to some portion of her equity?  In theory, the documents say the co-founder is entitled to nothing. And while some lawyers may argue that that is a fair result, if it were my company, I would want to come to a compromise position that rewards the departing co-founder for her time. Again, it’s all in the documents.

You Need to Distribute Founders’ Shares Before You Raise Capital

If you haven’t formally issued shares to founders until after you raise capital, you will have put yourself in a difficult position with the IRS. Typically, most startup lawyers recommend issuing shares to founders at the company’s formation at par value or a nominal valuation—usually a fraction of a cent. The IRS usually accepts that startup companies are worth nothing at the beginning, so the nominal valuation in the first few weeks is not a problem. But if you raise tens or hundreds of thousands of dollars, then it’s hard to argue that equity in the company is worthless. If all the shares of a company are only worth $100, then it doesn’t make sense that the investor just gave you $100,000 to acquire a small fraction of that interest.

It’s rare for startups to get audited, but if your company ever were audited, that incongruity is going to be very hard to explain—and you may be looking at paying income tax on tens or hundreds of thousands of dollars based off of the value of your vesting shares. That’s why your business should issue founders’ equity first, then go raise capital.

Dynamic Equity is Almost Always a Bad Idea

There are a few websites that have received some popularity in recent years that advocate for the concept of “dynamic equity.” What this means is that instead of issuing equity at the beginning, startup founders receive it over the course of multiple years.

I’m all for new, creative, and innovative ideas (heck, I even bought a pair of Google Glass…if anyone wants to make an offer). If it makes things better for startups and businesses, count me in. But dynamic equity is only workable if your company is going to have a very low valuation for an extended period of time. Because at all times, a company is only allowed to sell equity in the company at “Fair Market Value.” This is a complicated concept defined by hundreds of pages of IRS regulations. At the beginning of a corporation’s life, the company has a unique window where it can grant or sell to its founders large amounts of shares at an incredibly low price. As soon as the company gets traction, revenue, and funding, this window goes away. Seeing as how every startup I know is looking to get traction, revenue and/or funding as soon as possible, it simply does not make sense to let this window pass before distributing equity to the team.

If you don’t believe me on this, go ask your favorite angel, VC, or accelerator about whether they think that “dynamic equity” is a good idea. Prepare for a serious eye roll.

 

Hold Off on Complex Structure as Long as Possible

 Occasionally, founders want to create a complex, multi-tiered structure with different classes of shares and other bells and whistles from the very beginning.

This is a terrible idea.

If your company grows and raises multiple rounds of capital, your structure and cap table will get complicated enough. If you seek out complexity before it is needed, however, your company will be dead in the water before you get there. Early-stage complexity is a major turn-off for sophisticated investors and third parties looking to get involved with your company. It will also cost you more in attorneys’ fees, accounting fees, and administrative expense. There is simply no reason to create undue complexity before there is even a company with a real business that merits complexity.

With this in mind, avoid preferred equity or preferred shares as long as possible. Startups should raise capital initially with a convertible note, a SAFE, or a similar instrument, one that does not trigger either an initial valuation or require an immediate sale of stock. When startups do eventually sell equity in their company, they will usually be selling their investors “preferred equity,” which comes with rights and privileges that must be specified and enunciated in the formation documents of the company. Until you negotiate these terms with investors, you can’t know what the rights and privileges will be. Best to wait until you cross that bridge to set up that class of stock. And when you do cross it, all founders will be diluted equally.

Of course, divvying up equity at any stage isn’t just about the mechanics. It’s about personalities and talking out each players’ feelings of entitlement and commitment. These can be hard to navigate.

But managing expectations and having open discussions from the beginning is key. If your founder dynamic doesn’t allow that initially, your company is going to struggle with handling many hard conversations along the way. It is best to discover and hopefully address those frictions early on.

In the world of startups, if there’s one universal truth, it’s that things are almost never as easy as they initially appear. Those with the resolve to get things right at the beginning are invariably the ones most likely to succeed in the end.

[1] Do not try this at home. I’ve had many founders come to me after they put together their own founders’ documents, and they universally get it wrong. Be smart. Include professionals in your process.

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