How to Split Equity Among Co-Founders
Disagreement between startup founders over stock share is one of the most common issues in early-stage startups. Noam Wasserman, the American academic, states that about 65% of startups fail because of disagreements between founders. One of the critical factors that produce conflicts between the founders is disagreement on how to split equity based on their role in the startup’s success.
Therefore, determining the degree of ownership for each co-founder is an essential issue that needs special attention. In addition to preventing co-founder disagreements, especially when the startup has had significant success and multiplied in value, splitting equity is also important to investors. One of the most critical factors for investors is the ability of the founders to conduct tough negotiations. Therefore, a stock split before raising capital is a positive point for the investor.
However, startup founders are initially reluctant to address this vital issue for a variety of reasons. Focusing on product, initial capital raising, and the complexity of stock splitting negotiations are among these reasons. Regarding the importance of this issue, this article describes the approaches as well as the essential parameters in determining the shares of each of the founders.
Necessary Questions in a Share split
There are several ways to determine each founder’s percentages. Most of these methods require answering the following questions:
- Which co-founder’s role is more essential?
- What are the primary needs of a startup?
- Which of the founders creates the most value?
- How much and what kind of value does each person create for a startup?
- How do you compare and contrast different types of co-founders’ participation?
Although all co-founders’ efforts are precious in building, growing, and managing the startup, the main challenge here is to determine the role of each in startup success.
Common Approaches in Splitting Equity Among Co-Founders.
There are two general approaches in splitting equity among startup co-founders:
In this approach, the skills, experiences and professional background of each of the founders are taken into account.
Unlike the previous system, In this approach, the obligations of each of the founders and their impact on the future of the startup are essential.
Typically, a combination of these two mentioned approaches is used to divide shares between startup founders. As the founders ‘shares are usually determined at the startup’s formation, and what happens in the future determines the stock value, most of the startups prefer the future approach in determining individuals’ shares.
In fact, if the future of a startup is a set of opportunities and challenges that can create value for the startup or reduce its value. Thus, according to the skills, career background, and commitment of each of the founders and their role in seizing opportunities or overcoming challenges, it is possible to approximate the value that each of the founders alone creates for the startup.
Splitting Equity Among Co-Founders Based on the Type of Startup.
Based on the business model and the startup nature, different skills are required. Some startups, such as Google, need founders with in-depth technical knowledge, while startups like Airbnb have a balanced approach to technology, design, and operations, and the startup’s founding team requires all three skills.
In general, we can say that the splitting equity among co-founders depends on the following factors:
- Type of business model
- The type and amount of value created by each of the founders
In fact, splitting equity among co-founders using these factors helps the startup team to avoid valuing individuals based on superficial factors such as the order of joining the team, interpersonal relationships, or the individual’s share in the startup’s initial capital.
Common Founder Mistakes in Splitting Equity
Equal Distribution of Shares among Co-Founders
Although in some situations it may be best to divide the shares equally between the founders, this proceeding should not be done blindly. Investors are looking for CEOs who can resolve complex negotiations reasonably and satisfactorily. One of the first questions investors ask founders is how they divided shares between themselves. In fact, based on the answer, investors measure the ability of the founders to negotiate.
There is also a direct relationship between individual stakes and team leadership. In most startups, one of the founders (usually the CEO) usually has the primary responsibilities of the startup, including essential decisions, communication with investors and partners. So it makes perfect sense for investors to expect this person to have more shares than the rest of the co-founders.
Splitting Equity Among Co-Founders Based on Their Rights in the Labour Market
For multiple reasons, it is not correct to split equity among co-founders based on their rights in the labour market. Some of this reasons are as follow:
- Valuing startups, especially the ones that have not yet made profit, is usually inaccurate, and people do not agree on a specific number.
- Startup valuation output is usually expressed in terms of intervals, and for early-stage startups, this range is wider. Therefore, stock division will be associated with a lot of mistakes.
- Although for simplicity, the value created by each individual is based on that individual’s importance in the labour market, this is not always the case. Consider a simple example. Suppose a famous athlete with an annual income of $ 5 million is interested in the beverage industry and has decided to enter it. To start this business, he enters into a partnership with a person who has a high level of management ability in that industry. The annual salary of that person in his current job position is $ 150,000. If the shares are divided between these two people based on their wages and incomes, the athlete will have 33 times the shares, but the fact is that his role is not 33 times more than his co-founder. Therefore, determining the share structure based on the market value of individuals will not be fair.
We stated the general approaches in share distribution among the founders. In the following, we will explain how to determine the percentages of co-founders in the implementation phase.
Essential Parameters in Splitting Equity Among Co-Founders.
Commitment and Activity
Usually, people who spend more time on startups would receive more shares than individuals who work part-time.
The time devoted to the startup and the effort of each co-founder in the early stages of the startup is one of the critical indicators in deciding the number of their shares.
The Amount of Salary
The amount of salary received by the founders is related to their shares. Startup founders can receive a higher percentage of shares by accepting a lower wage.
Responsibility for Team Development and Human Resources Management
Team development and human resources recruitment is usually assigned to one of the team members. The person in charge is entitled to receive more shares than other founders.
Co-Founders Role and Position
The founders’ role in the below activities is related to number of their shares:
- The final product (Regardless of who the original idea belonged to)
- Designing user experience
- Understanding the customer’s needs and turning them into product features
- Selling and marketing
- leading the technical team
Every founder’s activity as a member of the startup team determines the value they create for the startup
The Role of Founder in Raising Capital for Startup
Regarding the value of raising capital, at least one of the founders should master the process of fundraising. This process includes startup financial forecasting, startup valuation, presentation to the investor, and related negotiation. Therefore, the ability to negotiate plays an essential role in the founder’s share.
Expanded Communication Network
Public relations and advertising play a vital role in startup success. Having someone with extensive communication and access to media and news sites helps develop a startup. Therefore, if a person has these characteristics in the team, it is necessary to give him more shares.
Startup Budget Management and Financial Forecasting
Startup budget management and financial forecasting become more vital when startups face capital shortages. The startup should manage its revenues and expenses as well as predict their future amounts accurately. Accurate forecasting empowers the startup to raise capital in the right amount and time to minimize shares transfer to investors.
In addition to the team’s ability to identify customer needs and provide solutions to them, other activities such as startup cost management and product marketing are necessary for a startup to succeed.
Therefore, if one of the founders is in charge of this duty, allocating more shares to him/her is logical.
The founders’ previous experiences have a considerable impact on the startup’s success. Accordingly, founders with experience in management, sales, operations, product development, and design are eligible for more shares than others.
“Founders who have been able to address related challenges in their previous positions can often address the startups issues in their current position.”
The Last Word
This article stated the essential parameters in splitting equity among co-Founders. However, not all startups are the same in each of these parameters. They vary according to the business model, the role and value of the idea, its critical operations, and the weight of each parameter. Knowing these parameters and their weight in any startup will help its founders to negotiate with a broader view to transfer fewer shares to investors.