The only wrong answer is 50/50: Calculating the cofounder equity split

Posted: April 28th, 2011 | Author: | Filed under: Startups | 19 Comments »

(Note: there are great conversations about this article happening at Geekwire and Hacker News)

The question of equity brings out the most fundamental differences, perceptions, and values in an aspiring startup.  In fact the equity question, more than any other, may strangle a young company before it can even get started.  And that’s a damn good thing.

But before we get in to that…

Who’s a founder?

Facial hair alone proves insufficient to determine founder status

As straightforward as this question sounds, it’s a tricky matter.  The founder moniker is black and white, but the situations are all shades of gray.  Setting aside the philosophical question and focusing on the more useful economic one, though, there is a simple approach: founders are people who take a very particular kind of risk.

There are, quite roughly, three stages in every company’s life:

1.  Founding.  The only money the company has is what you put in.  You are getting no money out of the company.  The company will probably fail, and you will lose all the money you put in, plus the lost salary, plus you have to find a new job.

2.  Startup.  The company has money, either from investors or from revenue, and they give you some of that money every month.  Your salary is less than what you’d get at a big company.  50/50 the company fails and you have to find a new job, plus you’ve lost the difference between your startup salary and the BigCo salary.

3. Real company.  You get “market” salary.  It’s unlikely the company fails, and if it does, your downside is limited to  unemployment.

The rule is this: if you’re working for a company that’s so young it can’t pay you, you’re a founder.  If you are drawing a salary on your first day at work, you’re not.

What’s a founder worth?

A founder is defined by the inability of their company to pay them (or anyone else) for anything.  A founder’s primary job, then, is to get their company some money – either by raising investment or by generating revenue.  So a founder is valued by two things:

1) Their contribution

2) The market

The first of these is fair.  The second is  economics.  Both are essential.

And now, the formula

Of course, there can be no right answer – but this one’s not so terribly wrong.  To start out with, give every founder 100 shares.

Somebody’s got to get things started (5%)

Some startups are born running, with all founders on board from the beginning.  But others come from one leader who recruits the others.  You may or may not take the CEO title, but if you’re the one who rounded up the cofounders and talked everyone in to getting things done, add 5% to your holdings.  If you were previously 100/100/100, you’re now 105/100/100.

You know. For kids.

Ideas are precious, but dwarfed by execution (5%)

It’s a lie to say that ideas are worthless and execution is everything… but it’s not too far from the truth, either.  If you’re the founder who brought the original concept to the table, increase your share holdings by 5% (so if you had 105 before, you now have 110.25) Note that if the idea is implemented, or patented, or otherwise has some execution behind it, then…

The first step is the hardest (5%-25%)

Creating a difficult-to-replicate beachhead can give a fledgling company direction and credibility.  It can help with revenue and with financing.  If you bring a concrete start to the table – a critical, filed patent (not a provisional), a compelling demo, an early version of the product that isn’t quite there yet, or something else that means much of the work towards financing or revenue is already done – you get a boost of 5%-25%.  The key variation here is, “How much closer does this get us to revenue or financing?”

CEO gets more (5%)

Common situation: the split is 50/50 so that neither party controls the company.

Well, if you don’t trust your CEO with the majority of shares, you’re founding the company with the wrong person.  Market rate for a great CEO is higher than market rate for a great CTO, so the CEO job gets a bit more equity.  This isn’t fair – the work isn’t easier or anything – but it does reflect some market realities.

Fulltime commitment is expensive (200%)

If you’re working fulltime while your cofounders are working part time, you’re the pig. You’re working more, and you’re risking a lot more if the project fails.  Furthermore, part-time cofounders are a big minus to someone considering an investment.   Their equivocating will be expensive.  Add 200% to the shareholdings of all the fulltimers.

Reputation is the most precious asset of all (50%-500%+)

If your goal is to get investment, some people make that much easier.  If you’re a first-time entrepreneur partnering with someone who’s successfully raised VC dollars, that person is a lot more investable than you are.  In the extreme, some entrepreneurs are so “investable” that their involvement is a guarantee of raising funds.  (It’s easy to identify them: ask the investors who know them best “would you back them no matter what they do.”  If the answer is “yes”, then they are that kind of super.)   These super-preneurs essentially remove all the risk of the “founding” stage, so you should expect that they get the lion’s share of the equity from this stage.

This point doesn’t apply to most founding teams, but when it does, expect the super-preneur to take 50%-500% or more, depending on just how much more significant their reputation is than their cofounders.

Treat cash like an investment (varies%)

Ideally, each investor contributes an equal amount to the company.  That, plus their labor, earns them their “founder shares”.  It’s possible, though, that one founder may put in significantly more.  The price for that is high, since it’s the earliest, riskiest investment.  That founder will get more equity; to determine how much, talk to a good startup attorney about a reasonable value for your company and work from there.  For example, they might say that your company could reasonably be valued at $450,000 for investment purposes, so a $50,000 investment would merit an additional 10%.

There are more structured ways to do this, ranging from revolving credit lines with interest and warrants to convertible debt that converts in to common shares.  But these all mean increased legal bills and, more importantly, complex cap tables – something that can scare off outside investment.

The final accounting

At this point,  you’ll have something like 200/150/250.  Just add up the shares (600, in this example) and divide each person’s holdings by that number to get their ownership: 33%, 25%, 42%.

If you have equal shares, you did it wrong

A couple of years ago I was asked to give a talk at a continuing education series for attorneys.  I asked to see the class list, and opposing counsel for a deal I was working on was being there, so I figured it was probably a good idea to do it.

I asked them what to talk about, and they helpfully replied “startups”. I pressed for more detail. “You mean like generic startup experiences?  Legal issues startups face? Advice for attorneys?”

“Yes, exactly like that!” came the enthusiastic reply.

Clear direction in hand, I started musing on the early days of Ontela.  Our company started as just two of us, Charles Zapata and I, brainstorming in a basement.  We covered a ton of ground – generating a million ideas an hour, each better than the last, on everything from business concepts to core values to better ways to file expense accounts.  No matter what came up, we either agreed, or quickly resolved our differences.  Life was good.  We split the equity 50/50.

It wasn’t until six months later, when we’d quit our jobs and committed our savings, that we nearly destroyed the company with our first real argument.

The advice I gave the lawyers was this: “The most common cause of startup death is founders who can’t resolve their differences.  Nobody hears about it; they just pack up and go home before the company ever had a chance.  If there’s one thing you can do to help your clients – really help them – it’s to get the hard questions on the table early and help them work through them together.”

Mark Suster talks a bit about this in this four minute video clip about “the co-founder mythology“.

Solomon was unavailable

50/50 isn’t a business decision, it’s a compromise

You need to get used to hard questions.  You need to get used to trusting each other.  You need to get used to the idea that you’re not all equal.  You need to have the difficult discussions about responsibilities, contributions, roles, and compensation.  You need to do  it before you make commitments to investors and employees.  And if you find that the only way you can get a decision made is by compromising – then you need to stop now, before the price of failure climbs higher.

There’s no way around it – you’re going to have to split the baby, but it doesn’t require the wisdom of Solomon to get it right.  Take your time, keep a level head, and remember: this is just the first of the decisions you’ll be making together for the rest of your company’s life!

 

PS: Joel, you’re awesome, but I couldn’t disagree more

Joel Spolsky is one of my favorite authors.  He wrote a thoughtful piece about the same subject that reaches very different conclusions.  Here’s why his article is wrong:

  • It confuses “easy” with “fair”.  If you’ve had two successful exits already while I’m doing my first startup, it’s easy but not fair to split it 50/50.  It’s fair but not easy to reach a more accurate split.
  • It advocates avoiding conflict so you don’t “argue yourselves to death”.  That’s exactly the wrong approach: if you’re going to argue yourselves to death, do it now when you don’t have investors and, worse, employees (“Mom and dad are fighting again”).
  • It gives too much equity to employees who are drawing salary, at the expense of the founders.  The majority of founders work without salary for companies that ultimately fail.  Employees are at least guaranteed a salary.  The difference in risk is monumental. Nivi provides a lot more detail here explaining why founders should get a lot more stock than employees.
  • It doesn’t reflect market realities.  A typical Series A allocates 20% for the employees.  Joel’s model has 33% for the employees, which means just 33% for the founding team.
  • IOUs are nearly worthless.  Most companies don’t succeed in raising money or getting profitable.  Of those that do, many investors will require that IOUs be waived as a precondition of investment.  A $1 IOU has an expected value of nickels.  The right solutions are either convertible debt (for investment) or equity adjustments (for anything else).
  • It’s worth noting that, by the way, Joel is spot on that founder vesting is required in any cofounder situation.

Joel’s already successful.  I believe this is his first startup with cofounders and investors.  This looks like a great, idealistic set of ideas – but it’s economically unsound, and doesn’t reflect the majority of the market out there.

Note: I’ve only founded two VC-backed companies myself, so I’ve vetted this analysis with a bunch of folks to access a broader experience base and make sure I’m not out in the blackberry brambles here.  That said, a few VCs (including Fred Wilson, one of Joel’s investors) have chimed in to endorse Joel’s analysis, so perhaps he’s not so crazy either.

Thanks to Bill Bromfield, David Aronchick, Galen Ward, Joe Heitzeberg, Rand Fishkin, Sarah Novotny, and Tony Wright for providing feedback on drafts of this.  Mistakes, overly broad assertions, and incendiary observations are mine, not theirs.

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  • http://geekanddad.wordpress.com/ Dad

    Great post. I like the way you’re thinking about this. The “menu of added value” and corresponding “cost” to the company in terms of equity.

  • http://www.hasoffers.com Peter Hamilton

    Can I just say that including a pic from Hudsucker Proxy was epic?

  • Sam Felton

    Ditto that. Largely underrated, but IMHO the Coens at their finest.

  • Sam Felton

    With respect to ideas (patentable or actionable ideas, not just random thoughts), I like to add them as a weighted mean. E.g., if a founder brings an idea to the table which becomes a major selling point to customers (as reflected in post-sales survey), we add the average across all investments with a 100% weighting – to pick the median from Dan’s formula, it would be [10*1]/[Total of Founder's Shares]. If it leads to something that helps the company but isn’t directly attributable to sale or customer satisfaction, split that in half: [10*0.5]/[Total]. And so on. It’s worked in the past, and it’s what we do here. In addition, we encourage teaming – if two or more people team to produce the “idea”, we split it between them. Etc. It works for us.

  • http://www.danshapiro.com/blog Dan Shapiro

    Unfortunately, it’s hard to “rework” the initial equity split based on later results. By the time you’re big enough to have post-sales surveys, you can’t easily reallocate shares between founders without affecting investors, incurring tax consequences, etc.

    Note that it also can create perverse incentives for founders to undermine each others’ contributions.

  • Sam Felton

    Definitely true – I guess I was going on the unstated (and admittedly risky) assumption that a pool of investor shares can be used for those who especially deserve the award. But you are right, there’s no underestimating people’s desire to self-reward at others’ expense.

    Great blog, btw – keep up the awesome work.

  • http://www.danshapiro.com/blog Dan Shapiro

    Thanks!

    Not sure what you mean by “a pool of investor shares” – in a typical deal, investors are granted new shares when they invest; there’s no pool to draw from. There may be a pool of shares to compensate employees, but that’s traditionally 15-20% of the total equity, shared among the entire company. If you reward a founder from that pool, you do it at the expense of the employees.

  • Sam Felton

    I misspoke – not investor shares – those are new shares, as you said.

    At the recommendation of the legal team delivering a presentation we attended early on, we set up a pool of founder-level shares for award as options to employees like you mentioned [15%], and another pool [15%] for use as incentive to reward founding members who add continuing or additional investment in the form of actionable ideas or hard currency. Awards from both of these pools have to be voted on by the board.

    This helps in two ways: 1) it acts as incentive to prevent founder “laurel-resting,” and 2) helps ease the founders’ concerns over dilution from option or common stock grants to employees.

  • http://www.danshapiro.com/blog Dan Shapiro

    That seems like it has some pretty severe drawbacks vs. granting the shares up front. I’m certainly no expert, but off the top of my head, I think:

    a) You lose the favorable tax treatment of founder shares (with 83b election etc)

    b) The capital gains clock doesn’t start until the shares are granted

    c) You’ll be subject to the stock option plan, so unless you play some additional games, you’ll have a vesting period that starts when the shares are awarded

    d) The strike price will have to be whatever your common stock is valued at, so you’ll have to pay some amount to get the shares (and until you do, you can’t vote them)

    e) You don’t get to vote shares that you don’t own, so the founders have less voting power vs. the investors than they would otherwise

    f) If the shares aren’t granted before an exit, then they “disappear” reverse-diluting the investors and employees, meaning the board has an incentive not to grant them

    I also think you can get pretty much the same effect (with many of the same drawbacks) by just having the board authorize and issue shares to a founder who’s doing good work.

  • http://www.elevatus.com elevatus

    I’m new to this but I am seeking answers. Here are some basic questions as this dialog is triggering additional thoughts on a slightly different tangent…so I am going to post them here vs. emailing you directly (in the event others might also find the answers helpful).

    1. Are you also saying that (broadly) it is best to grant shares on the front-end vs. granting them over time? or is there really no “plus or minus” on this topic and it has more to do with WHO you are granting them to (which would dictate when)?

    2. What are some of the tax ramifications of receiving shares? Are they counted as income? Taxed in relation to your overall tax bracket or only taxed once sold? Just a quick answer here is good, I can ask an accountant/attorney for details.

    3. In response to voting. Essentially, you are saying that “technically/legally” one doesn’t get to vote unless they own the appropriate # / % of shares, correct? Does this really only apply if/when one’s start-up has a board in place and there are formal votes occurring on business decisions?

  • http://www.danshapiro.com/blog Dan Shapiro

     Of course, the right answers are “go see your accountant/attorney” and “it varies”.  But some quick rules of thumb..

    1) Best practice for founders is to grant shares with a repurchase agreement that diminishes over time.  They own the shares (and can vote them etc), but the company can repurchase them from the founder at cost if the founder is terminated.  For employees, grant options that vest over time.  They won’t own the shares until they’ve both vested & been purchased.

    2) FILE YOUR 83(b) ELECTION.  If you do, then you pay taxes on the full amount of the shares up front.  Otherwise, you pay taxes on them as they vest… at the increased value.  That is very, very bad.  Good article here:
    http://www.startupcompanylawyer.com/2008/02/15/what-is-an-83b-election/
    When the company is sold, the increase in value is taxed as capital gains (long or short term depending on how long they’ve been held). 

    3) If you own 1 share, you get to vote it.  If that share has an unvested repurchase right, you still get to vote it.  If you own an option (whether or not it’s vested) and haven’t bought the underlying share, you do not get to vote.  But mostly, shareholder votes are just for board members and/or the dissolution of the company.  Most of the day to day power rests with the CEO, and to a lesser extent, the board.

  • http://x-mass.livejournal.com/ Big kate

    an incredibly useful article and one that i wish i had read many years ago . Actually it’s just made me rethink what happened at my first company when I was 18 and how if I could have handled it better (it went splat with all my savings). One day, some day, if I have another go at fiscal company building then I think it might avoid some of the arguments. I say fiscal companies because what i largely do now is start social companies also known as activism, but the underlying issues are exactly the same, its just that the product is different   

  • http://www.ocodewire.com Krishan @OCW

    An eye opener but now I can say, ” I am the founder” ;-)

  • Mark

    Unbelievable! This needs to somehow get in the hands of every person that is getting in to a partnership. I started 3 companies. 1 of them almost failed because of this particular issue, another did fail because of this and the 3rd well we just guessed the percentages 35% / 65% (it worked out ok, we sold the company).

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  • Pranjal Shanker Pathak

    interesting thoughts. attached is possible sheet for playing around with model for equity split and vesting mentioned above.

  • http://www.danshapiro.com/blog Dan Shapiro

    Awesome! Would be great if you made it a public file (e.g. a spreadsheet on Google docs) so people could play with it.

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