Co-founder Equity Split: A New Framework to Objectively Divide Startup Ownership and Get Back to Building a Business
Many startup founders find themselves lacking clarity and direction when it comes time to divide their new company’s ownership among co-founders. It’s a crucial step, and one that is very important to take seriously: in addition to having potentially massive effects on each person’s earning potential if the startup takes off, showing that your team (and CEO) can handle hard discussions is an important signal to potential investors. But finding and asking the right questions to split equity is difficult, and because your team is excited, new, and probably close, it’s tempting to avoid the issue, sidestep it, and take shortcuts. For founders who do take on the responsibility head-on, there are many existing guides, blog posts, books, Quora answers, and rules of thumb recommending processes to split equity, but many founders run into difficulties actually applying these guidelines and frameworks. They usually require estimating obscure values and seemingly arbitrary percentages: “Founder B increases our value by 25% sometime in the future, so I should be willing to give them 1/(1-0.25) of the company.” To arrive at that answer, you’d have to be able to guess your venture’s current value, future value, and if the value would increase by a certain percentage from a certain person’s actions, without any context at all. Our goal in building this Co-founder Equity Split tool was to consume all the different methods out there and build a framework that avoided their shortcomings but still appreciated the complexity of the question at hand. We found that, across all of these frameworks (and in our own experience), the most basic question co-founders need to answer is: “What are the venture’s needs, who is bringing value to the table, how much and what kind of value is each person bringing, and how can we make all these different kinds of contributions comparable?” By value, we mean any attributes or effects that will be integral to building, growing, and managing the venture. While there are many kinds of value each co-founder can bring to the table, there are basically just two ways to assess value: By looking backward: what background, skills, and experience is a co-founder bringing to the table? By looking forward: what impact and commitment will a co-founder bring to the table in the future? Given that startups split equity very early on, most companies going through this process have more future than they have history, so our framework puts more weight on the forward-looking framework than the backward-looking framework. The forward-looking framework, which is the backbone of our methodology, essentially looks at the potential path and future of the venture in terms of challenges that the company will face and the value the company will create by overcoming those challenges. By looking at the venture’s future as a series of opportunities to create or lose value, it becomes possible to estimate the value each co-founder may individually create, based on their particular background, skills, and degree of commitment. Our framework: At Gust, we reviewed hundreds of equity ownership agreements between founders of successful ventures, analyzed various forms of businesses, and studied the frameworks available to allocate ownership. This research helped us develop our own framework for determining a co-founder equity split. While analyzing these ventures, we found patterns in the types of skills that tend to lead to successful outcomes. Some ventures need founders with deep technological knowledge (think Google) while others require a balanced approach to technology, design, and hustle (think Airbnb). Most ventures require one entrepreneurial co-founder who can commit wholeheartedly to the company, serve as the primary spokesperson, be willing to forego work/life balance, and drive the venture to success. That person will usually act as CEO, but may well require a strong team of co-founders to complete the management team. Accordingly, we believe that you should view equity allocation as a function of: The type of venture you are pursuing (a big and difficult question that our tool can help you break down into several simple questions), and Which co-founders are bringing what kind of value to the table, what kind of value, and how much. Based on responses to questions about your business and your co-founders’ backgrounds and contributions, as well as the level of commitment and personal responsibility they are willing to sign up for, we can produce a venture-specific recommendation about the proportional ownership of the company. This framework doesn’t rely on figuring out your company’s current value, your company’s future value, or the benefits a founder is forgoing by joining the venture versus remaining on the market. In addition, it’s sensitive to what your venture is actually doing. Thinking about equity in these terms — as portions of the overall value created by the team — helps co-founders avoid mis-valuing each team member based on superficial factors, like the order in which they joined, interpersonal relationships, or small amounts of initial personal funding. In particular, there are two very common, very understandable, but very serious errors that co-founders make: 1. Splitting equity 50/50 is rarely the right answer While an even split may turn out to be the best answer, founders should not split the equity blindly. Investors look for CEOs who can have difficult conversations and resolve them sensibly and satisfactorily. The question of ownership between co-founders is one of the earliest of these difficult conversations, so it’s an important signal of the future CEO’s leadership and judgment for investors. Having a framework that helps co-founders discuss their individual relationships to the value the team must create as a whole, and the skills necessary to overcome future challenges, is key to considering each person’s role objectively. Some schools of thought suggest that an even split is necessary to prove or preserve mutual respect between founders. In some situations, this is a sensible move — if the founders have access to a large pool of possible co-founders where they can find mutually complementary skills and ability to create equal value. In most cases, though, these conditions aren’t met. Equity isn’t a portion of a company’s respect, it’s a portion of a company’s value. Not all founders deliver equal value, and that’s okay. Founders that don’t recognize this reality are already demonstrating their inability to act in the best interest of the venture by putting themselves or their co-founders first and the venture second. In addition to these concerns, there is also the relationship between equity and leadership. Most ventures hinge on the direction and drive of one co-founder in particular — generally the CEO — who will be the one to break tie votes, make the hardest calls, and probably sleep least. Because this person will be the primary focus of investors and partners, and thus the person on whose shoulders responsibility for the company’s performance ultimately rests, it is rational, reasonable and will be expected by investors that this person have a larger equity share than other cofounders. 2. Early-stage founder contributions should not be quantified in dollars or equated to salaries There are a plethora of reasons why pegging each founder’s contribution to a target dollar amount is a bad idea. Here are some: • Valuations are effectively risk-adjusted and time-adjusted future possible values, expressed in today’s terms. Adjusting for a future value and adjusting for risks is difficult even for a public company (despite being given all the identical data available about any public company stock, 20 analysts will produce multiple different opinions about its value). Doing the same for a new, pre-revenue startup in an emerging market is even less likely to produce a consensus estimate. • A company’s valuation is not a single data point. It’s a distribution of values, with more-likely and less-likely scenarios. With startups, the spread of distribution is so wide (any given company could yield either a 0x return or 1000x return) that using a distribution as the basis of a conclusion about the dollar value of equity would amount to a wild guess at best. • Despite the appealing simplicity of the concept, the fact is that value created by a member of a venture is not the same as the price of that person’s labor on the market. Take a simple three-person structure (hacker, hustler, and designer). The hacker could be making $200K as a consultant, the hustler may be making $120K base with a $100K commission at a fortune 500 company, and the designer may be making $180K as a VP of design at a Series D startup + 20,000 shares that he’ll have to forgo if he joins. But these figures are related to the value of their work for their employers, not their contributions to the new venture. Because equity represents the value each founder creates, not the price of hiring the founder, trying to peg the amount of equity a person receives to the amount of money they would otherwise make is a misuse of the concept. Take a more complicated scenario: a professional athlete who is making $5M a year, but is interested in the soft-drink industry and wants to use her star-power and fame to help launch a new venture. She finds a co-founder with entrepreneurial ability and technical knowledge that allow the venture to develop the product, but who makes $150K at her current job. The $5M salary that the athlete makes doesn’t represent a contribution to the venture that is 33 times more important than that of her co-founder, who is actually going to be driving the company, so structuring equity around their “market value” is neither fair nor sensible. Complicated questions rarely have simple answers, but these same complicated questions can be answered with intelligent approaches. We have found that the questions that will inform an equity split can be broken out into smaller, digestible steps. The resulting framework: Gust’s Co-founder Equity Split tool. We hope you enjoy it. Venture Forward! Source: Keyvan Firouzi, CFA is Principal of Preferred Return.