September 1st, 2022 | By: The Startups Team
Welcome to our four-part Splitting Equity Series. This is our Introductory piece and will continue to be split up into four phases:
Introduction - Early Startup Equity — Getting it Right ( ←YOU ARE HERE 😀)
Phase One - Startup Equity - Avoiding Early Mistakes
Phase Two - How Startup Equity Works
Phase Three - How to Split Equity
Phase Four - Equity Management
We are excited to guide you through your equity-splitting experience. Let's dive in!
We’re going to identify and isolate each of the key issues in splitting startup equity in a young company. Then one by one we will lay out which options are available, how most startups address this problem, and what key decisions the team will need to make to split the founder equity fairly and manage a plan long-term.
So here we are — just a few co-founders with a big idea for our new startup and it's time to figure out our equity splits. This shouldn't be too hard — there are 3 co-founders, so we all get a third of the equity pie right? After today we can settle this discussion and get back to the fun part which is building our giant world-changing startup.
(Cue haunting music suggesting a foreboding moment!)
If we're like most startup founders, we're about to rush through one of the most important and expensive decisions we will ever make. We'll make the decision on how to split founder equity without really understanding the consequences of our decision now and the brutal pain of it later.
A quick equity split is like getting married as a start to your first date. It sounds great to get things moving, but it's damn near impossible to unwind poorly thought out equity splits between co-founders. Actually, getting divorced is way easier than breaking up a bad equity split! In either case, let’s figure out how to avoid that outcome!
Before I go on a nonstop rant about why splitting equity is such a big deal, let me tell you a bit about who I am and why this subject freaks me out so much that I wrote a whole book about it!
I’m Wil Schroter, the Founder + CEO of Startups.com which helps over 1 million startups launch and grow. I’m a serial Founder myself, having built 9 companies over a few decades (which just means I’m old). In that time I’ve advised hundreds of startups of all sizes through the entire journey, and if all of that experience has taught me one thing, it’s this — Founders have no flipping idea how to split equity in a startup, let alone how to orchestrate a fair equity split.
What you’ll read here is the summation of decades of conversations with Founders in guiding them through these decisions, but also my own personal experience in watching me and my co-Founders wrestle with equity challenges time and time again.
My goal with this course is to help my fellow Founders get the benefit of all of these experiences by not having to go through any of those experiences!
There are lots of reasons we mess up dividing equity, but it really comes down to just two that matter.
First, we don't really know what we're doing. None of us has started a company before, and if we have, we probably just divided equity quickly using an even equity split. No one was an "expert" on how to split up equity so we just went with the playground rules of "let’s split equity fairly, equally'' regardless of whether that was the right way to do it. We just didn't know any better.
We simply don't know what questions we should be asking.
Second, we weren't ready to have a super uncomfortable discussion. Just about everything we need to discuss is really awkward. We have to ask tough questions like "How is my contribution potentially worth more than yours?" or "What happens if you leave — do I get your equity?" In some cases we may not even know each other that well, so broaching these discussions gets tabled for fear of creating an early rift.
We're about to avoid the most important discussions just because it’s uncomfortable.
Let's use the marriage analogy again. Imagine that we just met each other, and we are both crazy about the show Stranger Things. Our passion for camp 80’s sci-fi is so strong we both think it's a great idea to get married.
But before we do, shouldn't we ask some basic "big" questions about all of this? Things like "Do you want kids?" or “Do you really want to be married,” or the all-important "Did you think The Phantom Menace was a worthy follow-up to the original Star Wars trilogy?"
These are probably some important questions we want to clear now versus waiting until our honeymoon to get the answers.
This is the very nature of splitting equity. Asking all the important questions before we commit to getting married. The good news is that there is a fairly specific formula we can use to walk through the big questions and come to some reasonable answers.
All we have to do is understand the fundamentals. Those fundamentals are based on helping avoid the 3 most costly mistakes in splitting equity.
While our intentions are good — we just want to get on to building the business — that doesn't change the fact that if we motor through this too quickly, we're likely to make three giant mistakes in the process.
Mistake number 1: We fail to recognize ACTUAL contributions.
We won't split equity based on actual contributions. By dividing the equity into equal splits, the freshman college student will get the same equity as the seasoned veteran with 20 years of experience. The person who put in $0 will get the same equity as the person who gave up their life savings. That's going to become a real problem when we start to actually build the business and notice the future contributions definitely aren't equal — but the equity split is! Equal equity splits rarely equate to a fair equity split.
Mistake Number 2: We fail to incentivize our team.
There won't be any incentive for anyone to work harder. If we do a quick split of equity, and everyone has exactly what they "earned" before they did any work, what's the incentive to work any harder than anyone else? What if one of us works 10x harder than the others? All of a sudden our "fair split" seems like a bum deal.
Mistake Number 3: We fail to anticipate change.
We won't have a provision to handle major changes. There's a fairly good chance that at least one co-founder decides to leave or some of the early employees will run into a life situation where they have to leave the company. What do we do if they leave? How does that equity return if one or more founder remains, while one or more leaves? If it doesn't, do they just get paid for life? We need a plan that anticipates inevitable changes and makes it clear what happens next.
The focus of this course is to present all of the most salient challenges and options involved in getting a company formed and splitting equity. It’s not a Mad Libs-style walkthrough to supplement needing legal counsel or having our legal docs crafted.
Think of this more like a primer on what we might face — so that we know how to approach the legal docs.
Whether we decide to download some free form off of the Internet or enlist the services of the most expensive lawyer out there (please don’t), the most important part of this process is understanding the handful of major decisions we need to make, and why to make them.
That’s what this course is all about. Actually crafting the docs — that approach is up to you.
Our goal is to truly understand the major challenges and decisions we’ll need to make and walk through those issues methodically. What we’re most concerned about is isolating each issue where we may not have a consensus so that we can focus all of our time and attention on just those items versus “the entire plan.”
When we’re through with this exercise, we’ll have a few critical elements to our Equity Plan in place:
We’ll have a stock structure set up so that we can award equity to current and future participants.
We’ll settle on a fair way to split the company’s equity
We’ll have a plan in place to account for changes to the stock as participants are added or removed, like vesting schedules,
With that, let’s get this equity party started!
This Phase is a primer on all the key issues that we’re going to address throughout this course. We tend to find that being able to see the “big picture” first is helpful before diving into each individual decision.
We’ll also take a look at some of the bigger “meta-issues” that we need to consider before we even start making any decisions, such as how to think about the challenges of splitting equity in the formative years or how to get all of this in writing so nothing gets forgotten about later.
The focus here is going to be getting our heads around the entire process and all the issues. Thereafter, we’ve divided the issues and decisions into 3 distinct Phases that we can pick off one at a time. They answer 3 basic questions:
Phase 2 “How do we structure our deal?”
Phase 3 “How do we split the equity?”
Value contributions (current and future contributions)
Set contribution window
Evaluate actual contributions
Phase 4 “How do we manage equity?”
This process is broken up into distinct parts so that we can get into progressively more complex stuff as we go. We start with the “easy” conversations we can have now such as what Stock Structure we pick or what percentage of our stock to put into an employee Stock Option Pool. Then we’ll work into the “harder” conversations such as how the stock is divided and what happens if someone leaves the company.
Most books or courses on this subject are written as if two robots are going to have a binary discussion in code. The world just doesn’t work that way. The crux of the issues around splitting equity still deals with very real emotions, and ultimately — trust. So we’re going to ease into the discussions starting with the stuff that shouldn’t be as hard to agree upon and then moving into the more challenging discussions as we’ve built some early consensus.
This will also help us narrow down the list of “remaining decisions” into just a few so that we’re not confusing one specific decision with the overall challenge of splitting equity. We tend to find that the more focused the decision is, the more likely it gets resolved.
First, let’s take a quick pass at the entire process so we know what we’re getting into. Think of this like the “Cliff’s Notes” version of every key issue and decision we’re about to make:
Before we even begin this conversation, let’s make sure we all agree on how incredibly valuable our equity is so that we’re putting the appropriate value on every decision we make. Startup Equity represents 100% of the value of the company — which can change significantly with future valuation.
We can't have any handshake deals. Even if our agreement is as simple as a single-page document outlining the basics of how the company is split up, we have to have some tangible evidence that we agreed on stock ownership, even if we plan on changing it later.
Stock Structure. There are a few ways we can go about issuing stock and we’ll need to pick the version that suits our needs best. We’ll look at the 3 most popular methods and pick one that makes the most sense.
Ideally, everyone should agree to a "vesting period" for their equity so that they earn a portion of it over some predetermined period of time — typically a 4-year vesting schedule. This will provide a built-in mechanism to incentivize team members to stick around to earn their full share.
We’ll probably want to set aside a portion of the company’s stock in a “Stock Options Pool” to award future employees by sharing company ownership. Allocating stock options now will avoid us having to recalculate the entire company’s ownership (cap table) every time a new key employee person joins.
In order to value people’s contributions to the company, we need to know what the company is worth. By setting an initial valuation we’ll know that if someone contributes $10,000, it’s worth a specific percentage of the company’s stock (their equity split). This will also be required if we want to seek potential investors or venture capital providers.
We need to make sure each member is rewarded for their actual contribution over time, not a “best guess” at what their expected contributions will be for the next decade on Day 1. We’ll set up a plan that fairly calculates each person's cash and non-cash contributions in order to divide equity fairly.
We’ll set a “contribution window” (for example, 3 years) whereby we’ll determine our individual contributions in that period and tally our total actual investment, which will help determine our pro-rata startup equity stake.
Once our contribution window has elapsed, we’ll compare our actual contributions over the set period and determine what our final equity stakes will be, recognizing that more contribution should equal more equity.
The early stages of our startup company will likely see a lot of change, and that includes the core members of the company. We need to understand how many factors are potentially at play so we can get a good feel for how probable changes are and get serious about the plans in place to account for them.
We need to come to a basic agreement (and our documents and systems should reflect this) that if any of the co-founders or first key hires are no longer contributing to the company in a material way, we will make provisions to return our equity back to the contributors under some mutually-beneficial plan.
No one wants to put in 100-hour weeks while the other person gets the same benefit without even working there.
Times change, people change. In the event that a co-founder leaves or other employees leave the company, (for good reasons or bad) we need a mechanism for their stock to be returned to the company in a fair and equitable manner.
This also serves as an incentive to stick around, as the loss of equity becomes the opportunity cost of leaving.
Alright Founders, now that we have a basic understanding of what we’re about to tackle, let’s get a better handle on what we need to know about splitting equity.