This Phase is a primer of 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:
“How do we structure our deal?”
“How do we split the equity?”
“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 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 deal 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:
Phase 1: Overall Issues
Before we even begin this conversation, let’s make sure we all agree how incredibly valuable our equity is so that we’re putting the appropriate value on every decision we make.
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.
Phase 2: Structure Issues
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 "vest" their equity so that they earn a portion of it back over some predetermined period of time - typically 4 years. 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 an “Option Pool” to award future employees. Setting it aside now will avoid us having to recalculate the entire company’s stock holdings (cap table) every time a new 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.
Phase 3: Splitting Equity
We need to make sure each member is rewarded for their actual contribution over time, not a “best guess” at what they will contribute for the next decade on Day 1. We’ll setup a plan that fairly calculates each persons cash and non-cash contributions.
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.
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.
Phase 4: Managing Equity Issues
The formative years of our startup 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 us 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 folks 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.
Alright, now that we have basic understanding of what we’re about to tackle, let’s get a better handle on what we need to know about splitting equity.
Before we make a single decision, please, please, please, for all that is good and Holy - please read this section carefully. Nearly every bad decision a startup makes this early on is rooted in what we're about to say right now.
The point of this section is just to provide a primer on how to think about equity in a realistic sense. The problem most Founders run into is that they just don’t take equity seriously, and don’t realize what a huge mistake it was until it’s too late.
We’ll cover a ton of different issues throughout this course, but before we even consider how we structure our stock or dole out equity, it’s most important we understand the biggest pitfalls in handing out early equity, especially when we’re about to hand out the biggest portions ever.
The curse of early equity in a startup is that it feels as though it’s “free” to the Founders. 9 seconds ago, we had this amazing idea for a product and now people are willing to work for us for the promiseof a future payout. We wind up with an exclamation like this:
“Our Web Designer is working for free! She only wants 15% equity.”
The moment we go down this path – the path of thinking that equity is Monopoly money that we just printed and can’t believe people will take in exchange for real value – we have already lost.
Our equity is the single most valuable piece of currency we will ever have in our lives. It’s more valuable than money and it is (probably) the only asset class we will likely own that will be worth exponentially more than it is worth today. We don’t get it back.
Every time we give away equity we are reducing the future payout that we will work the rest of our career for. It’s not that we shouldn’t use equity – it’s a staple of the startup economy – it’s that we need to seriously respect just how valuable it is.
Every time we give away a share of equity, we not only give away its present value – we give away all the value it will have for the rest of our startup lives.
Imagine if I had $1 when I was 10 years old, and that $1 would magically produce another $1 every single year like clockwork. By the time I was just 20 years old I would have given away not only that dollar, but the $10 it produced each year. By the time I’m 100 (cyborgs, people!) I would have given away $90 in future earnings. Whatever I spent, that $1 had to be worth at least $90 of future value lost. That’s equity.
Now let’s play that out for our wonderful graphic designer who helped build our web site 7 years ago. She still owns 15% of the company. Every year we make $250,000 in profit, which is wonderful. Every year we send her a check for $37,500 as her 15% share of the profits. Every. Year…Forever!
Her web site wasn’t even that awesome, but we were foolish enough to think that “just 15%” was a deal. It’s not. Her contribution may have helped get us started, but we didn’t appreciate the time value of equity when we just gave it away - and now we’re paying for it for the rest of our lives.
We could have solved this problem so many other ways. We could have given her a capped share of profits: “You normally charge $10k, we’ll pay you back $50k over some period of time”. We could have given her a small amount of cash and a smaller equity stake. We could have done anything but give her a lifetime supply of our hard-earned work. We just needed to appreciate the “future value of equity” to force those decisions.
Not only do startups run into the issue of treating equity like Monopoly money, they tend to have a fascination with giving it away all at once – up front. If it were cash we’d never think to do that, but for some reason we’re compelled to think that equity should be a lump sum payment regardless of services rendered.
“Elmer Fudd is joining us to lead Business Development (he’s a great hunter). We’re going to give him a 10% stake of the company so that he can go chase the big customers.”
Why did we just pay Elmer 10% of the company? Has he actually sold any big customers yet? Why are we paying him in our most valuable currency – all up front – in hopes that he might be useful? That’s nuts. Why not let him earn his equity over a period of time so that if he does what he says he’s going to do, he indeed gets his 10%. But if he doesn’t, we didn’t just grant him some huge stake without any payout!
If we were to compare this to cash, it would look just as ridiculous:
If this sounds insane – it’s because it is! Now, we’ll cover this in great detail throughout the course with things like “stock vesting” and “clawbacks” that will help protect us a bit, but the bigger point is that we don’t want to just hand out equity quickly. We want to create agreements where there is the potential to earn more of our equity, but not giant Christmas gift grants!
By now there’s a clear pattern forming – giving away early equity quickly and without some serious consideration is a recipe for disaster.
That doesn’t mean we don’t have options for how we can manage our equity or give it out. It just means that when we do, we want to look way past where we are today and think about the greater needs of the business long term.
Dude, you’re going to work the hardest hours of your life on this company. Please be careful about who you give it away to. As a fellow Founder, no one believes you deserve the fruits of your labor as much as I do and if this final plea causes you one moment of pause before you give away a single share, my work is done here!
If it’s not in writing – it didn’t happen.
Of all the things that we don’t recall well – where we left our keys, our anniversary date, or the name of Willow Ulfgood’s arch nemesis in the movie, Willow (spoiler: it was “Mr. Burglekutt”) – not having 100% recollection of how we divided the most valuable asset in our company should not make that list!
When it comes to equity – the only conversations that matter are the ones we get in writing. Everything else is just “an understanding”.
There are many times where a handshake deal can work out great. If you ask me to help you move your stuff into your apartment in exchange for buying me a pizza and vodka (my rates are very specific) – we can shake on that. If we’re talking about dividing up an asset that could be worth a billion dollars – ehhh– we may want to write this one down!
There’s no reason we need to wait until we’ve got a final consensus on our equity arrangements to begin committing things to paper (or email). We can begin formalizing each of our steps individually and then eventually wrap them all into a single finalized document with our friendly startup lawyers.
Fun Ways to Commemorate Important Stuff:
For example, we could isolate a single decision, such as how we want vesting to work, with a subject line “Team Agreement on Stock Vesting Schedules” and begin the thread to include all members of the staff that would be affected. This not only makes sure that everyone focuses on a single issue (which is important) – it also creates multiple time-stamped copies of the same communication in case it needed to be referenced later.
However, a lot of this discussion may happen on a whiteboard in a meeting or on a road trip to a new potential client. They may be entirely offline. That’s fine. What we’ll need to do in that case is simply send a follow-up email, even if it’s just the two of us, to capture what was said, but also to provide a forum for rebuttal in case one of us didn’t understand the agreement in the same way. That’s just good communication.
When it comes to making decisions around equity – we can’t have fuzzy answers. If you think the valuation is $1 million and I think it’s $2 million – we need a number. If you think Elmer Fudd our BizDev guy should have 10% of the stock and I think he should have 15% - we need a number.
Even if we don’t agree, we need to document the fact that we don’t agree. It doesn’t have to be contentious either. I can write you a note that says:
“Yesterday we talked about adding Elmer as a co-Founder. You suggested his stake should be 10%, and I suggested it should be 15%. We don’t have a final answer but let’s agree we need to get to one.”
What we’re trying to avoid is a “he said / she said” or “I think we might have agreed upon X...” kind of conversation. We either agreed on a fixed number when it comes to stock or we didn’t. If we didn’t, we documented our respective proposals for future reference.
Once we’ve gotten a basic consensus on our key issues (and we’ll walk through those throughout this course) we can then bring in a lawyer to “paper it up”.
Good lawyers will advise that the more we can have discussed and determined before we call them, the more smoothly our documents will get crafted. Bad lawyers who need money will suggest we run every thought and suggestion through them. They are also quite expensive.
Our goal right now will be to present and discuss the substantive issues amongst ourselves and then take whatever we have decided upon (and perhaps a few issues in contention) and ask our attorneys to translate these decisions into binding, sign-able legal docs.
Can we do this on the cheap through a $99 “DIY” service? Actually, we can. But it’s less likely that the Mad Libs-style document we’ll have selected will accurately cover the key decisions we need to make in splitting equity. We’re not here to advocate for lawyers, but for this one – it’s a solid investment.
So that’s it – let’s be stingy as hell with our stock and make sure any discussion that’s substantive to splitting equity is captured in writing.
We’re about to make some massively impactful decisions among our team but we need all of us to have the same mindset around how important that equity is. The moment we start taking it less seriously – any of us – that’s the moment this whole process breaks down.
If we’re serious about our equity and our decisions are all committed in writing so that we can have a beautiful legal doc to keep us all on the rails – we win. It’s just that easy.
OK, it’s not “that easy” but it sure helps.