A Startup Lawyer’s Take on How to Allocate the Equity
Rock band feuds are usually the first co-founder disputes we are confronted with in life. But the split up of Take That, the Beatles’ break up or the separation of the Oasis brothers are just the tip of the iceberg: Many startup founders also fight long and hard about their startups’ equity, and the only reason why there are not so many public examples is that co-founder disputes often kill a startup before they get any attention. As startup lawyers, we not only accompany entrepreneurs in the early stages of the company but are also there when disputes arise.
In this blog post, we will share our insights on the economic and psychologic aspects of startup equity splits, why you should discuss it in-depth with your co-founders, what to talk about, how to talk about it and what legal agreements you need.
1 The Economics of the Co-Founder Share Split
A startup is an economic unit whose output is a function of its input. The input consists of capital, labor and ‘intangibles’ such as all the tech, know-how, network etc. that improves the productivity of the labor and capital.
When splitting equity, the founders in essence agree on the relative value of the capital, labor and IP each of them contributes to the venture. The typical drivers of value are:
- Labor: This is simply the time spent with the startup times the value of that time. What the time of each founder is worth depends mainly prior experience in venture building and industry-specific expertise.
- Capital: The actual cash or cash equivalents that a founder brings.
- IP: From a network in the industry to ‘having had the idea’, anything that cannot be appropriately reflected in the labor or capital category can be added here.
This may look as follows:
Allocation of shares of tech startup:
|Alice (junior developer, works 100%, ‘had the idea’ and wrote the code of the prototype)||350’000||0||100’000||450’000||45%|
|Bob (three prior exits, works 10% as advisor, brings seed capital and network)||50’000||50’000||50’000||150’000||15%|
|Eve (junior developer, works 100%, helped with the code for the prototype)||350’000||0||50’000||400’000||40%|
While it is easy to make up numbers, it is often very difficult to objectively value the contributions, not only from an economic perspective but also from a psychological perspective.
2 The Psychology of the Co-Founder Share Split
There are many emotional and psychological aspects at play when discussing the equity split with your co-founders. The fallacies we most often see in practice – without any claim to scientific accuracy – are:
- Avoidance / procrastination: Speaking about money and power is hard and uncomfortable, especially when there is a pre-existing personal relationship between the co-founders. As with anything that is hard and uncomfortable, we tend to avoid it or postpone it, hoping that the issue will never arise or resolve itself. However, speaking openly about the equity split avoids problems down the road and is a great way to find out how your co-founders handle difficult situations.
- Overconfidence-bias: Assessing your own skills and value objectively is notoriously difficult and we have a tendency to overconfidence: Be it in your university days with your flat-mates where each person is convinced that they clean the dishes more than the others, or on the road where a US study shows that an incredible 93% of American drivers rate themselves as above the median. So, when discussing the equity split, be aware that you are most likely overestimating your own value and underestimating what the others contribute. Also, getting the opinion of an independent third party (not your best friend or partner) can help to sanity check your own negotiation position.
- Relative deprivation / fairness: In principle, each founder should mainly care about whether the equity received is an appropriate compensation for the contribution and the risk. However, poverty research shows that our happiness depends not only on what we have in absolute terms, but also what we have relative to our peers. The split should therefore not only be a good deal for each co-founder in absolute terms, but it should also be fair in relative terms.
The biggest and most common issue is that the co-founders simply do not address the co-founder equity split because it is uncomfortable and hard, or simply wrongly assume that everything is already clear. Do not avoid the topic and do not make assumptions about the expectations of the others. Discuss the equity split in-depth and embrace the fact that the discussion will likely be tough. It will significantly improve your chances for success – or you will realize that your co-founders are incompatible so you can fail fast and move on.
3 Common Approaches & Best Practice for the Share Split
3.1 Why the Even Split is a Bad Sign
When it comes to the actual method used, there are basically two common approaches:
- The even split: The 50/50 handshake is quick and simple and, according to the Harvard Business School startup guru Noah Wassermann, the solution most co-founders opt for. However, this is also the method most commonly used in teams that do not discuss the split in-depth, and the same research shows that startups with an even split have triple the unhappiness levels compared to startups that have an uneven split.
- Split based on value-based calculations: There are many different calculation methods, but they all share the same underlying principle: The co-founders agree on a valuation of the contribution of each founder and allocate the shares based on this valuation. While the details of the methods vary widely, the key is that the cofounders agree on a split based on an in-depth discussion.
The most important question is not which method you choose, but whether you have chosen the method based on an in-depth discussion with your team.
3.2 What to decide
Besides the method to use and the initial equity split, there are many other topics that should be discussed. In fact, avoiding a zero-sum game around who gets how many shares by expanding the negotiation to other points can be a great tool to find compromise. Important topics to cover are:
- Rationale behind the split: Agree not only on a number, but also agree on why this number makes sense. Investors often ask about it and be sure that you have a sound logic behind the split.
- Future changes: The initial split is based on the current assumptions. These may change, so embed mechanisms how to handle the change. Everyone is excited about the new startup on day one, but few have the grit to still go full steam after two years of Ramen noodles and 80-hour work weeks. So, reach an understanding what happens if someone leaves or reduces the commitment.
- Titles, roles & responsibilities: Titles matter, so discuss who will be Chairman of the Board, CEO, CTO, and who will have which responsibilities and decision powers.
3.3 How to Speak about the Share Split
Speaking about the equity split between founders can be as uncomfortable as agreeing on a prenup prior to getting married: But as in marriage, communication in the relationship with your co-founders is key, and the money and power structure an essential element of your relationship. Our experience shows:
- Speak about it: As with any uncomfortable conversation, there is no right timing, so do it as soon as possible. This applies even more if you are friends. You can also use external pressure to start the conversation (e.g., ‘our lawyer said we have to agree on a co-founder agreement’)
- Be open and aware of the overconfidence bias: Try to be as honest and objective as possible on the value of your own work and appreciate the work of others. When talking about the value of the contribution of the others, be careful not to use derogatory language (‘your contribution is nice, but…’) as it can quickly get emotional.
- Accept that the discussions may fail: Starting a startup together is a big commitment, so ensure you really want to spend the majority of your waking hours with your co-founders. The equity split discussion is a great way to see whether your co-founders handle a difficult discussion with emotional maturity and business sense. The sooner you find out that this is not the case, the better – failing fast is a virtue.
- Expand the battleground: A great negotiator finds areas to compromise and avoids a zero-sum game. The equity split is just one question to discuss, so include titles (CEO, president of the board etc.), cash compensation, naming of the company or decision rights.
- Do not overvalue the idea: The idea is rarely worth much by itself and there are likely many others that had the same idea. At the end, it’s all about execution.
3.4 Co-Founder Agreement and Shareholders’ Agreement
A startup lawyer or even just a good template of the agreement between co-founders can be a great way to start the discussion and to ensure you do not forget an important point. There are two types of agreements used depending on the timing:
- Co-founder agreement: Prior to incorporating your startup, a co-founder agreement is used to define the key points and to ensure that all the intellectual property, such as software, created prior to the incorporation of the legal entity will vest with the company.
- Shareholders’ agreement: Once incorporated, the shareholders’ agreement is the key document for the money and power structure of your startup. Besides the equity split, the shareholders’ agreement contains most importantly the mechanisms that apply in specific events: What happens if a shareholder leaves the company (purchase rights), if a shareholder wishes to sell (right of first refusal and tag-along), if a majority of shareholders wish to sell (drag-along) etc.
Whether you’re a rock star or an entrepreneur, co-founder disputes are among the most common causes for failure. The equity split is particularly prone to cause debates, and while there is no guaranteed approach to avoid a dispute, speaking about the split in-depth with your co-founders is one of the best ways to mitigate the risks.