When a new company is formed, there is always much discussion about how to properly split the equity. Most of the time, discussion is based on predictions the future. People try to guess how much the company will be worth and who is going to contribute the most, which people have the best ideas and all sorts of other things that reflect a typical founding team’s excitement and optimism. Founders have big dreams, everyone makes big promises. This all leads to equity splits that based loosely on this equation:
SHARE % = INDIVIDUAL PROMISES ÷ FOUNDERS’ DREAMS
If this sounds silly, it’s because it is silly, but it happens all the time.
Of course, there are plenty of smart, experienced people who know better. Some have calculators and spreadsheets that can help, but these tools are based on their own estimates and intuition and not on the actual events that will unfold. Even if these approaches got it exactly right, it would instantly be wrong when something unexpected happens, which will lead people back to the negotiation and guessing problem.
There are two fundamental problems with this old-fashioned approach. First, it’s based largely on unknowable outcomes and second, it produces “fixed” equity splits that must be adjusted every time something changes (like adding or subtracting people or money).
This kind of thinking does not happen in non-startups. In a non-startup, managers do make predictions about the future in order to make decisions, but they acquire what they need based on the input’s fair market value. For example, if a manager predicts that buying a new truck will increase delivery services revenues he or she will actually pay the fair market value for the truck and pay the driver a fair market salary. The price, in other words, is based on the market, not the potential, future value of the truck and driver. When it comes to equity splits, startups tend to focus on the potential value of the assets, but fair market value is much more logical.
When a person contributes time, money, ideas, relationships, facilities, supplies, equipment or anything else to a startup and does not get paid a fair market value, that person is essentially “betting” the fair market value on the future value the company creates in terms of profits or stock value. Every day that passes consumes more time, money and other inputs so betting continues until the company reaches breakeven or raises Series A investment. At this point, the future is still impossible to predict, but the fair market value of the inputs is easy to quantify. Using the actual bets, instead of promises about future value added, a logical model for calculating a fair equity split can be created:
SHARE % = INDIVIDUAL BETS ÷ EVERYONE’S BETS
For example, consider two founders. Each is worth a fair market salary of $100,000 a year. One works 40 hours per week without pay and the other works 20 hours a week without pay. The first founder is, in effect, betting twice what the second founder is betting and, therefore, should receive twice as much equity if the company were to reach breakeven. Any other split would be unfair and would cause conflict.
A “50/50” split, which is extremely common, would mean that the second founder is benefiting at the expense of the first.
This model of basing equity on the fair market value of the actual contributions, also known as the Slicing Pie model, provides a logical structure for equity splits that allows founders to determine a perfectly fair split based on easily observable contributions.
