Rewards — splitting equity

Splitting equity? Welcome to the zone of contention. A guide on how to avoid common mistakes

Rewards

The most uncomfortable discussion that you will have with your co-founder will likely be about rewards. It can lead to intense fighting, mistrust, and heated conversations. Regardless, you need to have this conversation in an open and honest way. The repercussions for avoiding this “difficult conversation” can and does lead to the demise of many startups.

Unfortunately, there is no “right way” to have this discussion, but there are many ways to do it incorrectly. We are going to run you through different scenarios and make sure you avoid as many missteps as possible.

When to Split

This is up for debate. 73% of co-founders [Wasserman, 2012] split equity within the first month. I do advocate for getting tough conversations out of the way and having proper expectations set early on, but there are some tradeoffs when splitting quickly.

The benefit of splitting early is that you are having a tense discussion with cooler heads and less emotion while in the beginning stages of your venture. Many founders who decide to wait do so right up until they enter their first round of fundraising. Trying to negotiate a split with your co-founders at the same time you are negotiating with investors is a recipe for disaster. You can’t win a war on two fronts; Napoleon learned that lesson the hard way. In order to finalize the deal with your co-founder, there is a chance you will force your way through the tough discussion around splitting, and multiple parties will be upset.

The huge benefit that I see when looking at splitting early is the opportunity to set proper expectations. You do run the risk of having to renegotiate later, but if you wait until you start fundraising, you can run into a situation where expectations are wildly off. I’ve interviewed founders who have had this scenario happen to them, and it almost leads to the collapse of the company. Imagine that your company is on the verge of being funded only to see it dissolve right in front of you because you couldn’t agree on terms with a co-founder.

The challenge is that if you split early, you run the risk of being upset with the deal later on as the roles, contributions, and founder’s strengths are more properly measureable. A benefit of waiting is that it provides time for you to make better judgements on those key attributes.

There are tradeoffs with each scenario, so how do we overcome this? Wasserman provides an interesting framework for tackling this issue called the dynamic split. It might be a good exercise to think through for you or your team.

Dynamic vs. Static Split

Founders routinely overestimate their contributions and commitment to a venture. They base this off their initial excitement and passion for the venture, which always wane as time goes on. You plan for the best and write it into your founder agreement, but that is extremely challenging to maintain especially as life gets in the way.

The idea of creating a dynamic agreement where founders check their progress every three or four months as the venture progresses is a safe way to make sure that everyone’s voice is heard throughout each stage of building the venture up until you start fundraising.

We can take Spark xyz as an example: the first three months of the venture was an exploratory phase. It consisted mainly of talking with potential customers, identifying potential pain points, and flushing out the idea to see if we could execute it.

Had we recruited the technology side of the venture that early, the person we would have hired wouldn’t have anything to do. An inexperienced founder might look at the situation and think that their partner is being lazy because they aren’t doing anything, unaware that the technology side is going to become more cumbersome and intense in the second phase and during the build out of the venture.

Having an agreement that you can negotiate openly and fairly at each stage can serve all parties better and create a better working environment.

See below for an example of what this agreement might look like:

[Wasserman et al., 2012]

Keep in mind that this is from a case study, called UpDown, about co-founder challenges with splitting equity. Use this as only an example, as it was created by Michael (from the case study) and its terms were changed later to more equally reflect the work.

Splitting Equally

First, a warning: do not split equity in equal parts. Doing so is lazy, and outside parties including investors will view it as an inability to have a tough conversation [Schall, 2016]. Investors see it like that because that is what it is. If you split equity, one or more of the parties involved will most likely have buyer’s remorse.

If you ultimately hash out all the details and still want to proceed with equal splits — you can, but know that the odds are stacked against you, and that your discontent will “increase by 2.5x” [Wasserman et al., 2016] as the startup matures. Some people can defy the odds and be successful with the equal split, but it is not the advisable path to take.

How to split, what deserves more?

How much of the pie does each person deserve? This also does not have a clear-cut answer as this is dependent on a variety of factors.

What we do know is that the decision is typically based on a few main items: the source of the idea, intellectual property rights, contributed capital, investments of time, defined roles, an individual’s network, and specialized industry expertise. The most interesting piece of this list is that the “idea person” traditionally receives 10–15% more equity than anyone else [Wasserman et al., 2008]. I largely don’t agree with this logic as the success of a venture is far more predicated on the ability to execute an idea than it is to come up with it, though admittedly, almost half of the idea people also reach for the CEO role, which is granted a premium in a startup.

As you make your own determination regarding equity, walk through each of the items and carefully consider all of the above contributions. Some soft values such as a co-founder’s network are often excluded in negotiation, but items like these are integral parts of a startup’s success and often more valuable than human capital. [Spiegel et al., 2015]

The final note here is to check your emotions and how you are valuing your current contributions versus future contributions. This agreement, if not dynamic, is binding, and it is extremely expensive to try and change it. For reference, it cost Snapchat three-hundred million and Facebook close to half a billion to fix their mistakes.

Items to be Aware of

If we haven’t already expressed this enough, do not do a quick handshake deal, but do put everything in writing. I know of a startup that recently failed because they didn’t implement the items above nor the pitfalls we outline below. They didn’t put anything in writing, but spent an entire year working on this venture while at USC. They won an award and were on an upward trajectory. The problem was that their “CEO” (they did not have a good conversation about roles) decided to leave the company and unfortunately, he was the one who had purchased the domain and the other intellectual property If they had implemented the items discussed above and signed contracts, the remaining three co-founders would have been able to keep the intellectual property and continue the venture. Unfortunately, they didn’t follow these steps, and thus an entire year’s worth of work was wasted.

Items to Include in Your Contracts

Vesting Schedule: The typical vesting schedule is a four-year vesting period with a one-year cliff. What this means is that if one of the founders or employees leaves before completing a year of work, he or she will not keep any of the equity earned up until that point. Once these individuals reach a year, their contributions will catch up, and their new stock will vest each month going forward.

Intellectual Property (IP): If someone leaves the company, you need to have a stipulation in the contract that the IP is owned by the corporation not the person who created it. I do not need to tell you the implications of all your work walking out the front door.

Right of First Refusal: If someone in the company wants to sell their shares, he or she first must offer the corporation a chance to complete a buy back instead of selling to an outside party.

Capital Contributions: The amount of capital contributed to the venture by each co-founder.

Death/Disability: The actions that take place if a co-founder passes or is incapacitated.

Dissolution: An explanation of rights that each party holds if the company is dissolved.

Drag-Along Rights: Stipulations that enables a majority shareholder to force a minority shareholder to join in the sale of a company. The majority owner doing the dragging must give the minority shareholder the same price, terms and conditions as any other seller.

Transfer of Shares: Determines whether shares can be transferred and defines who they can be transferred to.

Optional:

Right of Repurchase: Provides the company with the right to repurchase all awarded common stock from an employee at fair market value.

Executive Power: Who can fire whom? This details the way in which a company can remove a co-founder under extraordinary circumstances

File your 83b

Close to the number one mistake that founders make after signing a stock purchase agreement; all it is is a form you send certified to the IRS within 30 days of creating your stock purchase agreement.

Here is a flow chart to explain what happens if you do not:

Final note:

Be wary of your greed while going through this process.

I am reminded constantly of a case study that we did in Founder’s Dilemmas called Haute Hunte. The case revolves around a student, Vikram, at Columbia Business School who went through a series of potential co-founders throughout him creating his venture. Most used the startup as projects in their classes, but there was one person, Daniel, who was the perfect co-founder for him. Daniel had connections in the industry they were getting into and he filled in the missing skill gaps that the venture needed. After a year of working on this, however, Daniel decided to move in a different direction.

Vikram eventually recruited new co-founders, but through a series of issues got tangled up right before they were funded. Those tangles wouldn’t have been an issue if Daniel had been part of the startup still. Eventually, the venture failed and Vikram’s single biggest regret? Not offering Daniel half of the company right then and there to stick with it.

When I started this venture I purposely overpaid my co-founder because I can’t do this without him. We are a team and he needs me as much as I need him. A couple percentage points in the long run is not worth losing real talent that can make your company successful.

Make sure you aren’t being greedy for no reason. You don’t want to lose your co-founder and talent.

References

Schall, G. 2016. Don’t Make Founders Equity Even. https://techcrunch.com/2016/07/24/dont-make-founders-equity-even/

Spiegel O, Abbassi P, Matthaus P, Schlagwein D, Fischbach K, Schoder D. 2015. Business Model Development, Founders’ Social Capital and the Success of Early Stage Internet Start-ups: a Mixed Method Study. Blackwell Publishing. Information Systems Journal 26, 421–449

Ayr, S. What is an 83(b) Election and When do I Make it?. http://acceleratedvesting.com/what-is-an-83b-election-and-when-do-i-make-it-part-1-with-graphic/

Wasserman N, Braid Y, Prasad N. 2014 Haute Hunte: Pursuing the Big Trophy. President and Fellows of Harvard College.

Wasserman N, Malhotra D, 2012. Negotiating Equity Splits at UpDown. President and Fellows of Harvard College.

Firouzi, K. 2016. Co-Founder Equity Split: A New Framework to Objectively Divide Startup Ownership and Get back to Building a Business http://blog.gust.com/cofounder-equity-split-framework-objectively-divide-equity/

Lucas is the founder of Spark xyz, platform management software for incubators, accelerators, Angel groups, and VC’s.