The Best Way to Split The Equity Pie in Your Startup
So you’ve started a company with a few others and are excited about the limitless possibilities that lay before you. Ideas about product, technology, marketing, fundraising, operations are probably swirling about in all your heads. Most of the team is probably already hacking away to get things done, but wait…. Slow down. One of the most important decisions to make before everyone goes full steam ahead is to determine the split in ownership of the new company. A good equity allocation will keep the team’s energy level sustained for the long haul. Oftentimes equity allocation is hastily decided or deferred too long. People also end up splitting ownership regardless of each person’s level of contributions. All these actions may lead to resentment, lack of motivation, break-ups and failure down the road. The sooner everyone can agree on how to split ownership, the more aligned everyone will be to achieve the team’s vision. So how do we split the pie?
Intellectual, Executive and Monetary Capital
We can use a simple framework to categorize value in any organization. The value of an organization is composed of human capital and monetary capital. We can consider monetary capital to be cash, but it also represents all tangible items such as equipment, office space, inventory that cash can purchase. We can split human capital into two categories: 1) intellectual 2) executive. Intellectual capital is composed of strategic and tactical ideas, product and technical architecture designs, branding, intellectual property etc. Visionaries like Steve Jobs bring enormous amounts of intellectual capital to the table. Executive capital describes action, getting things done and ‘executing’. Eric Ries’s ‘Lean Startup’ activities are more closely aligned with executive capital. Some people are thinkers, some are doers and having both makes for a good team. So we now have three categories: 1) intellectual capital (IC) 2) executive capital(EC) 3) monetary capital (MC). How you balance between these categories is subjective and really up to what your team emphasizes and what kind of company you’re creating. Someone who emphasizes lean startup methodology might value EC far more than IC. Others who consider Steve Jobs a visionary might put much greater weighting on IC. (Note: According to the article Welcome To The Unicorn Club, 2015: Learning From Billion-Dollar Companies, 83% of (unicorn) companies are working on their original product vision; only 17% significantly changed product focus in a big pivot.)
Growing the Pie Through Dilution
Once we have a framework of value it becomes much easier to assign each person’s contribution. The best way to explain how to split the equity is by walking through an example. Let’s suppose Steve Cobs forms a mobile software company called Peaches and has the vision, strategy and plan to dominate its industry. How much is the original idea worth? How about strategic ideas in the future? It’s up to the co-founders to come to a consensus on these questions.
At its very conception the big idea (vision, strategy, plan) is 100% of the value of the company. The original founder parts with a piece of the pie to add more people to make his/her vision a reality and increase the value of the pie. 50% of a realized vision is much better than 100% of an unrealized one. There is a balance between diluting and lowering current shareholder %’s in order to increase the total value of the pie. One of the goals for a company is to grow the pie by a larger percentage than the dilution throughout the growth of a company. We can see an illustration of how older shareholders keep getting a smaller percentage of a bigger pie as described in this article: How Funding Works — Splitting The Equity Pie With Investors
Allocating Contributions Between IC, EC, MC
Back to our example, let’s bring in two co-founders for Peaches and see how their contributions can be allocated. Let’s say Charles is a full-stack software developer and Debbie is a growth hacker. Let’s say Cobs and the two co-founders Charles and Debbie agree to divide 5 million shares of equity over a 4 yr period. First off, Steve Cobs can be compensated for most of the intellectual capital because he came up with the original idea and vision, but he and his co-founders can split future intellectual capital contributions.
Let’s assume that Steve Cobs gets granted 60% of the IC shares immediately for the original idea and vision and 20% vested over 4 years for future strategic direction. Let’s say the other co-founders will each get 10% of the IC contribution vested over 4 yrs for all the good ideas they will come up with in the future. Remember all equity is distributed based on the timing of the contributions. Equity is either granted for past contributions or vested in expectation of future contributions. IC is very difficult to quantify, but keep it reserved for those that are responsible for things like: vision, business & marketing strategy, product and technology design, branding, and intellectual property.
Let’s assign the following allocation of 5 million shares over a 4 yr period to be: 40% IC / 40% EC / 20% MC. Hence Steve Cobs gets 60% of 2 million shares available for IC now (ie. 1.2 million shares) and 400k shares vested over 4 years. The other two co-founders each get 200k shares vested over the same period.
Allocating Executive Capital & Determining Valuation
Now let’s split up executive capital. All EC should be on a vesting schedule because it is composed of expected future contributions based on action & results. Shares are delivered for execution and completed work. Any co-founder that is not succeeding for whatever reason can be fired and unvested shares will remain with the organization to compensate a replacement co-founder/employee.
The next step is to agree upon an average valuation for the company over a 4 yr period as a reference point. You can use any time period you want, but it should be aligned with the vesting schedule of co-founder shares. The average valuation can be pegged to the expected average valuation cap of convertible notes or value of equity on financing rounds over that period. (Note: the valuation cap of a convertible note is the maximum valuation of the company for which it can be converted into equity.) If you are offering someone like a consultant or contractor equity you’d probably just use the current equity valuation or the valuation cap on the current convertible note.
There is also a bottoms-up approach you can apply to get a valuation. Instead of estimating a valuation first and trying to make it equal to the sum of IC,EC, and MC you can start with estimating the value of IC, EC, MC individually and then build your way up to a valuation number. You can even use this approach to negotiate terms with investors in the early stages to decide on equity valuation or valuation caps for convertible notes.
In our example we’ll keep it simple and assume the co-founders all agree on an average valuation cap on future convertible note financing of $5 million to use as a reference point.
Executive Capital and Market Rate Salaries
Next we can divide up each co-founder’s contributions simply by determining their salaries over 4 yrs. You can start with market rate salaries and negotiate from there based on skills, experience and track record. Co-founders usually wear multiple hats so assigning higher salaries compared to average corporate salaries can be justified. You can split EC into three categories: Business Strategy & Finance, Sales & Marketing, Product & Tech. You may want to use a table like the one below to allocate capital by category :
Going back to our example let’s break down the executive capital and responsibilities as follows:
Steve Cobs — CEO (responsible for vision, strategy, business, fundraising, and cool launch demos)
200k sh/yr or 800k shares vesting over 4 yrs ($200k/yr for 4yrs = ‘$800k’)
Debbie G. Hack — Growth Hacker (customer acquisition, sales, marketing, branding, biz dev)
150k sh/yr or 600k shares over 4 yrs ($150k/yr for 4yrs = ‘$600k’)
Charles F. Stack — Full Stack Engineer (product, UI/UX, backend)
150k sh/yr or 600k shares over 4 yrs ($150k/yr for 4yrs = ‘$600k’)
Total: 2.0 million shares (‘$2 million’ in shares)
For IC we have:
Steve Cobs — 1.2 million shares now, 100k sh/yr over 4 yrs (‘$1.2 million’ now, $100k/yr over 4yrs)
Debbie G. Hack — 50k sh/yr ($50k/yr over 4yrs)
Charles F. Stack — 50k sh/yr ($50k/yr over 4yrs)
Total: 2.0 million shares (‘$2 million’ in shares)
For MC we have:
Total: 1 million shares ($1 million cash for general & admin/legal/consulting/rent/equipment/outsourced marketing, development, operations etc.)
In total we have:
Steve Cobs — 1.2 million shares and 300k sh/yr vesting (2.4 million shares after 4yrs)
Debbie G. Hack — 200k sh/yr (vesting) (800k shares over 4yrs)
Charles F. Stack -200k sh/yr (vesting) (800k shares over 4yrs)
Investors — 1 million shares ($1 million in cash)
Overall Total: 5 million shares (‘$5 million’ in shares)
The equity allocation starts out with Steve Cobs owning 100%, but after four years the allocation is projected to be:
48% Steve Cobs
20% Investors
16% Debbie G. Hack
16% Charles F. Stack
(Note: this simple model assumes nothing changes in four years, but most likely you’ll add employees and more investors so the allocation will be more complicated. You can use the same framework no matter how complicated the situation gets. All you have to do is conduct the same analysis every time you add a new investor, consultant or employee)
There are many ways to split up the allocation among a larger team. You can imagine we can split up the multiple roles & responsibilities that each of the co-founders has in our example. Again the goal of the company is to grow the pie and co-founders should be happy to dilute and share more equity with more employees and resources if the value of their piece of the pie increases.
This equity allocation framework is flexible. You can increase or decrease the valuation amounts as well as decrease the time period of the assessment period from 4 yrs to one year or even less. If you shorten the time period for determining equity allocation you can allocate everyone’s contribution incrementally as time passes. Perhaps a company can reassess everyone’s contribution and compensation year by year if desired.
Seamlessly Swapping Cash for Equity Compensation
In this example all the co-founders are taking compensation in the form of equity, but most co-founders won’t have enough personal savings to take all equity or may not want to take that much risk. In our model, we can easily swap human capital with monetary capital. Since the average valuation cap for MC is $5 million, we can swap equity for cash at $1/share for any of the co-founders. Perhaps Charles needs a higher cash salary so he takes $100k/yr in cash and $100k/yr in equity. Let’s say Debbie has enough savings so she takes $75k/yr in cash and $125k/yr in equity and Steve Cobs takes only $75k/yr in salary and $225k/yr in equity. Hence the company can raise an extra $1 million in convertible notes for a total of $2 million in MC to cover $1 million in salaries over the 4yrs.
In this scenario the equity allocation after four years is projected to be:
42% Steve Cobs (Receives $300k in salary over 4 yrs)
40% Investors (Contributes $1 million more to cover salaries)
10% Debbie G. Hack (Receives $300k in salary over 4 yrs)
8% Charles F. Stack (Receives $400k in salary over 4 yrs)
Here the co-founders all end up with less equity, but receive salaries.
You can use this simple framework to manage the cash & equity compensation for future employees, advisers and contractors throughout the life of the company. In the early stages you can offer equity at various stages. Why not offer equity early on to advisers, employees and contractors when you peg your company value at $1 million or $2.5 million. If you are a non-technical entrepreneur with a great idea why not use $250k or $1 million as the value of your IC to get a developer to do $25k worth of work for 2.5–10% of the company to build an MVP? As your company’s valuation increases the company can offer equity at higher valuations (e.g. $5/$10/$50 million). With this framework your company can more comfortably offer equity to consultants, advisers & freelancers in various areas of expertise at any time. A company can easily go back and forth between equity and cash compensation based on each recipient’s subjective valuation of the company, risk tolerance and personal cash needs as well as based on valuation assumptions in each financing round.
Monetary Capital
Lastly we can allocate MC based on all cash needs such as salary, legal costs, general & admin, overhead, equipment, rent etc. As we mentioned above we can convert any amount of IC or EC with MC in the form of cash salary at anytime as long as we know the cash value of equity. The allocation of MC ultimately boils down to valuation. In our example the cash value of equity we used was $1 per share based on the expected average valuation over a 4 yr period. The valuation of course should increase as time goes on and it’s just a matter of using an appropriate valuation at any point in time or over a given time period in the future.
Conclusion:
In summary, we can describe a simple framework to split equity as follows:
1) First determine the allocation between: intellectual, executive, and monetary capital.
2) Allocate intellectual capital for each co-founder based on strategy, vision, plans, ideas etc. Allow room for co-founders to earn future contributions in IC on a vesting schedule.
3) Next determine a time period (e.g. 1 - 5 years) for equity distribution and estimate the avg. company valuation over that period as a reference point.
4) Allocate executive capital for each co-founder using market-rate salaries as a starting point and place all executive capital on a vesting schedule. For a software company you can split up responsibilities into: business, sales & marketing, product & technology.
5) Finally determine your monetary capital needs for salary, equipment, rent and other needs.
6) Just make sure you assign the allocation so IC + EC + MC ends up equal to the valuation.
Every company is different and the allocation is never going to be perfect, but using this framework should make everyone much more comfortable that the equity was allocated using a process that they understand so everyone’s energies can be focused on achieving success instead of being weighed down by internal conflict. Remember you don’t have to have the entire allocation set immediately and you can continue to work, but you can use this framework to settle the equity allocation and employment contracts much sooner than later. Companies who use this framework should have far less headaches down the road and should increase their probability of success. Let me know your thoughts or if you have any questions. Thanks!
