Splitting equity is tricky business.
According to The Harvard Business Review, the percentage of founders who say they are unhappy with their equity split more than doubles as their startups mature. Since 2008, HBR has studied the equity splits taken by more than 3,700 founders from over 1,300 startups across the U.S. and Canada.
HBR identified a correlation between increasing discontent over equity and an increase in turnover. There is no denying that disagreements, resentments, and uncertainties will arise over the divvying up of shares. Even the most minor differences in equity can translate to major leadership rifts.
"As a member of the founding team, you should take responsibility for splitting equity in a way that's fair to all contributing parties, while simultaneously positioning your startup for long-term success," says Drew Hendricks, contributor at Entrepreneur, "The problem with splitting equity, however, is that there's never a 'clean cut.' Any time you have more than a couple of people involved, disagreements will erupt over what value people bring to the table, which parties were there from the beginning, etc."
The Startup Founder Equity Agreement Cheat Sheet
How do cofounders start to think about a fair and equal equity split? For many cofounders, in the early stages of startup development, splitting equity is never a topic of conversation. In fact, between growing the company, finding funding, hiring, and more, equity is the last thing cofounders want to think about. However, the most successful tech startup cofounders agree on equity split right from the beginning.
To master startup founder equity agreements, industry-leading cofounders consider the following factors:
A vesting schedule determines when cofounders will be fully "vested" or acquire full ownership of startup assets. Typically, vesting schedules will require cofounders to stick around for at least four years. A vesting schedule is also a particularly important "safeguard" for cofounders. Without a proper vesting agreement in place, there's nothing stopping a cofounder from prematurely quitting and taking his or her shares.
"The only solution in such a scenario is to negotiate a repurchase of those shares, which could be very expensive or impossible (if the departing founder wants to screw with his cofounders)," says Scott Edward Walker of Walker Corporate Law Group PLLC. "And if the departing founder has a huge chunk of equity, it is unlikely that the company will find many sophisticated angels or VCs interested in investing."
Partnering with an experienced attorney to outline a mutually beneficial vesting schedule is an essential part of every equity agreement. Founders should also remember to file an 83(b) election with the Internal Revenue Service within 30 days after the grant/purchase date of the restricted shares.
Avoiding the 50/50 Split
There is no best practice when it comes to constructing an equity agreement. Some cofounders split their shares down the middle with a quick handshake, while others take their time developing more customized agreements.
"In our data, we find that those teams that negotiate longer are more likely to decide on an unequal split: the harder you look, the more likely you are to discover important differences," said Noam Wasserman and Thomas Hellmann of Harvard Business Review, "More generally, we argue that if cofounders haven’t learned something surprising about each other from their dialogue, they probably haven’t engaged in a serious enough discussion yet."
Considering that venture capitalists invest in a small fraction of the pitches they hear, it's safe to assume they are looking for reasons to say "no." Many investors see an equal split as a red flag indicative of poor negotiation skills and potential resentments between cofounders down the road.
The founders of Smartix, Inc., who developed a smart ticketing system for sports venues, decided to delay splitting equity during the initial stages of scaling their startup because roles were constantly evolving. After reviewing each person's current and future contributions, it became clear that a 50/50 split would have been unfair.
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Other Factors to Consider
Here are some additional factors to consider when splitting equity:
- Sweat Equity: The term "sweat equity" refers to the amount of time, effort, and energy someone puts into building a business. As Entrepreneur contributor Ryan Himmel says, equity splits should reward a combination of the highest-valued contribution and the largest undertaking of risk.
- Domain Expertise: Has one founder brought more connections to the table? Has he or she been "in the business" longer? Use a leader's experience as a benchmark for startup equity.
- Funding Contributions: How much money has each person contributed out of pocket? If one founder has invested heavily in the startup, he or she may be entitled to a larger share.
As you can see, there is no one-size-fits-all formula for constructing equity agreements. Fortunately, you don't have to issue all of your shares right away. Peter Ziebelman, cofounder of Palo Alto Ventures, routinely advises founders to implement equity safeguards until roles become clear:
“What we counsel is to hold some shares back. Let’s say 75 percent of the company is being divvied up among three partners. Instead of giving 25 percent to each person, consider 20 percent each and hold 15 percent for what we call course correction."
Equity Agreements Are Never Easy
Undoubtedly, splitting equity can feel uncomfortable. No one wants less than he or she deserves and no one wants to hurt anyone's feelings. Factor in the close personal relationships many cofounders share, and it's easy to understand why many rush into equity agreements they later regret.
The best way to approach the equity splitting process? Speak with founders who have already done it. Our tech campuses house Seed to Series C funded startups with minimum viable products in place, many of whom have already constructed equity agreements. If you are looking for a supportive tech ecosystem to help you scale faster, look no further than RocketSpace.