Force of Good

Startup Equity Distribution

Oct 30, 2008

On my Skribit app (located in the right sidebar) someone suggested that I write about how an early stage technology startup should determine who gets how much equity and when.  With the upcoming Atlanta Startup Weekend 2 expected to spawn 5 - 10 projects spread across 100 "founders" it seems like a good time to address the question.

The Simple Answer

Divide all equity equally.  People do this all the time.  It's simple.  It's makes everybody equal.  It avoids the difficult discussion of the value and effort that each founder brings to the startup.  And it's the wrong answer.

It's the wrong answer because everyone does not bring the same value to the venture.  It's the wrong answer because everyone usually does not bring the same effort to the venture.  It's the wrong answer because having the complex discussion about who is worth what, what value they bring, and what role people will be playing is a key to success in the early stage of a venture.

A More Complex Answer

I will grant you this.  Assuming equal equity might be a good starting point to a discussion about equity distribution... but it should be just a start.  The founders need to look at their specific situation and adjust accordingly, weighing the contributions of time and expertise that each founder brings to the table.  If a founder is crucial to the task, they deserve more equity.  If someone has a role that is somewhat interchangeable with a host of other individuals perhaps they get less. 

You can approach this logically.

Start by giving everyone that was "in the room" when the concept was conceived a 5% stake.  The idea in and of itself should be worth something.  If you don't think it is find another startup.

Then sit down with your co-founders and determine what key milestones need to be reached in order to add significant value to the company.  That will lead to some interesting discussions around company direction, funding strategy, and corporate control.  When it is all said and done you will have some idea of strategic direction on which to build.  Direction that all the founders can agree on.

Now look at those milestones.  Break them down.  Determine who is going to do each task.  Determine the person's open market hourly rate (What they make as a contractor or annual salary multiplied by 1.4 divided by 2,000).  Determine the time it is going to take to complete the task.   Get buy in and commitment including dates. 

Determine the valuation of the company and the number of outstanding shares, use that to calculate the share price.  But determining valuation in an early stage company can be hard.  If you are truly early stage use the Y Combinator model.  Average Web startup with 3 founders is worth $285k.  Use that as a start.  Use whatever makes sense for your situation.  Just think it through.

Then allocate each cofounder a number of shares whose value equals the hourly rate that they charge multiplied by the number of hours they contributing.  You now have a nice analytical basis for which to have a meaningful equity split discussion as well as a clear understanding of roles and responsibilities.

I have seen this done effectively several times.  There is usually enough common left over to hire shorter term contractors in this manner as well if the startup cares to do so.

Timing

Notice that I used the word allocation above.  Allocated means not vested.  In my mind all founders stock should have either a milestone or time based (or some mixture of the two) vesting schedule.  If you want to know why find someone to tell you a story about a cofounder who walked away from the company and is still holding a 25% ownership stake. Trust me.  It creates problems.  Personally I prefer 25% one year cliff vesting with 6.25% quarterly vesting thereafter combined with individual milestones.

Legal Issues

I am sure that many of my legal friends will disagree with me on this but pre-funded companies need to conserve their cash for things other than attorney fees.  Lawyers are last.  Founders can memorialize their arrangement through a simple letter agreement and a covenants agreement.  You will find samples of both below.  Disclaimer:  I am not an attorney and I am not providing you with legal advice. Consider them illustrative.

Download sample_letter_agreement.doc

Download sample_covenant_agreement.doc

Summary

The issue of equity allocation and the timing is a very important discussion that startup founders need to have.  Yes it is a difficult discussion.  A hard discussion.  But starting a company is difficult and hard.  Take the time and energy needed to think and talk through who gets how much equity and when they should get it.  Every startup is unique and the equity structure of a startup should reflect this uniqueness.

Posted in Entrepreneurship, Startups
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