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Startup Equity Distribution

Oct 30, 08 in Entrepreneurship, Startups   26 Comments

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.

Comments

I am guessing this is more likely to work for startups with 5+ founders. When it is only 2 or 3 people, trying to work through a complex formula would likely unravel badly. In my experience, it is more of a negotiation than anything else.

Here's an example that worked for me in the past. Three founders. Each gets one share. One founder brings the technology, they get an extra share. Another partner bring a launch customer, they get an extra share. The ownership split is 40/40/20.

Paul Freet  |  Oct 30, 08 at 08:22 AM

Thanks for blogging about this, Lance.

I'd assume that equity is not created until these milestones are reached?

Colin  |  Oct 30, 08 at 08:46 AM

Colin: Equity is "created" through a company's Articles of Incorporation. The Articles of Incorporation authorizes the number and class of shares. These authorized shares are then issued. If you use vesting then the shares are issued but not vested until the milestones are reached. And again, I am not an attorney. Perhaps one will come to our aid.

Lance  |  Oct 30, 08 at 09:02 AM

Great post, Lance. I have to say I never thought about setting up a vesting schedule for stock grants (rather than option grants). That's a good idea.

Another question: what are the trade-offs of non-equal equity distribution? Let's say you have 2 founders that get non-equal shares, but in reality they both work just as hard, take the same sweat equity, etc. Do you ever see the non-equal distribution of equity as causing resentment, differing commitment levels, etc?

We had non-equal equity for 3 founders in my first company and I do think that it caused some feelings of inequity and resentment. Not in a major way, but definitely in a noticeable one. But that can be tough when you're working non-stop for years with a few people on a big project. Thoughts?

Alan Pinstein  |  Oct 30, 08 at 09:59 AM

Great post, Lance.

The initial notion of equality among shares is the first hard decision we force VentureLab projects to rethink.

To me, equity distribution needs to reflect not only the resources brought to bear (hours spent, technology brought to the table, customers corralled), but also the risk being assumed by the founders. If one founder has a steady "day job" and works on the project at odd times, while another founder has decided to quit her "day job" and commit whole-heartedly to making the new venture a success, then that risk taken should be rewarded via increased equity.

Keith  |  Oct 30, 08 at 10:00 AM

Great feedback. Thanks for posting.

Marc  |  Oct 30, 08 at 11:51 AM

Alan: I know that this might seem like way to simple an answer but I believe founders need to create an open and honest culture where they can address any feelings of inequity before they cause resentment. Easy to say. Perhaps not so easy to do.

Lance  |  Oct 30, 08 at 02:13 PM

I'm not sure I understand who owns what prior to the vesting. So, if you have 3 people in a startup, and their equity hasn't vested, who "owns" the company?

Micah  |  Oct 31, 08 at 09:48 AM

Micah: The people that came up with the idea. Example, 1,000,000 share company. Three founders, Julia a marketer, Rachel a designer, and Robert a dev. Julia and Rachel came up with the concept. They each get 50,000 shares with no vesting. 100,000 shares outstanding. They each own 50% of the outstanding shares. Robert has nothing else to do so he is working full time on the project. When he gets the alpha done he will get 50,000 shares.

Rinse and repeat.

Lance  |  Oct 31, 08 at 10:04 AM

Lance,

Thanks for the points and interesting perspective. I am curious how much should be given if you are to hire a a high level executive that is requiring compensation but reduced from market value. Is it as simple as running some math on market value of the person, market value of the business, and then adding some sort of risk premium to the equation for the exec? Any guidance on this is appreciated.

Dave Williams
CEO, BLiNQ Media, LLC
Social Media Intelligence
dave@blinqmedia.com
404-822-7939

Dave Williams  |  Nov 06, 08 at 12:17 AM

Dave, I think something like that is a good way to start a discussion. If someone wants/needs more cash comp they should get less equity.

Lance  |  Nov 07, 08 at 03:35 PM

Very helpful post, Lance. In a setup such as the one you are describing here, what happens in the case of an acquisition prior to vesting of shares? Would there be a provision to automatically vest those shares, or would that typically be rolled into the acquisition structure itself?

Jason  |  Nov 15, 08 at 11:24 AM

Once you get to the point where things get all papered up putting an accelerated vesting clause in the event of change of control is an option. There are standard versions of these clauses. You then set up a nice negotiating discussion with the acquiring company on issuing you more shares in their company if they want you to stick around.

Lance  |  Nov 15, 08 at 11:33 AM

Accelerated vesting clauses are a must once you're up and running. They don't have to be in the first breakdown (which Lance describes in this post) but will need to happen sooner rather than later. Its one thing that helped us with our acquisition negotiations

Brian  |  Oct 28, 09 at 06:19 PM

Great to discussion about who-gets-what, but there is another element here besides dividing up that future payout - the job of an owner.

As an owner you should be providing overall direction to the management to execute.

I've seen people confuse the roles and responsibilities of owner, manager and employee which can result in poor decisions.

Make sure your owners area able and willing to entrust and empower one person to head the management of the business and make it happen... not every decision deserves a board vote.

Sean Mahoney  |  Nov 04, 09 at 07:10 AM

Great post Lance, this is a topic of discussion that comes up every few weeks with my partners. We have agreed in principal but I think it is time to put an agreement in writing, thanks for the samples!

I also really love the idea of using a vesting schedule. It keeps everyone honest and dedicated. I am going to bring this up in our next meeting. Thanks!

Steve Roach  |  Nov 17, 09 at 12:25 PM

Lance, a great post, and something that I suppose many startups don't think about at the start. As a co-founder in a company with 3 co-founders, this is a topic I read with great interest! Thanks for sharing your ideas here.

Eck

DEckoff  |  Nov 17, 09 at 02:51 PM

Kinda funny how the comments on this post have a huge chronological gap in the middle but the content is still extremely useful!

Andrew Watson  |  Nov 17, 09 at 03:04 PM

Hey Lance, I came across this on answers.startups.com, and I'm trying to use a structure like this to set up a company now, but I have a couple of questions.

I know you aren't a lawyer or tax advisor, but if you are effectively assigning people shares based on a service agreement, do you know how people deal with the tax implications that come with that? It makes sense that if you just assign all the shares initially based on how much everyone should get if they get there share, and include vesting, you don't really have to worry about this. However, if you do something like what Dave mentioned above where he is exchanging stock for service with an exec, doesn't that count as income?

How do you deal with this at startup weekends? Any other articles or resources on how this is done in practice would be greatly appreciated.

Thanks!

Frederick Cook  |  Feb 03, 10 at 09:47 PM

Frederick:

You are very correct about me not being an attorney or tax advisor. This article was a bit more about allocation not distribution methodology. But think about it this way.

Taxes result from 'financial events.' Paying something and earning something are financial events.

Examples. I worked last month. I got paid. Financial event. I bought APPL stock some time ago. It has appreciated greatly. I still hold it. No financial event.

The same applies to stock options. While the rules are many and you really need to seek advice from counsel I believe if the stock is purchased-given at it's current market value then it is not a financial event.

When you get to the point where your startup is gaining steam and moving beyond the involvement of what you would consider those to be founders, get a good attorney to help you with the details while keeping as much of the foundation the founders have agreed to in place.

Lance  |  Feb 07, 10 at 09:12 AM

Lance,
I'm not sure you got that last point correct. I am also not an attorney, but my understanding is different. Stock can either be sold by the corporation to the founders, as in each kicks in some real money, or stock can be granted to founders for value received. In either case you have to come up with a value for each share. "Buying in" to the company is the cleanest and has no income tax consequence, but requires a real cash contribution from each of the founders. If the initial stock price is set low enough, this amount does not have to be more than a few thousand dollars each. On the other hand, granting stock is more or less equivalent to paying someone for their services, and, according to what I have been told, this is a taxable event. So a grant of 1000 shares at $.10 per share would create taxable income in the amount of $100. I like your idea about having the grant vest over time. I'm not sure, but I would presume that this also delays and spreads out the taxable events that would then correspond to the vesting schedule. In other words, there would be no taxable event until the first portion of the grant actually vested, and so forth. My follow up question, however, is ... what price per share is used in calculating those future vestings? Is it the grant price way back at the beginning, or is it the then current market price which will be much higher? If this all makes sense, then the answer to this question may make vesting somewhat problematic. I'm hoping someone else can jump in here and advise. Thanks for listening.

David Arella  |  Jun 01, 10 at 02:11 PM

Granting stock options is not a financial event unless the options are granted at a price that is below market value on the day they are granted.

There is no taxable event until you exercise the options and actually purchase the stock.

Typical vesting is 25% per year. Sometimes after the first year companies vest at 6.25% per quarter.

When options are granted the document will state the price of the stock. This is known as the "strike price." The strike price is fixed.

The taxable event occurs when you exercise the option at some price above the strike price. Depending on if you sell or hold the exercised options, this is treated as ordinary income or capital gains respectively.

Lance  |  Jun 01, 10 at 02:25 PM

Yes, I follow what you're saying for stock options. But, I was speaking about granting stock, as in awarding shares to founders for value received. Isn't that another way to get stock distributed to founders?

David Arella  |  Jun 01, 10 at 02:48 PM

We need an attorney.

Lance  |  Jun 01, 10 at 03:30 PM

This is a great post. I have a question:
Is "hourly rate" the actual hourly rate of person or the hourly rate that a contractor would charge for the work?

Pancham Singh  |  Jul 25, 10 at 01:48 PM

I think you can take the amount of money you would be paying each founder and determine what hourly rate would be or use their hourly rate on the open contractor market. Just need to apply one method or the other consistently.

Lance  |  Jul 27, 10 at 09:08 AM

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