How to split equity among co-founders

One of the earliest challenges startup founders often face is how to distribute equity. Generally, the choices are to either simply go for an equal equity divide or opt for a weighted split, however there is no definitive right way to proceed. Often it may depends on factors like the level of commitment, expertise or business experience etc of the parties involved.

Ultimately it is a crucial discussion that needs to take place and here we’ll discuss the pros and cons of these approaches, offer industry professionals’ views and highlight common best practices for you to consider when deciding on equity allocation.

Equal equity split

As the name suggests, this approach enables each co-founder to get the same number of shares of the company, e.g. a 50-50 split among two founders, etc. It is a common approach among startups and is usually adopted when each founder will be considered to contribute equally to the company’s growth.

PROS:
– An easy, quick solution
– Can strengthen the relationship between co-founders
– Encourages all co-founders to be equally committed to and invested in your company

CONS:
– May lead to deadlocks in decision-making

What do industry professionals say:
Michael Seibel, the Managing Director, Batch and Group Partner at YCombinator is an advocate of equal (or nearly equal) equity splits among a founding team. He believes founding team members are battle buddies who spend more time together than with family members and therefore help each other decide the most important business issues.

Research from Harvard Business School professors, however, shows that investors are less likely to invest in startups with an equal divide. It suggests an equal split can send worrisome signals about the team’s ability to negotiate and resolve difficult issues.

Weighted split

Alternatively, founders could be assigned shares based on factors like commitment, risk levels, domain knowledge, how much funding each founder brings and previous business experience, etc.

For example, it is not unusual to have one or more founders devote all of their time to the project at the early stage, while others might still have a full-time job elsewhere. In this scenario it is clear there are two different levels of commitment and risk in this and therefore it might be reasonable to suggest this be reflected in the equity split.

PROS:
– Achieves a fair equity allocation treatment by quantifying each founder’s input based on time, commitment, etc.

CONS:
– Can get tricky when assigning a tangible value to each factor
– Contributions by each founder may change in the future

What do industry professionals say:

Scott Dettmer, a Silicon Valley-based lawyer who has been advising startups since the mid-1990s, indicates a 50-50 split doesn’t always make sense as sometimes one or more of them may be contributing more than the others because of their experience, skills and role.

However, an extreme split can be a red flag to investors. Bryant, the Founder of CollabsHQ, suggests investors may use an equity split to assess each founder’s motivation and value. As a result they may look poorly on equity splits that are skewed towards one founder’s direction, e.g. 80-20 split.

There’s no magic formula – The “right” split is highly circumstantial

While you’re still pondering which approach you should opt for, remember there’s no universal right or wrong answer and what investors generally want to see is clear reasoning and transparency about how your team came up with the split chosen.

However, there are some best practices you can follow when allocating a founder’s equity split:

• Start an honest, transparent conversation early on
• Set up a vesting schedule
• Consult finance and legal consultants
• Document the splits accurately in your cap table
• Update your cap table if and when any of the equity split details change

1. Start an honest, transparent conversation earlier

Your co-founders are the people you are going on this journey with, so you should be open to discussing equity allocation with them. Encourage everyone to bring up their arguments and bring any concerns to the table in order to reach a fair decision. No one should feel their voice hasn’t been heard.

2. Set up a vesting schedule

Whether your team lands on an even divide or other split, the founder’s equity should be subject to vesting, which means a waiting process to receive ownership of an asset. The common practice in startups is to have four years of vesting with a one-year ‘cliff’.

This means that if a founder leaves within one year, they will get nothing no matter how much they own on paper. Should they leave after one year, they can walk away with 25% of the shares and the remainder (i.e. unvested shares) can be repurchased by the company. In addition to promoting long-term commitment to the business, this approach can serve to prevent any of the founders from leaving completely with a large chunk of the business.

Remember potential investors will also take notice of your vesting schedule.

3. Consult finance and legal consultants

As discussed, every business is unique and your considerations may be more complex to quantify. Speak to an industry professional to get this matter sorted as early as possible, as they will be able to look at your individual circumstances.

4. Document the splits and update your cap table

All the agreements you and your co-founders make regarding equity and vesting should be written down in legal terms and signed by all parties. It’s often best to have a lawyer compose the documents in case of any disagreements or queries arising at a later stage. Once this is done don’t forget to update your cap table to reflect details of who has ownership in your company and how much they each own.

The cap table should always represent the current equity ownership in a company and provide potential investors with a snapshot of the financial situation of the business.

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