Monday, April 23, 2012

Entrepreneur Startup Share Depends on Contribution

One of the first tough decisions that startup founders have to make is how to allocate or split the equity among co-founders. The easy answer of splitting it equally among all co-founders, since there is minimal value at that point, is usually the worst possible answer, and often results in a later startup failure due to an obvious inequity.

Another common “failure to start” situation I see is one where the “idea person” insists that the idea is 90% of the value (and 90% of the equity). In the real world, the "idea" is a very small part of the overall equation. A startup is all about "execution" - meaning the equity should be allocated based on the value that each partner brings to the table in each of these dominant variables:

  1. Experience running a startup business. Running a new business starts with building a solid and credible business plan, working the investor funding process, and building an organization from nothing, with minimal resources. Successful Fortune 500 executives need not apply, since most would have experience with any of these tasks.

  2. Domain expertise and connections. If you are recognized as an expert in the business area of your startup, with a good reputation, and you know all the key vendors and customers, your value is huge. Building a product doesn’t get it distributed and sold. Expertise can be marketing, technical, financial, or sales.

  3. Pre-existing intellectual property. Ideas are not intellectual property, until they have been converted into patents, trade secrets, trademarks, or copyrights. In many cases, one founder has started earlier and brings an important completed piece of work to the table, and that can have great value.

  4. Sacrifice and time commitment. A part-time commitment, while holding down a “real” paying job, is obviously not the same as a full-time executive role, especially if the cash compensation is nonexistent, deferred, or at high risk.

  5. Funding. Providing the major funding source for an early-stage startup is a totally different dimension, but it usually trumps all the items above in demanding some equity. For purposes of commitment and business decision making, I always recommend that execution partners retain control of at least 50% of the equity.

An arbitrary, but perhaps rational equity factoring approach would be to assign each of these five items as 20% of the total, and allocate equity based on each partner’s relative contribution to each. For example, if your rich uncle is providing all the initial funding, but has no active business role, it might be smart to offer him a 20% slice of the pie.

Equity allocation is usually the first point in a startup where outside help should be considered (legal counsel, potential investors, startup advisors), as they may be able to provide experience and more importantly, an unbiased view that the entire team can trust.

An important key is NOT to dodge the discussion up front, come to some agreement quickly, and write it down. If you and your potential partners can’t get through this discussion in a timely fashion and come to agreement, then it’s unlikely that your startup can ultimately survive anyway. Startup decisions only get harder later, never easier.

Even still, regardless of the initial equity split, you should seriously consider vesting your founders shares over at least two years. This means they will be metered out month-by-month, and a partner who changes his mind or defects early will not walk away with half the company.

The next big challenge for a multi-partner startup is the allocation of roles. Who will be the CEO, CFO, and CTO? The same variables apply, but here skills and experience are paramount. If you are an inventor and have the key patent in hand, that doesn’t mean you should be CEO. Of course, holding key assets and money always provide leverage to management rights as well as economic rights.

All partners should never forget that their allocated shares are only the beginning, and will be diluted proportionately when outside funding is later required from angels or venture capitalists. Investors will be quick to remind you that a small percentage of something is worth more than 100% of nothing. The same logic applies to splitting equity with co-founders.

Marty Zwilling


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5 comments:

  1. Yes spliting work depending upon their ability. Great post and must read for every startup.

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  2. Marty, this strategy makes total sense and is the best way to evaluate contributions for start-ups. We have opted for a simple ration from the off and all partners are involved in the decision making. It is very tough in the 1st year and so it is important that clear definitions are made over roles. Thank you for an excellent post!

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  3. Marty,

    You made a great point in this article. I too think that startup shares should depend on the contribution. Otherwise you will face a situation when one(or more) of the founders will start slacking off and still demand an equal share.

    Money and success needs to be earned.

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  5. Having a small business or startup business with tons of decision to make is mind bubbling brain-wreck, but I tried reading the Book Slicing pie by Mike Moyer and it all made sense, in his book he emphasized the startup equity by providing an example; also talked about splitting equity using grunt calculator and dig in to details on equity structure, founders equity, equity compensation, and differentiating your choice on salaries or equity.

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