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How to Calculate Equity Split Between Founders in Startups

How to Calculate Equity Split Between Founders in Startups


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The other day, I got asked a question about how best to divide up the equity stake in a new startup, between the founders.  I told him that was a very big question, with lots of variables that go into to calculating a fair equity split.  It inspired me to write this post on the topic, to document my answer for all of you.

 

splitting_equity

To me, the key variables that need to be considered here, include:

  1. Whose original business idea was it?
  2. Who is funding the business?
  3. How important is this person’s role within the company?
  4. Is this person taking a salary, or deferring compensation?

Let’s tackle each of these points below.

In my opinion, there should be a big premium placed on being the originator of the idea.  With all other things equal, that means that a 50/50 split between 2 co-founders, could be 66/33 based on the premium for coming up with the original idea, for starting the initial development efforts and sourcing the original team.

If people are funding the business, they should get a premium, because at the end of the day, a cash-funding founder is acting just like a seed-stage investor.  That means a 50/50 split, with all other things equal, would need to be adjusted for the cash investment.  Let’s say that one founder puts in $100,000 in seed capital.  That could be worth 20% of a seed-stage company’s valuation.  A fair split would be closer to 60/40 in favor of the funding founder, when diluted for the cash.  The calculation for this would be the original 50/50 diluted down 20%, which then means 40/40 for the financing, and then the one founder gets that 20%.

Key executives should get a premium stake over non-key executives.  For example, a CEO or CTO would get a much higher stake than an office manager or a graphic designer.  In this case, I would take your total ownership and divide it up by employee tiers.  Maybe something like 10% each for 5 C-level executives, 2.5% each for 10 VP level executives and 1% each for 25 director/manager level staff (adding up to a total of 100%, with all other things being equal).  Understand that not all of this will be granted day one, with everyone having higher stakes in the short run, but you will have an equity cushion to play with as the employee base scales.

People that are not taking a salary should also get a premium stake.  To me, that is no different than financing the business.  If someone is deferring a $100,000 per year salary, this is like a 20% stake in a brand new startup.  So, with all other things equal, a 50/50 split would be closer to a 60/40 split, with the same calculation and logic we used in the cash investor example above.

And please notice, I kept saying “with all others things equal” in each paragraph.  You need to collectively take all 4 paragraphs into consideration when calculating a fair equity split between the founders.  Keep in mind, there may be additional considerations to take into account, like contributing patents, sourcing investors or other value to the startup.  Make sure you have a comprehensive view of what a founder is bringing to the table, across the board.

But, splitting up the pie is only half of the exercise.  This lesson should be read in conjunction with Lesson #124 on Vesting of Founder’s Stock.  So, in the event that the founders split ways, there are mechanisms in place to get any unearned equity back into the hands of the company.

Reprinted by permission.

Photo credit: icrowd.com

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About the author: George Deeb

George Deeb is a managing partner at Red Rocket Ventures, a Chicago-based startup consulting and fundraising firm with expertise in advising Internet-related businesses. More of George’s startup lessons can be read at “101 Startup Lessons — An Entrepreneur’s Handbook.”

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  • Neil St. Clair

    I’ve been through a few startups, and I’m always a fan of just splitting the equity among the original founders evenly. I’ve done it the other way, and it just creates animosity. The “original idea man” should have a memorialized share and the others should be on vesting schedules. But having everything on an even footing day one is definitely my preferred way to go!

    • http://cynthiaschames.tumblr.com/ Cynthia Schames

      An equal equity split means no one is the decider.

      Bad.

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  • Andrew Ackerman

    I dealt with this in detail in my last venture.

    Treating funding contributed and foregone salary as dilution off the all-else-equal split is completely reasonable. There’s a little grayness on how to value foregone salary – it should really be what “the market” would charge for those skills, not what the founder is giving up – but it’s manageable.

    Valuing the idea is tough. Opinions ranging from the minimal (“execution is everything”) to very high (“idea is key”). The only real *hard* data I could find was a working paper called “THE FIRST DEAL: THE DIVISION OF FOUNDER EQUITY IN NEW VENTURES” by Hellmann & Wasserman (www.nber.org/papers/w16922) which looked at all the factors that caused ventures to deviate from 50/50 splits. Other than funding contributed, the biggest factor was prior successful startups and experience fundraising. When all the dust settled, whose idea it was accounted for just a 5-10% bump.

  • Nathaniel Pool

    Having founded, angel invested and mentored a number of companies, “idea founders” are a dime a dozen, and unless they can add additional value such as key customers, operations, software engineering, or substantial seed capital, then their equity stake deserves a lesser than equal starting point (let’s say 20% for argument’s sake.)

    Founders or investors that bring tangible value to the table, such as: seed and operating capital, the developer(s) of the tangible asset to be sold (ie: software, product prototype, etc) deserve similar equity stake as the person with the original idea. However, If the idea founder also provides and will be responsible for delivering some or any of these other components to the company, then he is deserving of additional equity to his stake.

    Another important position that seems to often get overlooked or undervalued is the key “deal-maker” (ie: the person with the Rolodex (contacts) that brings in key customers and can develop new biz opportunities that bring cash flow into the company). Without that person, there are no revenues, and without revenues, no business.

    My allocation model is as follows:
    20% = idea founder
    15% = product developer
    15% = key biz person
    5% = key operations person
    5% – 30% = investors
    5% – 20% = employee acquisition

    There are always exceptions to the rules. And then sometimes none of the rules apply, particularly if YOU are THAT idea founder, in which case, you negotiate to keep as much equity as possible. ;)

    Nathaniel Pool
    http://www.linkedin.com/in/npool/

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  • Business owner

    I need some help. We are starting up a company split up into 4 shareholders. 2 of us will be funding the idea and the other 2 will be building the idea (web development). The funders (2 shareholders) will be paying the developers (other 2 shareholders) to build the concept. Since they are using time and we are using money is it best to split this equally 4 ways? We all bring different skills to the company but I have always preferred finding the right partners and splitting the shareholding equally. Any comments on this?

    • http://www.alleywatch.com/ AlleyWatch

      Since the devs are getting a cash component, you need to look at how much they are forgoing. What is the replacement cost of the skill set they are providing? There will never be a right answer to this but you need to look at all factors before you come to an agreement that works for your co.

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