Big companies draw in potential employees with cushy benefits and high salaries, whereas startups have a different trick up their sleeve to attract talent. For employees, startups represent the opportunity to profit through share company ownership. This guide provides an introduction to the ways in which companies determine how to divide equity fairly among the founders and employees at early-stage startups.
Granted, there is no one right way to structure an equity split, and the best solution likely depends on the specific circumstances of each startup. Therefore, it is highly advisable to solicit advice from an attorney before finalizing any equity split agreement.
Defining an Equity Split
Equity is non-cash compensation that represents partial ownership in a company. The equity is typically distributed among the early founders, financial supporters and sometimes employees who join the startup in its earliest stages. This small share in company ownership serves to compensate employees for the smaller salaries and job uncertainty that working at a startup entails. This compensation model certainly worked out well for the first 13 employees of Instagram, who shared a 10 percent equity stake with a total value of $100 million after Facebook acquired the company in 2012.
Factors to Consider in a Fair Equity Split
Creating an equity split that treats founders, investors and employees fairly is a challenge even for the most experienced employers. However, considering the following four factors will help you determine how to achieve the best possible split.
In some cases, co-founders and employees will agree to work for an extremely low salary in exchange for an ownership stake in the company that they believe will appreciate greatly in value in the future. The designer of Nike’s logo agreed to such an arrangement; he earned just $35 plus a piece of equity, which is now worth over $640,000.
Logically, the extent to which each co-founder contributed to the company in its early stages should inform how the equity is split. Whoever proposed the chief value proposition of the company typically receives the greatest percentage of equity ownership. For instance, one of Instagram’s co-founders was granted a 40 percent equity stake because his technological innovation formed the basis of a company that later became incorporated into Instagram. The other co-founder joined later in the process and got a 10 percent equity stake in the company.
Unfortunately, division of equity is not always this simple. Concrete, measurable contributions in capital and sweat equity might matter more to the success of your startup than a single idea. Therefore, a fair equity split will usually follow a careful analysis of the relative amount of early development work contributed by each co-founder.
Co-founders and employees alike who join a company in its earliest stages of development, such as before the seed round or series A funding, often receive larger piece of equity to recognize the time they invested and the risk they assumed in working for such a young company.
If one founder provided more seed capital into the business than the other, he or she will often be rewarded for that through equity. For example, if the co-founders’ contributions to the company are otherwise equal, a 60/40 equity split might be established.
Other past contributions should also be considered, such as:
- Involvement of each person in presenting the business model to potential investors.
- Each person’s role in the development of the company’s intellectual property.
- Future contribution factors to consider include, among others:
- Time to be spent on business development.
- Projected ability to address future issues based on the individual’s professional network and prior experience.
- The opportunity cost to each individual of contributing to the startup.
It should be noted that the particular elements (such as number of shares, price of shares, percent of outstanding option pool, equity relative to other employees and strike price of options) that comprise an individual’s equity share are not as important as the actual equity percentage of the company received.
No matter how you ultimately distribute equity among co-founders, it is essential to establish a vesting schedule. A vesting schedule specifies when and how co-founders can exercise the stock options awarded in the equity split agreement.
A typical vesting schedule allows for incremental vesting over a four or five year period with a large portion of options vesting at the end of the first year.
Vesting schedules protect young companies by prohibiting a co-founder from leaving the company and taking a large piece of the company’s value with him or her.
Example of an Equity Split
This example for an equity split following the first round of funding comes from global equity firm Advent International:
- Founders: 20 to 30 percent divided among co-founders. The distribution is rarely exactly 50/50
- Angel Investors: 20 to 30 percent.
- Venture Capital Providers: 30 to 40 percent.
- Option pool: 20 percent, which can be divided among employees.
This example merely describes one generic way in which a business might decide to split its equity. The distribution chosen by your company should be informed by its unique nature, needs and business plain.
What Tools Can Help Navigate an Equity Split?
Equity calculators, such as the those offered by Founder Solutions and Foundrs.com, are also good resources. The calculators determine how equity should be split by considering several factors (ideation, time spent away from other projects, per-hour pay estimation, etc.) Foundrs.com also directs founders to this helpful venture capital calculator.
Equity vs. Stock: What’s the Difference?
Equity and stock are not the same thing. Stock is a kind of company equity, but equity consists of more than stock. Company equity has many other forms, such as include stock options, bonds, warrants, paid-in capital, retained earnings, etc. Stock options, however, are not part of equity until they are exercised.
Stock Options Commonly Offered to Employees in an Equity Split Agreement
Other Factors to Consider
- Anyone with an equity share of less than 10 percent should likely be categorized not as a co-founder, but instead as a first employee whose equity share should be accompanied by a salary.
- More co-founders does not necessarily equal better. One or two co-founders is ideal, and four should be considered the maximum. If you find your company surpassing this number, reassess each individual’s role in the company.
- Emotions shouldn’t influence equity split arrangements. Assess of the value of each equity holder’s contribution objectively, even and especially when co-founders share close personal or familial ties.
- Be realistic, but not stingy. The larger the equity share, the bigger the incentive to help the company prosper.
- Be patient. It can take some time accurately gauge relative value of each individual’s contribution to the company.
- Don’t go with a completely even equity split unless you’re sure that it truly represents the contributions that each co-founder made. Otherwise, investors might take it as an indication of managerial immaturity, and you risk inciting the anger of co-founders who believe that their contributions were not properly rewarded.
- Consider retaining some shares for future distribution. It is probably that some people will end up contributing more to the company than was originally expected, and shares that haven’t yet been allocated can be used to correct this mistake.