Allocating Equity in a Startup
Building a business is not unlike constructing a building, except that the required materials aren't tangibles like bricks and mortar, but intangibles such as a great idea, strategy, execution and most importantly capital. However, with multiple founders showing up with varying contributions at different times, it's hard to know how to divide the ownership of the company. This is particularly difficult when the company is in its early startup or development phases. However, before outside capital is sought, the division of equity ownership amongst the founders is a matter than must be settled. How much should be given to the entrepreneur bringing the idea versus the individuals required to execute? What about the investors contributing the initial development and launch capital?
Fair and equitable allocation of equity ownership is a question frequently asked of Harbour Bridge Ventures. While leaving this question ultimately to be settled by the entrepreneurial founding team, we have always suggested that a winning business partnership is built on compromise and fairness. But to split up equity fairly, all founders must agree on exactly what "fair" is. The option we most often suggest is for founders to think like investors when determining the value of their contributions, even if they have no plans to raise funds. As there is a significant volume of information and experience of valuations conducted by investors, this can be useful in providing a market-tested, third-party framework for equity allocations. By relying on such market-driven criteria, no party needs to prove the value of his or her particular contributions.
So let's take a closer look at how professional investors value founders' contributions in a Series A round, when a young company closes its first phase of financing. Typically, after such a deal, founders will be left with 30% to 50% of the total equity. That represents the product, the strategy, and other noncash contributions. The investors will get 30% to 50% of the equity in exchange for 12 months to 24 months of operating capital. Some 10% to 20% is reserved for future hires, including key managers.
Of the 30% to 50% set aside for the founders, the idea alone commands little payout. If contributing nothing more, the person who came up with the idea--no matter how brilliant--can expect to hold on to less than 5% of the company. After all, ideas are bound to evolve many times during the life of a startup. Even the principals of venture successes such as Google and Facebook only began to see a premium after the Series B and C rounds, once the businesses started to gain traction.
Instead, the bulk of founders' equity is granted for developing the product, building a viable business plan, and leveraging relevant experience and contacts. Founders responsible for the product or strategy should be compensated for their efforts, with a premium paid for a proprietary, working product. Founders who join the company full-time deserve more equity than those making early, one-time contributions. Opportunity costs are a factor, too. Equity should not only compensate founders who are giving up lucrative careers but also motivate them to propel the startup over the next four to five years.
Then there's the importance of cash. Even companies launched through bootstrap capital generally require some working capital to finance day-to-day operations until the company can support itself and its employees. This may be far less than a venture capitalist is likely to invest, but that's partially offset by the fact that the company, and any investment, is much riskier in the early stages. And these days, capital is frequently scarce and difficult to raise for early stage companies. In a tough fund-raising climate, cash commands a premium. In the current financial climate, Investors are valuing potential portfolio companies at 40% to 60% less than they did in 2007, when private equity flowed relatively more freely.
A final point is that, as time passes, the company will become less risky, and those who take on less risk deserve less equity. So later investors in a business that is cash flow-positive will receive far less for their contributed capital. Similarly, a founder or senior manager who joins a startup after it already has some traction should expect less equity -- the foundation, after all, for later success and growth has already been laid -- than an early founder who took potentially greater risk.
Under No circumstance... let me repeat this: UNDER NO CIRCUMSTANCE should you ever devise a corporate structure that leaves two people owning 50% of the equity/control of the entity. this is a recipe for ultimate doom.
You would not race a sailboat with two people's hands on the tiller, would you?
If need be, you can write an agreement to split the profits interest 50/50 and the equity/control 51/49, but only one person should be driving the boat and have ultimate decision making power. Trust me, I've been there and thank god, it was early in my career and learned a valuable lesson from it.
Companies are not democracies.