The distribution of equity is a critical decision for any startup. It determines the ownership structure, aligns incentives, and can significantly influence the startup’s trajectory. While this can be a complex and sensitive process, clear communication and thoughtful decision-making can lead to an equitable solution.
This article explores the essential considerations when splitting equity among co-founders.
1. Contribution of Each Co-Founder
One of the primary factors to consider when splitting equity is the contribution of each co-founder. This includes the initial idea, capital, business connections, and the time and effort dedicated to the startup.
The person who conceived the idea may argue for a larger share, but remember that execution is equally, if not more, important. The co-founder who quits their job to work full-time on the startup, brings in crucial funding, or offers industry expertise can significantly drive the startup’s success.
Therefore, it’s essential to assess the value of each co-founder’s contribution and assign equity accordingly. This may result in an unequal split, but as long as it reflects the value each co-founder brings, it can be a fair arrangement.
2. Future Commitment and Roles
While past contributions are essential, future commitments and roles also play a crucial role in equity distribution. A co-founder who will be working full-time on the startup or taking on a significant role may warrant a larger equity share than one who will be involved part-time or in a lesser capacity.
It’s also important to consider the risks each co-founder is taking. For instance, a co-founder leaving a secure job to join the startup is taking a substantial risk and may deserve a larger equity share.
3. Vesting Schedule
A vesting schedule is a common mechanism used when splitting equity. It protects the startup and the co-founders by ensuring that the co-founders earn their equity over time, typically four years. If a co-founder leaves early, they only get the portion of equity that has vested.
The vesting schedule aligns the co-founders’ incentives with the long-term success of the startup. It encourages co-founders to stay and contribute to the startup’s growth, ensuring that they earn their equity.
4. Handling Changes and Disputes
Even with a well-thought-out equity split, changes and disputes can arise. A co-founder may leave, roles may change, or disagreements may occur about the equity distribution.
To handle such situations, it’s crucial to have a clear, legally binding agreement that outlines the equity split and how changes will be addressed. This agreement, often called a founders’ agreement, should be drafted with the help of a legal professional.
5. Seeking Legal and Financial Advice
Splitting equity involves complex legal and financial considerations. Therefore, it’s advisable to seek professional advice.
A legal professional can help draft the founders’ agreement and ensure it complies with relevant laws. They can also advise on the implications of the equity split, such as control over the company and financial rights.
A financial advisor, on the other hand, can help assess the value of each co-founder’s contribution and advise on a fair equity split. They can also explain the financial implications of the equity split, such as tax liabilities. Startups often turn to back office management services to handle complex tasks such as equity distribution, ensuring a fair and legally sound process
Q: What happens to the equity if a co-founder leaves the startup?
A: Generally, if a co-founder leaves, their equity is subject to the terms in the founders’ agreement. If a vesting schedule is in place, the departing co-founder would only receive the equity that has vested to date. The remaining equity would typically be returned to the company’s equity pool.
Q: Can the equity split be changed after it’s been agreed upon?
A: Yes, the equity split can be changed, but it requires the agreement of all co-founders and potentially the board of directors, if one exists. Changes to the equity split should be clearly documented in a revised founders’ agreement.
Q: How can we determine the value of each co-founder’s contributions when splitting equity?
A: Valuing each co-founder’s contributions can be challenging, as it’s not just about financial input but also time, effort, business connections, industry expertise, and more. Some startups use a points system, assigning points for various contributions, then dividing equity based on the proportion of points each founder has. A financial advisor can provide guidance on this process.
Q: What’s the difference between vested and unvested equity?
A: Vested equity is the portion of equity that the co-founder has earned and has the right to keep, even if they leave the company. Unvested equity is the portion of equity that the co-founder is set to earn in the future, based on the vesting schedule. If a co-founder leaves before their equity fully vests, they forfeit the unvested portion.
Q: How does equity distribution among co-founders affect future investment?
A: Equity distribution can affect future investment in several ways. Investors may look for a fair equity split that reflects each co-founder’s contribution to the startup. They may also be wary of investing if a single co-founder holds a significant majority of the equity, as this can create decision-making bottlenecks. Additionally, startups need to reserve equity for future investors and employee stock options, so a high initial equity distribution among co-founders can limit the startup’s ability to attract future investment and talent.
Splitting equity among co-founders is a critical decision that can shape the startup’s future. It requires a careful assessment of each co-founder’s contribution, future commitment, and role. Implementing a vesting schedule and having a legally binding founders’ agreement can protect the startup and co-founders. Seeking legal and financial advice can also help navigate this complex process.