A friend asked me recently if I knew of any good guidelines for dividing up equity between founders, and specifically what to do in the case when a co-founder provides seed capital.
The truth is I don’t know of any great guidelines – this is seems to me a very case-by-case decison.
Obviously the main consideration should be the relative importance of each founder to the future prospects of the venture. And, as in any negotiation, the alternatives each person has will also factor in.
Probably way too many founders divide things evenly just to avoid a difficult conversation. Most likely, this will lead to a difficult conversation down the road (or worse).
(As an aside – you should also figure out titles early on. When founders say “we are co-CEOs” or “we don’t have titles” that more often than not means there is a big fight looming. Startups are little dictatorships for good reason.)
One thing I’ve also noticed is people tend to overvalue past contributions (coming up with the idea, spending time developing it, building a prototype, etc) and undervalue future contributions. Remember that an equity grant is typically for the next 4 years of work (hence 4 years of vesting). Imagine yourself 2 years from now after working day and night, and ask yourself in that situation if the split still seems fair.
Another consideration is if one founder has had greater career success and will therefore significantly improve the odds of getting financed at an attractive valuation. One way to figure out how much this is worth is to estimate how much having that founder increases your valuation at the next financing and then, say, split the difference. So if having her means you can raise $2M by giving away 30% of your company instead of 40% of your company, let that founder have an extra 5%.
If one founder had the idea for the company, it is sometimes reasonable to give that person additional equity. If that idea involves a bona fide technology breakthrough, they could be entitled to considerably more equity, say 10-20% (or you may have to give some of that to a university or other IP owner). But if the idea is more abstract and doesn’t have real IP behind it (“User generated X” “A marketplace for Y”) that should only earn a few extra points of equity, if any.
If one founder is providing seed capital, assuming there are no other investors involved, the best way to do this is a simple interest bearing (say 5% annual rate), non-convertible loan to the company. I did this once and just had my partner write an IOU on a single sheet of paper, without using lawyers. When you raise further money the best thing is to have that loan convert into equity at the same terms as the rest of the investors (it looks a somewhat bad to investors to take their fresh capital and pay it right out to a founder – unless the founder is in dire financial straights).
The reason you want to avoid granting equity for a founder’s seed capital is 1) it would cost a lot more in legal fees and 2) you would have to come up with a valuation without a 3rd party, arms length offer.
If there are multiple seed investors, including non-founders, things get more complicated and you might have to resort to a convertible note or full blown equity round.
Related posts:
15 comments ↓
Chris, these are good guidelines. In your seed capital description (3rd to last paragraph), don’t you mean a convertible loan since that debt should convert to equity at a qualified financing? BTW, I’ve used this model and it works well.
Thanks,
Louis
Well, to keep it super simple I just personally used a regular loan with the expectation everyone would be fine letting me convert it.
Chris,
Thanks for another great article!
You touched following points –
1. Future contributions
2. Past contributions
3. Past success stories
I was wondering what are your thoughts on risk profiles of co-founders when they are not located at same place? Say one is located in Silicon Valley and other is located in low cost development country. Since the lifestyles are different, should we consider this location factor?As their might be difference of 5x cost at both places.
Or on the side note, is it not a good idea to have a co-founder a distant apart?
Your thoughts will be appreciated!
Thanks,
Aditya
[...] This post was Twitted by PhilipHotchkiss [...]
Aditya – I don’t see why location should be a determinant of the equity split. Perhaps it could be a determinant of cash salary, but that seems like all to me. If you create, say, 50% of the value in the company, you should get 50% of the equity.
Re having co-founders apart – If there is some strategic reason you need to (e.g. sales office in US, operations in India) it can make sense, but if that’s not the case I’d say it’s highly preferable to have everyone together in the same location.
The approach we guys used is the founder’s pie calculator by CMU prof.
http://www.andrew.cmu.edu/user/fd0n/35%20Founders‘%20Pie%20Calculator.htm
Its a more a analytical approach and makes you think about all the different factors and their relative importance.
i think himanshu meant: http://www.andrew.cmu.edu/user/fd0n/35%20Founders%27%20Pie%20Calculator.htm
Interesting article. I agree with most of the points mentioned in the article. The one point that seems unfair is to create a loan for the one founder that put in seed money. Loan’s are usually secured by hard assets and putting money in at a start-up is a high-risk, high-reward game. For a seed money at a 5% interest loan, it’s still very high risk but the reward is just not there. If I were the “no cash” co-founder, I would take that deal all day long.
[...] First Tweet 1 day ago jayfallon Jay Fallon RT @cdixon: dividing equity between founders http://www.cdixon.org/?p=367 view retweet [...]
Great posts. We came up with the Equity Splitter, see Equity Fingerprint website, to provide a tool to help founders split the equity. It is simple and perhaps does not take into account enough of future scenarios. So important to have good leaver/bad leaver provisions as you say. Your stress on looking to the future says it all. Thanks for great posts
Dividing equity between founders…
Obviously the main consideration should be the relative importance of each founder to the future prospects of the venture. And, as in any negotiation, the alternatives each person has will also factor in….
[...] From cdixon.org [...]
[...] cdixon.org / Dividing equity between founders (tags: startup) [...]
[...] http://www.cdixon.org/?p=367 [...]
Why is it called a non-convertible loan if it is intended to convert into equity?
Question two:
If one were to hire a salesperson and offer them 10% commission, and were to offer them payment using the non-convertible loan strategy, would it offer the salesperson a perverse disincentive to keep the valuation low? Or is the valuation essentially proportional to the salesperson’s revenue? Would the salesperson benefit from pressuring the founders towards taking investment prematurely?
i.e. in what circumstances are the salesperson’s interests not aligned with the founders’?
I am curious to understand what does and does not align interests of people working for the company at an early stage.
Leave a Comment