Dividing equity between founders

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.

Founder vesting

The most important term in a startup term sheet that no one seems to think carefully about is founder vesting.   There are two key points about vesting:

1) All startup employees – including founders! – should vest over 4 years from their start date (with a one year “cliff”).  When I used to work in VC I can’t tell you how many companies I saw where some random former founder who was long gone from the company and was only there for some short period of time owned some big chunk of the company.  Not only is this just plain unfair, it also means there is a lot less room for giving equity to employees and for raising new capital.  Even if you are founding a company with your best friend – actually, especially if you are founding a company with your best friend – everyone should have vesting.   If you have a lawyer who tells you otherwise, get a new lawyer.

2) Founders should always have acceleration on change of control!  In particular, you should have full acceleration on “double trigger” (company is acquired and you are fired).  In addition you should have partial acceleration on “single trigger” (company is acquired and you remain at company).  I prefer a structure where you accelerate such that you have N months remaining (N=12 is a good number).  This gives the acquirer comfort that the key people will be around for a reasonable period of time but also lets the founders get the equity they deserve without spending years and years at the acquirer.  Consider the scenario where your company gets acquired 1 year after founding and you have 3 years of vesting remaining.   Suppose further that you just aren’t a big company type and leave after 1 year.  In that case you would forgo half your equity.  It’s always surprising to me how much time founders spending focusing on valuation that might change their ownership by a few points when vesting acceleration (albeit under certain circumstances – but I have seen this happen) can have a far larger impact on their ultimate equity ownership.