Divvying up equity fairly can be tough amongst members of a founding team. Many a startup has foundered upon these rocks, with squabbles over equity rapidly causing relationships between entrepreneurs turning acrimonious. In light of this, working out a split that suits all involved can be pivotal in ensuring a company goes the distance.
First of all, whilst it may be tempting to just split things down the middle, this isn’t necessarily the most effective solution. “There’s a school of thought out there that suggests that all co-founders should be completely equal,” says Luke Davis, co-founder of Money&Co, the peer-to-peer lending platform, and CEO of IW Capital, the private equity firm. “But not all companies are created equal: there’s often one person that brings a lot more to the table than the others.”
One of the most significant things that an entrepreneur will be bringing to the table is the initial idea for the startup; as the core innovation that will drive the company, Davis believes this entitles the entrepreneur to a higher stake in the resulting business. “That should be reflected in the equity they receive because it was the catalyst that brought everyone else together,” he says. “Without that initial spark, there wouldn’t be a company to share in the first place.”
Another consideration that will play a significant role in determining how much equity each team member is entitled to is how much effort they are likely to be investing in growing the business – so-called sweat equity. “If all founders are giving 100% of their committed time to the new project that’s one thing,” says Alessandro Casartelli, vice president at GP Bullhound, the international investment firm that provides advice on mergers and acquisitions, capital raising and private placement. “But if one of the founders is still doing a full-time job and can contribute only partially then that should be reflected in the ownership structure at the beginning.”
But it isn’t always easy to predict how much work each party will end up contributing to a startup when founders first meet over a long black. Fortunately, this becomes much clearer with time. “You know intrinsically if people are pulling their weight or not,” Davis says. He gives the example of a startup in which he was the majority shareholder: because the company wasn’t his only commercial commitment, he found that his co-founders were contributing much more time to its growth than he was. “They were basically driving the business forward and I was having to focus on other companies,” he says. “So I completely changed the equity structure and doubled their stakes.”
Sweat isn’t the only factor that warrants a greater stake however; the equity split should also reflect how critical a founding team member’s skills are to the long-term goals of the business. “For example, if you’re building the next big artificial intelligence then the person who’s got a PhD in cognitive intelligence is going to write all of the algorithms,” says Casartelli. “That makes them the cornerstone of the business.” Given their talents will be instrumental in creating the startup’s secret sauce, this means they will warrant a much higher stake than someone working in a non-core area of the business. “The answer will be completely different from sector to sector but it boils down to the impact that they’re going to have on the success of the business,” he says.
Not every consideration around equity is about what co-founders are bringing to the table: it’s also about the things they’re giving up. “If you’re founding a fintech company and you’re taking someone from a six-figure job in the City then there needs to be compensation for what they’re sacrificing to come onboard,” Davis says.
Given startups don’t have the same financial clout as their larger brethren, they’re not going to be offering colossal salaries: instead the only way they can successfully fish in the same talent pool is by offering key hires a greater stake in the business. “You’re never going to be able to match the salary that they had from the income of a startup,” he says. “So you should offer equity options when certain milestones are reached.”
No matter how founders go about splitting equity, it is vital that a proper vesting structure is put in place so that equity is awarded incrementally with time. “It depends on the industry but vesting should take place over three to four years to incentivise people meaningfully,” says Casartelli. “And, typically, for the first year they don’t get anything.”
Ultimately the goal is to ensure that team members are incentivised to stay with the startup long-term whilst still allowing them to accrue a decent stake of the company in the medium-term. “Also you should give people a chance of earning some liquidity along the way, for example by putting in place a scheme to repurchase equity for a set price,” he says.
Discussions around equity should be an ongoing conversation: it is unlikely that any startup will hit upon the perfect split the first time around and never need to adjust things down the line. “The door always has to be open for discussions like that,” says Davis. “I’d rather someone sat down and spoke to me than think ‘it’s never going to move’ and end up going to a competitor.” Being willing to revisit equity arrangements periodically and having an open-mind when they do means that startups can ensure that all members of the team are pulling in the same direction. “It’s important to have flexibility, rather than just setting and forgetting it,” he says.
Lastly, when working out cap tables and deciding how equity should be split amongst their founders, Casartelli urges startups to avoid over-complicating the issue. “The overarching rule is simplicity,” he says. “These systems can become very messy and, if you create the wrong incentives, take a long time to unravel.”
Instead of putting in place onerous and restrictive systems to divvy up equity, the most important thing to remember is rewarding those who will be instrumental in driving the company’s future growth. “It all boils down to what people have contributed to the story so far and how they are going to contribute to the story going forward,” he concludes.