How does one determine founder equity splits at the outset? originally appeared on Quora: the place to gain and share knowledge, empowering people to learn from others and better understand the world.
Here’s one good framework to determine founder equity splits at the outset:
- First divide the equity allocation between initial contributions and future contributions.
- For instance, if you’re commercializing a patent / IP that is now being brought into the company, the founder behind the IP is making a significant initial contribution.
- In another instance, if a non-technical founder is bringing an idea, and the technical co-founder will be building out that idea over the next few years, the latter’s future contributions are more significant.
- Let’s assume we allocate 30% towards initial contributions and 70% for future contributions. From this allocation, make equity splits across co-founders.
- To build on the example, let’s say there are 2 co-founders (A and B) and both get the same split for their initial contribution: 30%/2 = 15% each.
- However, co-founder A is expected to make greater future contributions than co-founder B down the road. Therefore, it is mutually decided, that A will get 2/3rds of the equity split for future contributions and B will get 1/3rd. Therefore, A gets: 70%*(2/3)=47% for future contribution and B gets 23% for future contributions.
- Summing 3 and 4, we get the following:
- A gets 62% and B gets 38% from the math above
- Now, step back and see if this equity allocation feels right and factor in any adjustments that we need to make. Typically, adjustments are made:
- For initial capital contribution to the business before it raises external capital.
- To account for opportunity cost of each founder.
- Any idea premium.
- Let us say co-founder B,
- Has put in initial cash in the business that warrants an additional 3% of equity.
- Is letting go of a high paying job because he believes in the startup and deserves an additional 2% of equity in the company.
- And let us say co-founder A,
- Initially had the idea, which makes the company unique and reckons the idea premium is worth 2%.
- Now netting out, A gives 300 bps of equity to B for these adjustments, with the net equity allocation yielding:
- A gets 59% of equity in the company and B gets 41% of equity in the company.
- This is a simple framework to illustrate some parameters to consider while determining equity splits: a) initial contributions b) future contributions c) adjustments for initial cash, idea premium and opportunity cost.
- While the framework gives some analytical rigor, the guiding principle behind this discussion should be: what keeps the relationship thriving between the co-founders? As investors, we have seen this go both ways: equity splits create friction and disincentivize; fair equity splits do the opposite.
- Note: equal equity splits are the default outcome but not always the best outcome. It is worth doing the exercise above and having a candid discussion with your co-founder at the outset.
- Vesting matters, even for founder equity allocations.
- Baking in a process to keep certain % of the future equity allocations dynamic may work in some occasions. You trade certainty with flexibility.
- Worth reiterating: one should not miss the forest for the trees. How the other co-founder feels about their ownership in the company is more important than getting the precise bps right on the equity allocation.