Monday, April 1, 2013

Lesson #139: How to Calculate Equity Split Between Founders in Startups

Posted By: George Deeb - 4/01/2013


& Comment

The other day, I got asked a question about how best to divide up the equity stake in a new startup, between the founders.  I told him that was a very big question, with lots of variables that go into to calculating a fair equity split.  So, it inspired me to write this post on the topic, to document my answer for all of you.

To me, the key variables that need to be considered here, include: (i) whose original business idea was it; (ii) who is funding the business; (iii) how important is this person's role within the company; and (iv) is this person taking a salary, or deferring compensation.  Let's tackle each of these points below.

In my opinion, there should be a big premium placed on being the originator of the idea.  With all other things equal, that means that a 50/50 split between two co-founders, could be 66/33 based on the premium for coming up with the original idea, and for starting the initial development efforts and sourcing the original team.

If people are funding the business, they should get a premium, because at the end of the day, cash funding founders are acting no different than a seed stage investor.  That means a 50/50 split, with all other things equal, would need to be adjusted for the cash investment.  So, let's say that one founder puts in $100,000 in seed capital, that could be worth 20% of a seed stage company's valuation.  So, a fair split, would be closer to 60/40 in favor of the funding founder, when diluted for the cash.  Calculated as follows:  original 50/50 diluted down 20% to 40/40 for the financing, and then the one founder gets that 20%.

Key executives should get a premium stake over non-key executives.  So, a CEO or CTO, would get a much higher stake than an office manager or a graphic designer, as an example.  So, in this case, I would take your total ownership and divide it up by employee tiers.  Maybe something like 10% each for five C-level executives; 2.5% each for  10 VP level executives and 1% each for 25 director/manager level staff (adding up to a total of 100%, with all other things being equal).  Understand that not all of this will be granted day one, with everyone having higher stakes in the short run, but you will have an equity cushion to play with as the employee base scales.

People that are not taking a salary, should also get a premium stake.  To me, that is no different than financing the business.  So, if someone is deferring a $100,000 per year salary, this is like a 20% stake in a brand new startup.  So, with all other things equal, a 50/50 split, would be closer to a 60/40 split, with the same calculation and logic we used in the cash investor example.

And, please notice, I kept saying "with all others things equal" in each paragraph.  You need to collectively take all four paragraphs into consideration, in calculating a fair equity split between the founders.  And, keep in mind, there may be additional considerations to take into account, like contributing patents, sourcing investors or other value to the startup.  So, make sure to take a wholistic view of what a founder is bringing to the table, across the board.

But, splitting up the pie is only half of the exercise.  This lesson should be read in conjunction with Lesson #124 on Vesting of Founder's Stock.  So, in the event the founders split ways, there are mechanisms in place to get any unearned equity back into the hands of the company.

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