Splitting equity with your startup's co-founder(s) is an awkward yet essential part of establishing a successful business partnership. However, if not done right, the equity split you choose can have devastating consequences on the future of your startup. And that's why Mike Moyer (Managing Director, Lake Shark Ventures) has outlined some of the considerations that founders must remember when splitting equity.
Founder disputes can wreak havoc on a startup company and few issues are more vulnerable to disagreements than the division of equity. At the core of the problem is the fact that most teams default to “fixed” splits in which equity is doled out to participants at the outset of the venture in pre-determined percentages in anticipation of future contributions. The most common fixed split is an equal split, but sometimes founders use unequal splits based on a number of factors such as estimates of future commitment in terms of money and time and ideas. Next, founders slap on a time-based vesting schedule “just in case,” and they are off to the races. This style of equity split could kill your company because the next conversation about equity is probably going to be a fight about equity. I call this the “Fix & Fight” model for equity splits.
Things Always Change
You and your cofounders will fight when actual commitment levels of time & money differ from what was originally anticipated. You will fight when you bring on new people and you will fight when someone leaves. Each fight will end in unpopular compromises that will take a toll on interpersonal relationships. When new agreements can’t be reached, in come the lawyers. Start-up lawyers are all too familiar with this story and it rarely ends well. There is a better way, however.
Startups are a Gamble
Think of your startup as a game of Blackjack. You and a partner do a traditional “Fix & Fight” split—50/50—and sign an agreement with a traditional time-based vesting schedule. You both place $1 on the same hand of Blackjack. You have no idea if you’re actually going to win. Different hands may pay different amounts so you have no idea how much you’re going to win. Also, you have no idea when you are going to win as your game could have multiple rounds of betting. The future, in other words, is unknowable.
The Dealer Deals Two Aces
In Blackjack, you can “split” the aces into two hands and bet again or “double down.” You and your partner decide to go for it, but your partner is out of money. You’re not, so you put down $2 more. Like before, you don’t know if you’re going to win, how much you’re going to win or when you’re going to win. The future is still unknowable. What is knowable, however, are the bets. You bet $3 and your partner bet $1. Does your 50/50 deal still sound fair? Probably not. It should be obvious that you deserve 75% and your partner deserves 25%. Your share of the winnings should be based on your share of the bets.
Of course, you signed an equity agreement and you are legally obligated to give him half. But, just because you agreed to it and just because it’s legal doesn’t make it fair. You should still fight it—hence, “Fix & Fight.”
Founder Contributions are “Bets”
Startup companies are the same as Blackjack (albeit with lower odds!) When someone contributes to a startup and does not get paid, they are putting their contribution at-risk. They are, in effect, “betting” the fair market value of the contribution on the future “winnings” of the startup which come in the form of profits or the proceeds of a sale. Just like in the Blackjack scenario, a person’s % share of the equity should be based on that person’s % share of the at-risk contributions.
Types of "bets" made by founders:
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Time- without pay or partial pay
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Money- investments or unreimbursed expenses
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Ideas- intellectual property
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Relationships- for sales, investments or partnerships
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Supplies- consumables
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Equipment- computers, machinery, vehicles, etc.
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Facilities- office, warehouse space, retail space, etc.
A Logical, Self-Adjusting Formula
Basing equity splits on actual events rather than guesses about the future enables startup founders to apply a logical framework to the allocation and recovery of equity in an early-stage company. This model, known as Slicing Pie, provides a standard equity formula for all startups where founders put their contributions at risk. The formula self-adjusts over time and terminates at breakeven after all the bets have been placed. All splits adjust, Slicing Pie simply provides a logical formula for making adjustments and allows founders to avoid the fights!
About Mike Moyer
Mike Moyer is a career entrepreneur who has started companies, worked for startups, and held senior management positions at established businesses. He is now the managing director of Lake Shark Ventures, LLC, a company that provides growth consulting and early-stage investments. He is an adjunct faculty member at Northwestern University and the University of Chicago’s Booth School of Business. He is the author of several business-related books including Slicing Pie: Funding Your Company Without Funds and The Slicing Pie Handbook: Perfectly Fair Equity Splits for Bootstrapped Startups. He lives in Lake Forest, Illinois, just north of Chicago.
(Fighting business partners image by Shutterstock)
