How should co-founders split equity in a startup? What should you discuss before formation of the company? This post outlines the discussions that you need to have, including a framework for those discussions. I’ve also included some tools you can use to help define equity splits at both the early stage as well as the operating stages of your startup.
It’s sad when I get asked the question about how to rearrange equity “after the fact” or post incorporation because the co-founders didn’t have a discussion before they incorporated – thus the title Awkward Co-Founder discussion. Regardless of the timing, it will be awkward, it is a negotiation and resetting expectations – I’d recommend you get it done while is cheap!
First, let me point you to a previous post on why 50/50 is the only wrong decision. I still believe this to be true and even though I’ve blogged about it that doesn’t make the conversation any easier to have with a new co-founder. Someone should be the lead. It’s the first difficult conversation that you need to have and it likely means you kicked the can and split the stock equally vs. taking on a known issue.
The goal of this post is to give you a framework for productive discussions, ideally before you incorporate. We’ll work through the post-incorporation topic in the second half of the post.
This is a “Two Event” process. What I mean by that is that you need to put a discussion on the calendar with your co-founder(s) for “Awkward Co-Founder Discussion Meeting 1 of 2” – call it what it is, it’s not comfortable, but it needs to happen. Plan it offsite, not at the power of one person’s office, no white boards are necessary, just a discussion.
Meeting 1 of 2
This is the first meeting, grab a beverage of choice and settle in for an extended discussion. It’s not so important that you get to the answers at this point, but you’ll need to start discussing the questions.
First, recognize this moment is likely “as good as it gets” for your relationship. I don’t mean that to be negative, just realistic. Right now, the world is laid out in front of you! You’re in love with your idea – the product is brilliant and your either going to:
- Change the world
- Get Rich!
That’s what I mean, this is as good as the honeymoon period gets. You haven’t talked to 50 potential customers and had them tell you why the idea won’t work.
You haven’t done the 80 hours a week while your partner works at their day job and brings home a paycheck when you haven’t.
You haven’t yet talked to 50 investors and have them tell you to come back and see them when you get “traction” whatever the hell that is!
Here are the first set of discussion topics to discuss:
- What do you want to achieve with the company?
- Grow and sell? How much is enough?
- Build a great company over the long haul? Is this your forever company?
- What type of Company Culture will you build?
- How do you value people?
- What type of culture will your company be known for?
- Capital in vs. Capital out
- How much cash is each of you putting into the company?
- Do you need to take cash out?
- How long of a “runway” do you have of “personal runway until you need to go get a paycheck?
- What’s your passion for the idea?
- Who’s leaving their day job (or who doesn’t have a job?)
- How passionate are you – do you want to stay when it’s tough (and you’re not getting paid?)
- Do you share the same work ethic and how it manifests?
- Do you work early or late – stay until it’s done
- Are you more of a 9-5er?
- How well do you talk about awkward topics?
Each co-founder needs to go to Startup Equity Calculator. Input your individual view of the contribution by each founder on the organization. Print out your results and bring them to the next meeting for discussion. If you feel awkward about the results – for example, you’ve overstated your contributions, you can recalculate and see the differences. But each of the partners has a hypothesis. This tool is just a forcing function for the discussion.
Note here: The value of the idea is alway higher to the person with the idea. When you hear an investor say that “ideas don’t matter, only execution matters” know that is a semi-truth – the fact is that bad ideas matter and big ideas are truly rare. It is true that execution is more important. However, if you execute a flawed idea, you’ll just fail faster.
Now, take a week of time to go process what you’ve learned and set the next appointment for the second meeting date.
Meeting 2 of 2
Bring your printouts with you to the second meeting.
- What did you learn about each and yourself other from the last meeting?
- Any surprises?
- Everyone talks and listens?
- Share the print out from the equity calculator
- How close are you?
- Who over/underestimate their contribution?
- Why did the evaluate themselves that way? Listen
- How will you be dividing up the responsibilities?
- Are roles and deliverables clear? How about deadlines?
- Who has put in what cash at this point?
- Will you each bring it to pro-rata amount?
- This will determine your basis at time of incorporation
Set the third meeting if you need to have more time to discuss the outcomes.
Time to Incorporate
Now that you’ve had the discussions and have done some market relevant math you should be ready to incorporate. Have you agreed on the splits? If you have issues, now’s the time to address them head on. No passive aggressive behavior and no “we can just take care of that later”, the time to take care of it is now!
One of the things you’ll want to include in your documents is a “Reverse Vesting Schedule” – you’ll be granted stock for a minuscule price at the time of incorporation. The stock is granted, but like a vesting schedule, if you leave early you don’t get to keep all of your stock.
That way the clock can start on your 83b election and (hopefully) when you sell the company you can be taxed at capital gains rate vs Regular Income rate – this is a slight digression but something you should talk to your attorney about before you select who’s going to do your documents. If she/he doesn’t know anything about 83b (assuming the US) then find a different attorney.
What reverse vesting provides is that is one of the co-founders departs the company, say at the 12-month mark, you’ll need to get the remaining three years of unvested stock back to backfill their role in the company. If they were the lead developer, you’ll need another lead developer.
This is a topic about company health and chance for success, not about you personally.
People, circumstances and enthusiasm change over the time growing your startup. You need to be able to address those changes as you build out your product and ultimately a company.
For this term, you’ll find a good resource in the tool/book called The Pie Slicer by author Mike Moyer, it’s designed for bootstrapped startups where your equity is based on contribution. It’s a very clean way to think about contribution over time. When you add your profile, you input your market rates less what you are currently being paid by the startup.
So if you were a developer and market was $100k and you were getting $4,166/month you’d be getting 50% of market rate (I like simple math when I can).
You don’t get to inflate your math – and you should agree on what market it before you start the exercise – e.g. agree on your previous salary.
Mr. Moyer has also built the app to track over time so that you have a Cap Table that can be calculated at the time someone exits and it will calculate the value.
Based on the posts, it doesn’t have a way to incorporate hourly tracking yet in a real-time version of the app, so you’ll need to add hours manually at a regular frequency.
What’s your result? Did the equity splits finish like they started?
If you have more questions, feel free to start a discussion in the comments section below.
This was originally published here.