How much equity should founders take in their startups, and how much should they leave for other stakeholders? How should co-founders divide their share of the equity amongst themselves? There are many theories on equity splits, but there are no definitive answers. However, some guiding principles are supported by data and tested over time.
Common Patterns for Co-Founder Equity Splits
Many co-founders split their equity in one of these ways:
Equal splits
Splitting the equity 50/50 for two co-founders, 33/33/33 for three, and so on, is easy. This is the most common type of co-founder equity split – it feels intuitive and fair and may be fine at the very beginning, but it will look less attractive when the real investors show up..
Negotiated splits
Cofounders negotiate how they will divide the company’s equity. The split will be whatever they can ultimately agree on. The negotiation process adds an element of what is perhaps underlying reality. Not all founders bring as much to the table. In fact, rarely is the contribution equal, and some founders may be more essential in the long term than others. This point leads to the next point.
According to each cofounder’s contributions
Dividing according to contributions involves taking into account how much value each founder provides to the company in terms of ideas, capital, time, work, and/or connections. This can be done by formulas that monetize various contributions. However, these decisions are more of an art than a science. We have seen situations where a founder is the face of the company, the developer of a unique technology, the person with all of the key contacts, or all of the foregoing. In those situations, the company may be so personal to the founder and/or so dependent on the founder that extraordinary equity allocations are warranted.
Conversely, we have also seen situations where the true founders hand out too much equity in an effort to be magnanimous. These decisions can take on a different aspect in the succeeding years when expectations are not met. When founders aren’t happy with the equity split, that underlying flaw in the structure of the cap table exacerbates tensions. Dean Noam Wasserman and Professor Thomas Hellmann wrote in the Harvard Business Review that the percentage of founders who are unhappy with their equity split increases 2.5-fold as their companies mature.
Fast and Impulsive Versus Slow and Thought Out
Studies that Wasserman and Hellmann conducted show the value of founders investing sufficient time and thought in their equity-split decisions. Cofounders who had longer and more serious discussions about what contributions were expected and potential uncertainties had better outcomes than those who rushed through the process.
Their studies show that co-founders who negotiate longer are more likely to agree on an uneven split. They also show that when founders split the equity equally, it becomes harder for them to raise venture capital, although an even split is often more a symptom rather than a cause of their companies’ problems.
Keeping Long-Term Planning in Mind
Michael Seibel, Y Combinator Partner, says that equity splits should motivate co-founders to stay with the company over the long term, put in the hard work needed, and feel like true owners. A CEO’s decisions on the allocations of equity incentives should focus on maximizing their cofounders’ motivations, he says, rather than on how to come up with a split based on negotiations.
Vesting as an Equity-Division Strategy
Imposing a vesting schedule on the equity given to co-founders provides a safety hatch in case the initial decisions turn out to be flawed. Typical vesting (which we recommend) is four years with a one-year cliff: Founders cannot access any of their equity until they have been with the company for at least a year and can’t access all of it unless they stay for four years. That way, if a co-founder leaves or is otherwise separated before a year, the company doesn’t lose anything, and no one feels “taken.” We encourage the use of a one-year cliff. Under this scenario, vesting is suspended in the first year, but the day after the one-year anniversary, all of the shares that otherwise would have vested in the first year become vested. These provisions can become buy-back provisions in stock subscription agreements that enable the company to issue all of the Founders stock up front (while the company is new, the stock is “cheap” and there are no material tax consequences to the recipients of the shares) and then buy back any unvested stock of a founder or equity holder who separates from the company during the vesting period.
Being Generous With the Equity for Cofounders
Seibel suggests that when you are protected by vesting, you can be more generous with your equity shares. The point is that there are multiple variables that can be drawn into the discussion.
Allocating Equity to Stakeholders Other Than Cofounders
Initial equity allocations take place in what is hoped will be a temporary setting. The goal is for investors to arrive, and they will dilute whatever equity is outstanding. A common general equity split is:
- 20% for cofounders
- 55 – 60% for investors (who may hold preferred shares with a liquidation preference)
- 10-20% in stock options for employees
- 5% (if any) for advisors
There is no standard formula. However, founders are motivated to push the company to revenue generation and ultimately profitability as soon as possible. As long as the company is burning through equity investment, the need for further investment (with the dilution it brings) becomes entrenched. Later, investors can drive hard bargains.
How Venture Studios Are Allocating Equity
Historically, regions with active business communities fostering economic growth have used two different approaches to growing a start-up community. One approach is the venture studio. Venture studios take ideas that are sourced internally or externally and create startup companies from the ground up. They can bring all manner of expertise and experience to a fledgling company, including business connections, management recruiting, professional advisors, and, in some cases, even coding. They also may provide seed capital and introductions to formal investors.
There’s growing interest in venture studios to stimulate business growth in a designated region or as a pure investment play.. Venture studios can be found around the country, creating startup critical mass beyond the tech hot spots of Silicon Valley and New York City.
Venture studios vary greatly in terms of the equity they take in their startup companies. Their equity stake can range from 15% to 80%, depending on what they are bringing to the table. For an investor or an entrepreneur looking for a turn-key start-up platform, a venture studio may be the answer, even if the equity stake for the founder will be lower. If this topic interests you, see our article on Venture Studios.