Q: When it comes to co-founders and early team members, what is the best way to approach equity?
A: One of the more complex issues founders face in structuring their startup is deciding how to split equity between founders, team members and advisors. It’s a tricky issue to navigate if you haven’t done it before, and one that is easy to second guess at a later date.
There are some basic yet critical concepts to grasp as you fund your startup, and it’s very important to get these right, as they create the structure that keeps all key parties properly motivated in the ebb and flow of building a startup (and fairly rewarded when you have a successful exit).
Related: What Entrepreneurs Call 'Sweat Equity' the IRS Calls 'Taxable'
Here are some thoughts on how to split among the key players:
One thing that most founders I know will agree on is that the “easy” answer of splitting equity 50/50 is absolutely the wrong answer. Instead, founders should assign relative value to what each person brings to the table in the best, fairest way possible. Initial questions to ask include: Who had the idea? Who is creating the business plan? Who has domain experience? Who will raise the capital? Does one of the founders have previous startup success that makes it easier to hire key early team members?
By assigning a value to each of these questions, you can set a starting point for a rational and fair equity split. In my experience, navigating this discussion with your co-founder(s) in a way that makes everyone feel positive is the first test of how well you and your co-founder(s) will work together. Getting this variable wrong often results in a later startup failure due to an obvious inequity.
For key hires it’s important to create emotional and financial alignment on the product and the company you are building together. It’s unlikely you'll be able to use a formula for equity grants with these first employees, and it's definitely more art than science. However, a rule of thumb for those first 10 to 15 hires is that they will own roughly 10 percent in total of the business in aggregate. As your startup matures, it’s incredibly important to switch from art to science when granting equity. Not doing so is very expensive and will create structural issues at a later date. I highly recommend you assign a value to the equity based on the valuation investors or potential acquirers have recently placed on your company.
Related: How to Split Equity Without Giving Away the Company
Establishing the right group of advisors to support your start-up is one of the most strategic tactics you can deploy to help set the tone for how your product will be used and to help acquire early adopters. Typically, a startup allocates 1.5 percent to 3 percent of equity for all advisors. It’s important to keep the grants small, somewhere around 1/10th of a point in the company. I suggest granting the shares as fully vested, because it will remove much of the friction from the deal by shifting the conversation from “what percent of the company am I getting?” to “that’s great, happy to help out.” It’s a smart deal for everyone involved. The advisors aren’t burdened with unclear expectations on what they’re supposed to do, and they get compensated regardless of what happens. Because the grants are properly sized, you gain the flexibility to engage additional advisors, including people with diverse backgrounds and expertise, regardless of how much time they are able to commit to your company — and that’s an advantage.
Because dividing up equity at the beginning is typically more art than science, it’s one of the more challenging aspects of getting your startup structured correctly from the outset. It’s also one of the areas for which I highly recommend you get experienced outside help (legal counsel, potential investors, startup advisors, other founders), as they can provide input based on their experience and, more importantly, an unbiased view that everyone involved can trust. Getting this right will help you get off to a strong start in building your company — one in which everyone is in alignment.
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