Over the next week we’ll be publishing a three-part series on equity. Here in Part 1, we’ll discuss issues relating to founders’ equity; in Part 2, issues relating to investors’ equity; and finally in Part 3 we’ll discuss issues relating to equity issued to employees.
One of the primary issues founders face when it comes to equity is how to divide up the equity. Many entrepreneurial teams simply divide up equity equally among themselves. While this is not necessarily a bad or incorrect thing to do, a good attorney or founder advisor will immediately question how the founders came to that distribution. More likely than not, an equal distribution does not accurately reflect the contribution each will make to the company. Some founders may be devoting more time to the company, may be contributing capital, or may be bringing in intellectual property. The notion that some members of the founding team are contributing less than others is a hard and uncomfortable fact for many teams to acknowledge; however, some investors may see an equal equity split as indicative of the notion that a company’s founders are unwilling to acknowledge or deal with difficult questions. Founders should ask themselves whether an equal split is truly fair — the worst case scenario is that, after each founder’s contribution becomes clear, some feel disgruntled that their contribution has been undervalued by the equal split.
Similarly, if there is a clear lead founder in the team (for example, someone who is providing the idea, the IP, the seed funding, and/or the majority of the sweat equity), it may also be best to avoid an equity split where the lead founder receives an absurdly large share of the founder’s equity while other team members receive a comparatively tiny share in the company. The motivation behind such a split might be the lead founder’s desire to ensure his or her equity share is not diluted after a few financing rounds. However, while the lead founder will still be the majority owner after financing, the other team members may likely be diluted to the point that the value they receive is minimal, which may dampen their commitment to the venture. Even if the founder or founder team doesn’t control a majority of the equity, it is possible to structure the equity so that founders retain voting control, either through the use of extra voting power or giving a class of equity veto power over major transactions.
The question then becomes how to divide equity among the founding team. One method is to value the contribution each founder brings to the venture. For example, if one founder provides $50,000 in seed money, while the other two founders bring the ideas/intellectual property worth $200,000, then the total value of contribution would be $250,000 — under that valuation, the founder providing the seed capital, worth 1/5th of the total value brought to the venture, gets 20% of the equity; the two remaining founders get 40% each. Although the preceding example is overly-simplistic, it illustrates the basic principle. However, as the example also illustrates, contributions such as intellectual property, or sweat equity, must also be taken into account, but such contributions are difficult to value.
Finally, founding teams may also want to consider not giving out all of the equity from the get-go, primarily in order to avoid a situation where an original founder leaves the company early in its existence, yet once the company reaches a liquidity event (e.g., merger/acquisition, IPO) that founder still gets a significant payday. Instead, founders can take a small number of shares to begin win, then have additional shares vest over time — the longer a founder stays with the company and puts in work, the more shares and the greater a return the founder will get. Alternatively, a venture can set shares to vest on the occurrence of a particular event. For example, in a tech company if one member of the founding team is responsible for developing the technology, his or her additional shares can vest upon the release of a beta product or final version.
As a last point, however the equity is divided among founders, the team will want to make sure the equity structure prevents deadlock among owners, either by making sure that no combination of votes results in a deadlock, or giving an owner or a class of owners veto power over major transactions.