See if this sounds familiar: A couple buddies come up with this super cool idea to completely dominate the SaaS market for tools that help companies save billions by monetizing their social media reach . These buddies know the technology, have the contacts and VC’s want to pour money into this “change the world” company. Sounds like a pretty good deal. Something that anyone would want to jump at and they probably will. The problems you will face getting this great new venture off the ground will be many and the first one will be the distribution of founders equity. What I mean by founders equity is the founders stock in a C-corp. The same techniques can apply to LLC’s but for simplicity, let’s focus on a C-corp
This will probably be the first uncomfortable meeting you and your co-founders will have. To help reduce your anxiety, let’s take a look at a some scenarios that you might find yourself in so that when this topic comes up, at least you have a starting point.
Scenario #1: The Golden Three
In this scenario, you ideally have three co-founders. One is the CEO that has experience starting and raising money. Number two is the technology guy who has a track record for building really cool stuff. The third is the marketing guy who knows anyone and everyone in your target market. These are the golden three that will start and build your new company into what will become the next “insert your favorite successful company here.” In this scenario, the distribution of founders equity is pretty easy — each person gets a third. The reasoning is that each will play a critical role in the success of the venture and without them, the venture would fall flat. Now, I am sure there is some debate about whether two or three founders is the ideal number. There are plenty of successful examples for both. Just keep in mind that you need those skills and your foundering team needs to have them.
Tip: When the golden three are present and contributing, equity should be distributed equally.
Scenario #2: Money Bags
Unfortunately, we live in a world where it takes a certain amount of money to get stuff done. Startups are no different. The first permeation on our ideal scenario is the founder with a ton of money. To be honest, this is a mixed blessing. On the one had, you need the money. Actually, you really need the money. On the other hand, a founder with a lot of money will want more control and will tend to dominate the decision making process. This is why it’s best to not have a founder with a huge dollar stake in the business. I know, the temptation is huge to take the money but the cost of this money is more than the equity you give up. You see, gentle reader, this money will control the business more than it should. The co-founder that has a huge financial stake will make bad decisions for the business since what might be good for the company may not be good for an investor. Case in point, when an exit strategy presents itself, the co-founder with the huge equity stake will probably revert to investor getting a return mode than executive that wants to build a company. Granted you might have a founder that puts in a little more than the rest but that’s unavoidable and manageable.
Tip: Beware the co-founder with a potential huge financial stake in the business.
Scenario #3: Connected
Have you ever seen a Rolodex? Back in the day, your “manhood” as a mover and shaker was directly proportional to the size of your Rolodex. Today, it would be the number of connections you have on LinkedIn. Someone that’s well connected will have tons and tons of contacts. These contacts are a potential source of customer leads and/or money. Read that last line again. These contacts are a potential source of customer leads and/or money. It’s great that a potential founder might have a huge list of people they can call to get business. Does this mean they should get more equity? Maybe but that’s a big maybe. Contacts are only good if you can convert them to something tangible. If they can do that, then it’s worth it. In terms of the split, it would be fair and related to the contribution.
Tip: Setup some realistic goals that can prove the power of their connections.
Scenario #4: Wunderkin
Some hotshot techie dude , who either invented the Internet, C++ or Python or all three, has this great idea for his next new invention. The only problem, he has no clue about business or the market or how to raise money but the idea is uber cool and can “sell itself”, he tells you. Sure. Are you also interested in a bridge? It turns out that it’s actually hard to sell stuff and raise money. The idea or technology is only the beginning of a long and painful assent to a real company. Now, the idea is important and if your Wunderkin actually built the silly thing or has a bunch of patents on it, then he deserves a little more equity. If it’s just an idea, then that’s just like a contact that’s not converted. Ideas do change over time and once you get a bunch of smart people working on a problem, that great idea will have morphed into something completely different.
Tip: Sweat equity requires some sweat. Ideas are great but something tangle is far better and should be rewarded.
Scenario #5: Delivered The Goods
Sometimes you get a founder that actually built something, got some sales and now needs to take it to the next level. These founders will have a huge vested interest in retaining more control then the “new guys.” This is just human nature, so don’t take it personal. The best way to handle this is to clearly state what everyone brings to the table. If the IP or product is really going to be part of the venture, then it makes a lot of sense to give that founder more. The problem will be in how much the IP or product is really worth. Those discussions can be contentious since human nature being what it is will mix some ego into the negotiations. Resist going down that path.
Tip: Take a hard look at contributed IP or products. Do a detailed evaluation on what it’s worth and agree with your fellow founders on how much equity you will give up for it.
Scenario #6: Hangers On
It’s also inevitable that your new whiz bang idea will attract people who think they can help you and really can’t. Or even worst, the people who could help but are either too distracted, too busy or just too lazy to step up. These hangers on will make splitting equity a challenge since they will expect far more than they actually contributed. The best way to deal with this is to gather up your real contributing founders and chat about how to handle your hangers on. A unified front will make the arguments on why they want more equity end quickly. You do need to be cautious since the “forgotten” founder problem can give you a major headache in the future. So, unless they really did nothing, you should give them a little something just to hedge your bets on future claims.
Tip: Get your real contributors together and discuss how to fairly deal with hangers on.
Scenario #7: The Mashup
Take all of the above scenarios, stick them in a blender and then hit liquify. The resulting mush will probably resemble your situation more than anything else. Every situation is different and having a formula or method that works for everyone will be hard to achieve. In general, you need analyze the situation from both a business and fairness perspective. Doing this will make the process a little less crazy and a lot more productive. In addition, there are a couple more guidelines that seem to work well. These include:
Founders agreement: Writing down the deal between founders is a great way to avoid the challenges of equity distribution. If you have triggers or vesting rules, put those in as well. Everyone should know what they are getting into.
Don’t incorporate right away: One problem with starting a company is that you really don’t know if it will work out. You also don’t know if these new founders will actually do what they say. That’s why it’s important to get your team to put in a little work up front to achieve some sort of milestone together. This way, you can vet the founders while getting something done.
Be fair and transparent: Treating everyone fairly is important. Part of being fair is to be as transparent as you can about how performance will be evaluated and equity distributed. If the goals are clear and the decisions are transparent, then things should go fine.
Sweat Equity to Founders Stock Conversion: Most founders choose to convert all that sweat equity into stock via some conversation factor. Whatever that factor is, make sure that it’s consistent and that the hour tracking is agreed upon. It usually better to do it based on some tangible work product rather than total hours spent since some people are slower than others. A good rule of thumb is to have everyones rate (dollars per hour) be the same and then have some sort of percent conversion after all the hours are added up. Better yet, setup milestones that earn certain equity percentages. Either way, make sure you write it down.
Founding a company is fun. Splitting the equity can be a nightmare. Take the time to think about each founders contributions and take a step back to really deal with what is fair and equitable. In the end, dealing with dividing your founders equity up front and transparently will set up your new venture up for success.
Also published on Medium.