Many founders, focused on product development and fundraising, postpone formally dividing co-founder equity. To sidestep an awkward discussion many opt to divide equity equally. Others, hoping to ensure fairness and avoid offending a partner, use formulas that assign weighted values to actions. Both approaches have shortcomings with long-term consequences. Studies show that that dividing equity equally doesn’t ensure fairness. Instead, it often leads to future discord. Shikhar Ghosh serial entrepreneur, investor, and Professor of Management Practice at HBS, has witnessed common mistakes many co-founders make when divided equity. In an informal discussion, he and serial entrepreneur Lara Hodgson, review typical mistakes. Hodgson shares tips for structuring equity splits with dynamic provisions to mitigate future conflict among co-founders.
Ways Structure Equity Splits to Mitigate Future Co-Founder Conflict
- Don’t Overestimate Early Value
- Include Provisions to Keep Everyone Accountable
- Consider Dynamic Approaches such as Layering of Value Over Time
When Structuring Co-Founder Equity Splits, Don’t Overestimate Early Value
Research shows that 73% of founding teams allocate founder equity within a month of starting their ventures. As a result, most founders overestimate the value of early contributions they bring to the venture. And they underestimate the future contributions and needs that the startup will have. After studying 3,700 founders from 1,300 startups in the U.S. and Canada, Noam Wasserman and Thomas Hellmann identified equity split dissatisfaction as a source of founder conflict that escalated over time. Why? Few want to consider circumstances that could change the dynamics of the team.
“One of the biggest mistakes most people make at the outset is obsessing over how to divide the pie based on early contributions instead of designing their team to build the biggest pie.”Shikhar Ghosh
The Problem with Static Equity Splits Made Early
Many founders begin with a short-term view of the factors that affect equity splits. Most believe that their early level of commitment will persist or grow over time. The majority of founders don’t anticipate how drastically the roles they perform will change as the startup scales. But studies show that nearly 50% of founders experience a change in their business model within the first year.
If each founder agrees to a share of ownership that persists over the venture’s lifetime or a period of pre-determined years, but circumstances change, resentments often arise. Deciding to start a family could cause one person to de-prioritize the business for months or years. Unanticipated challenges or changes to your business model may affect roles. Individual contributions made by founders often fluctuate over time. Establishing a static 50/50 equity split during the early stages can spark future conflict if one founder devotes less time and effort to the venture but retains 50% equity.
When Structuring Co-Founder Equity Splits Include Provisions to Keep Everyone Accountable
One of the best ways to mitigate risks of future conflict is to build in mechanisms to make your agreement dynamic. While you can’t predict every circumstance that will arise, provisions like vesting can provide a sense of fairness.
Vesting provides a framework to follow if changes or certain events occur. Typically, vesting terms stipulate provisional conditions under which founders can receive their equity shares. For instance, co-founders may agree to an equal split at the outset of their venture. Following vesting, none receive equity instantaneously but instead, they earn equity after a set period of time or after meeting certain milestones.
Why is this desirable? If you have two or more co-founders, and one leaves unexpectedly or is unable to contribute as anticipated, vesting provides a safeguard to other founders. The provision helps ensure that co-founders will remain actively involved in and committed to the startup.
Some recent trends like “grunt funds” operate in a far more complex manner. Based on a book, Slicing Pie, by founder and adjunct professor of entrepreneurship Mike Moyer, the concept gained popularity in 2012. Following its premise, founders apply a formula that assigns a monetary value to various actions—or contributions—a founder makes, including IP, time, network, and cash invested. Founders track their time and actions online and accumulate equity in a grunt fund based on how the formula assigns value to their contributions.
Accountability Matters to Investors
Many people don’t consider tangible ways to hold founders accountable for the entire life of the business. Describing expectations and building in mechanisms of accountability within your founders’ agreement can help.
Key Questions to Help Keep Co-Founders Accountable
- Can you incentivize behavior so that everyone has the skin in the game?
- Are expectations appropriate for each founder’s role?
- What happens in the event that somebody’s life takes them in a different direction? Can you adjust your agreement easily or does it become a mess?
Hodgson notes, “those are the types of things that outside investors want to know when they come in because they don’t want to inherit a mess. They don’t want to see capital inefficiently used by a partnership that doesn’t work well.”
Dynamic Approaches to Structuring Co-Founder Equity Splits
At NOW Corporation, Hodgson and her co-founders challenge that assumption. Assigning monetary value to actions assumes equity is finite. “When we think about a company and equity inevitably, you think of it as some form of pie. You’re constantly thinking about how to carve it up.” But unlike a pie, equity is not a fixed circle to slice into progressively smaller pieces. “You’re trying to cut something up but grow it at the same time.”
She analogizes, like an inverted “tiered cake, you start it with a base that you carved up among the people that started the company.” Then you build an additional layer on top of that base. “I think of it as kind of concentric circles that build on each other. That’s how your pie gets bigger. You don’t constantly re-divvy up the original core.”
Build Ways to Reassign Value Over Time
She and her partners developed an iterative approach to equity to address the fact that a founder’s level of commitment, resources, and value they add may ebb and flow over the course of the company’s life. At NOW Corporation founder equity is structured like an inverted tiered cake.
Imagine your core business idea is a mini-cupcake that forms the base layer. When you launched, you divided that mini-cupcake with your co-founders, so your aggregate ownership share started with a percentage of that core idea. As your startup grows, you add subsequent layers of value—slightly larger cupcakes—on top of that core idea.
“Each time you create a unit of value, you add a new layer. Each one is bigger than the next, and they all sit atop each other. But each one is carved up differently. It’s not just a fixed circle that you’re carving up into potentially infinitely tiny pieces. ”Lara Hodgson
Layering Value—Adjusting Co-Founder Equity as It Grows
For instance, if your company has three co-founders and you divide equity equally when you launch, each would own 33.3 percent. But, when a significant layer of value was added to the startup, each founder could receive a different percentage of that new layer, based on his or her contribution. Unlike grunt funds that rely on complex formulas to automatically assign value, this type of iterative method requires co-founders to define, discuss, and negotiate each new layer of value.
At NOW Corporation, the co-founders all agreed on what constituted value at the start. And they agreed to regularly assess new layers of value and discuss how to divide each to reflect the partner’s contribution to that layer. Questions to consider:
- Who’s putting time into the business?
- How do we attribute value to time?
- Who’s creating the company’s intellectual property?
Define and Negotiate Value Regularly
Often, she notes, “you don’t realize that until it’s been created.” Making time to assess value as you create it can help keep co-founder relationships amicable by recognizing that partners’ contributions change. For instance, one of Hodgson partners identified a program that could benefit the startup immeasurably and enable it to scale at an accelerated pace. That person spent less time with the startup on a daily basis and thus had a smaller percentage of equity. But the specific new contribution promised to have a huge impact on the valuation of the company, so he received a larger portion of equity for that layer of value.
Communicating Openly as Needs Change
If you’re interested in trying an iterative approach to equity, Hodgson emphasizes that frequent communication is essential. On a regular basis, and anytime a partner makes a contribution that could bring value, stop and talk about it. Even if you decide not to attribute value to it at that time, having those conversations can prevent future friction.
Failing to communicate openly as new value gets created can lead to ongoing tensions, resentment, and serious conflict. Hodgson notes, “One person thinks, ‘Well, I’ve added all this value. Nobody’s recognizing it.’ Then a year later, there’s friction. Having those conversations early on and allocating value at the point that you see the potential for it, leaves room for a lot less arguments later.”
Anytime you see a unit of value being created, you should stop and talk about it, even if you decide not to attribute value to it at that time. It leaves room for a lot less arguments later.Lara Hodgson
Hodgson explains, “our egos can assimilate the fact that ‘I played this role here, and now, I’m playing a different role.’ And that doesn’t take away from your initial stake.” Myriad ways to structure equity splits exist. Whichever way you decide to divide equity, consider the following best practices when structuring co-founder equity splits.
Easy Ways to Help Reduce Equity-Related Co-Founder Conflict
- Make sure that all founders have a vesting provision.
- Establish a clear governance structure and agree upon a way to resolve conflicts if they arise—especially if you opt for an equal split.
- Be prepared to justify your co-founder equity split to all stakeholders and your investors.
We recommend the following sources that dive deeper into common mistakes founders make when dividing equity.
- “The Very First Mistake Most Startup Founders Make,” reviews results of a multi-year academic study of equity splits adopted by over 3,700 founders from over 1,300 startups in the U.S. and Canada. Authors Noam Wasserman and Thomas Hellman examine the perils of deciding to split equity too quickly and neglecting to talk about personal uncertainties and expected contributions. Their research demonstrates that “even the best of ideas can falter when the founding team neglects to carefully consider early decisions about the team: the relationships, roles, and rewards that will make the founders a winning team.” Additionally, it reveals that founder unhappiness with the structuring of equity splits intensifies over time. “The percentage of founders who say they are unhappy with their equity split increases by 2.5x as their startups mature.” Equally useful, the article examines the pitfalls of splitting founder equity well between family members or close friends.
- In “Founder’s Dilemmas: Equity Splits,” by Eric Ries, reviews key points from The Founder’s Dilemmas: Anticipating and Avoiding the Pitfalls That Can Sink a Startup. These include founders’ failing to understand that that the role they had during the early stages will remain the same over time. And overestimating the amount of value of early contributions and underestimating future contributions.
These assessment tools provide different formulas and ways to calculate equity splits:
- Slicing Pie, a paid tool geared towards early-stage, bootstrapped startups, calculates equity using a formula based on the concept that each co-founder’s equity percentage should equal their share of the at-risk contributions. A sample of the Slicing Pie handbook is available to download for free.
- Gust, a global SaaS funding platform for early-stage startups, designed a free tool that provides founders with questions to help them determine how much value each founder will contribute. It provides a recommendation for a fair equity split based on answers.
- Co-Founder Equity Calculator is an experimental calculator that asks a series of questions to each founder than suggests an equity split.