What Are The 5 Rules You Need To Divide Founder Equity?
“How much equity do you think I should give “Frank?”” That was the question “Sam”, the co-founder of a company that I'm working with asked me last week. He was considering bringing Frank on as a late co-founder to the company.
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“I’ve drawn up a spreadsheet breaking the equity up between the three of us," Frank said. "Take a look and tell me what you think.”
I looked at the spreadsheet Sam had drawn up and I smiled. Sam, in my opinion had done something really smart:
Rule number one in dividing cofounder equity: You need to separate your equity as an investor from your equity as a co-founder.
Sam put about $100,000 of his own money into financing the company. He was the only investor in the company and he was the CEO.
The roles, and equity allocation, of a CEO and an investor are different. You need to acknowledge the difference.
Yeah, I know I said the same thing as I just did, but it’s worth repeating. Let me explain what Sam did.
Sam felt (right or wrong) that his $100,000 investment in the company was worth 15% ownership in the company. That’s separate from his equity as CEO.
So Sam set aside 15% of the equity for his investment. That left 85% to divide up. That leads to…
Rule number two in dividing co-founder equity: Look at the future contribution of your founders, not just their contribution today or in the past.
Frank had a set of skills that was really going to move the company forward fast. In fact, Frank had already been helping the company before formally becoming a co-founder.
Sam felt really good about what Frank’s contribution was going to be going forward. So Sam took that into account when dividing up the remaining equity. That leads to…
Rule number three in dividing cofounder equity: Be generous and be fair.
There were three co-founders including Sam and Frank. Sam wanted to make sure that “Eric”, the third co-founder, was going to be okay with being generous to Frank.
The key to having a fair equity split, as Sam realized, was that all the co-founders feel good about what their equity and they feel good about the equity the other cofounders have.
Fortunately, Sam had taken into account the cultural fit of his co-founders (read: Why Your Startup Culture Is The Key To Your Company's Success), so he already knew Eric cared more about winning than having his equity diluted. That helped a lot.
Sam ended up dividing the founders equity as 25% for Sam, 20% for Eric and 20% for Frank. Sam’s total equity as an investor and CEO was 40%. But what about the other 10%? That leads to…
Rule number four in dividing co-founder equity: Leave some stock available for future employees.
Sam already had developers working for the company. The developers were getting paid, so they weren’t founders, but they did deserve stock options.
Having 10% of the equity available for future employees allowed Sam to easily give stock options to new employees as needed. That leads to…
Rule number five in dividing co-founder equity: Make sure you have the equity of you and your co-founders vest over time.
20% is a lot of equity to give to a cofounder that doesn’t work out. In my experience over 50% of founder relationships end up with a co-founder leaving the company in the first two years.
Having your co-founder equity vest over time is the way to reduce your risk of dead equity being on your cap table. The typical vesting schedule of a one year cliff (where no equity vests for 12 months) followed by remaining equity vesting monthly for the next 36 months works well.
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