In the startup world, equity is split among investors, founders, advisors, and early employees. Investors get some shares in exchange for their money. On the other hand, founders, advisors, and employees get their shares in exchange for their efforts. In this article, we will cover the best practices for equity splitting among founders, advisors, and early employees.
Founders’ Equity Splitting
One of the toughest discussions each startup founding team must make regards equity splitting. Normally, each member of the founding team wants to get as much share as possible. Although many startup accelerators prefer even equity splitting, in most cases this may not be the right approach. Even equity splitting can lead to a deadlock when making hard decisions. In addition, many investors believe that the founders of even-equity-split startups were not mature enough to have such a difficult discussion. For this reason, they may avoid funding these startups. Unfortunately, there is no mathematical method to use for equity splitting.
Team members should get their shares based on their contributions, experience, and assumed risks. For example, full-timers must get more share than those who work part time. Full-timers are risking their livelihoods for the benefit of the startup. Accordingly, they must get more equity so that they remain motivated. In addition to amount of time, each member’s role and responsibilities should directly affect their shares.
So, how to split equity?
Consider a founding team of three members, two of whom are full-timers and one of whom is a part-timer. Normally, full-time founders tend to work 10 to 12 hours a day in the early stage. Meanwhile, part-timers cannot work more than four hours a day. Moreover, those who work as full-timers are taking more risk than are part-timers. If all team members have equal experience, the fair share each full-timer receives should be at least two times more than what the part-timer receives. In our example, each full-timer should get 42.5%.
Founders make many common mistakes during the equity splitting discussions. One of these mistakes is giving high weight to the business idea. Those who come up with the idea usually overestimate its value. In my opinion, an idea is worth nothing if it isn’t implemented correctly. Moreover, most founders make maneuvers for their products after launching. Accordingly, the extra share given to the one who developed the idea should range from 1% to 5%. In addition to the idea, those who started working early on the product will want to get much more share than those who join later. Usually, the startup takes around seven years to be successful. Therefore, if someone started working in a startup six months earlier than others, he/she should get no more than 7% extra share.
There are many free online tools out there to help entrepreneurs in equity splitting. These include Foundrs’ Shares Calculator, FrontApp shares calculator, and GUST equity split. Besides splitting, it’s recommended to link each member’s equity to milestones. For example, if someone fails to achieve one or more milestones, he/she should be penalized by a reduction in his/her share. This way, all the team members will do their best to achieve their milestones.
Most startups around the world have an advisory board. This board usually consists of four or five individuals who have experience in different areas. An advisory board provides contacts, guidance, and best practices for entrepreneurs in the startup’s early stage. If selected properly, they will save tremendous time and effort for the founders. Some startups pay such experts in cash. However, most founders give them equity instead.
A rule of thumb is that each advisor shouldn’t get more than 1%, and the whole board shouldn’t own more than 5% of the company. In most cases, they get 0.5% share in exchange for their efforts. Before appointing any advisor in your startup, you must agree with him/her about your expectations. For example, you can agree with them about number of hours they’ll spend or the milestones they’ll achieve in exchange for their share. If they can’t give you those hours or achieve those milestones, they won’t get the agreed-upon equity.
A common mistake that founders make is attracting big names to their advisory board. Although these names can grab the attention of investors, partners, or even customers, if they aren’t committed, they will provide nothing. In addition, if the startup equity is wasted on those who don’t have time, no share will be left for those who can truly lift the business. In other words, founders should choose the ones who are interested in the business and who are committed to helping them.
Most startups cannot offer competitive salaries for their early employees. In addition, most startups’ employees may spend more hours at work and take on more risk than people who work for corporates. In compensation, such employees should get some shares in addition to their salary. The employee share pool can range from 10% to 30% based on the startup stage. For example, if the startup is in its early days (i.e., still trying to find a product/market fit) and its employees are getting salaries below the market rate, the employee share pool can be around 30%. On the other hand, if the product is already generating revenue, the employee share pool can be around 10%.
Employees should get shares based on their roles as well as their efforts. For example, if you hire a CEO, you must give him/her at least 5% shares in addition to a salary. Other C-level positions (like CFO, CTO, etc.) usually get 2.5% shares. Vice presidents can get up to 2% shares. Lead engineers can get around 0.5% shares. While planning for the employee share pool, you should identify the key hires first, then assign shares to each one.
To remain committed, founders, advisors, and early employees must get their shares through vesting. Vesting is the process in which shares are disbursed over a specific schedule (like four years). There are three types of vesting: immediate, cliff, and graded. Immediate vesting is for transferring the shares to individuals unconditionally. Cliff vesting is for transferring shares once a specific period (like one year) is spent. Finally, the graded one is for transferring the shares gradually over a specific period (usually four years).
In most cases, startups utilize both cliff and graded vesting at the same time. For example, most founders get their shares over four years through graded vesting with a one-year cliff. In this example, if a founder decided to leave the venture before the end of the first year, he/she would get zero shares. On the other hand, if he/she decided to leave immediately after his/her first year, the equity allocated to him/her would be reduced to 25% of its planned amount. The same concept can be applied to early employees and advisors.
In all cases, the company has the right to get the shares back if the founders, employees, or advisors didn’t get 100% of their share. This way, if anyone decides to break his/her commitment, the company will have a chance to get another individual to fill the space. If the company can’t find anyone qualified, the shares will be returned to the company. In other words, each person’s share will then have a higher value.
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