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Deciding how to divide up equity in your early-stage startup can be one of the most difficult and delicate decisions you can make. No matter how you do it, there are long-term consequences that are usually uncomfortable.

This is because startup companies change a lot during their early formation and what founders think is going to happen rarely actually happens. However, they often divide up equity based on what they think (or hope) will happen because they don’t know how to divide up equity based on what actually happens.

When equity is divided up based on what founders think will happen, they are basing their decisions on a complex set of business assumptions that are being viewed through rose-colored lenses. They think the company will grow; they think everyone will work hard; they think investors will line up with checks in hand; they think customers will be clamoring for their products, and they think that success is eminent.

Based on these optimistic assumptions, they attempt to predict how much their company will be worth based on yet another set of complex assumptions and then determine how much each of the team members deserve based on what they expect each to contribute.  Because the future value is based purely on assumptions — all of which are debatable — founders will no doubt engage in debate in order to ensure they all get the best possible deal. This type of “every-man-for-himself” debate is unhealthy at best, destructive at worst.

Optimism is Good

Feeling good about the future of a company is not only normal, but helpful. Founders should be optimistic and excited about the prospects for their new business, otherwise they wouldn’t get far. Bad equity decisions made early on, however, can cast a pall over what should otherwise be an exciting time. Of course, sometimes things go bad and startups can be stressful. However, when everyone’s interests are aligned they can work through the rough times together.

Dynamic Equity Splits

The solution to the equity problem is the use of a dynamic equity split system. So, rather than dividing up equity based on what people think will happen, the equity is split based on what actually happens.

Founders and employees of a startup company contribute different things to a company.

Time and money are the most common, but they also provide intellectual property, supplies, equipment, relationships and other important inputs that the company needs to grow. Using a dynamic equity split system the company tracks the various inputs and allocated equity based on the percent of the contributions made. This creates an intrinsically fair equity split where each founder or early employee gets exactly what they deserve to get.

The other important consideration is what happens to equity splits when a person leaves a company — either because they are asked to leave or they choose to leave. The circumstances under which they leave have bearing on what they should be able to take with them in terms of equity. For instance, an employee who is fired for poor performance should not have the same expectations as someone who did what they were told, but were asked to leave because a strategy changed.

Count What You Can Count

I’m a big believer in a dynamic equity split method called a Grunt Fund. Using this method, the contributions of the various participants are assigned a theoretical value that allows the value contribution to be understood relative to the contributions of others. With a dynamic equity split system a company is able to provide equity over time that is in proportion to the contributions individuals make. That way someone who provides 25 percent of the contributions to a start-up, for example, would ultimately receive 25 percent of the reward.

This means that larger contributors wind up getting larger amounts of equity. Central to this method, and others like it, is the notion that only what can be counted should be counted. It’s impossible, for instance, to truly know the value of an idea. Likewise, it’s impossible to know the value of providing personal security for loans to the company or the value of a business relationship.

However, it is easy to count the time, money and value of business equipment that is provided. Counting what you can count and ignoring what you can’t provides an objective process of measurement. This doesn’t mean that ideas aren’t important (they are critical), but while you can’t count the idea, you can count the eventual outcomes created by acting on the idea.

Dynamic equity splits using methods like a Grunt Fund, are by far the most equitable way to divide equity in a startup company.

Previously on GeekWireThe only wrong answer is 50/50: Calculating the co-founder equity split

Mike Moyer is the author of Slicing Piea book about dividing up equity in early-stage companies. He is an entrepreneur who has started a number of companies including Bananagraphics, a product development and merchandising company, Moondog, an outdoor clothing manufacturing company; and Vicarious Communication, Inc, a marketing technology company for the medical industry. He has taught entrepreneurship at both Northwestern University and the University of Chicago. 

Comments

  • http://wac6.com/ William Carleton

    Seems fraught with adverse tax consequences to founders. Or is your idea a variation on restricted stock with the “dynamic” part being reverse vesting on some basis other than time?

    • http://twitter.com/GruntFunds Slicing Pie

      Hi William, you are absolutely correct. There are a number of ways to address the tax issues (depending on the corporate structure). In a corporation restricted stock can be issued and the dynamic model can be used to determine vesting. LLCs offer more flexibility. In an LLC the dynamic model can be used to determine the distribution of profits.

      Thanks for the comment!

      • http://www.danshapiro.com/blog Dan Shapiro

        I think William was being kind. It seems impossible to implement in any way that would be workable for a typical investable tech startup. Are there reputable lawyers with standard, tested paper for this?

        In general, innovators in the area of startup equity are usually spotted standing outside the line of the IRS office several years later, so having robust, tested legal paperwork seems like a necessary prerequisite to recommending the approach to anyone.

        • http://twitter.com/GruntFunds Slicing Pie

          HI Dan, I would be happy to put you in touch with an attorney who can assist in the implementation of a dynamic fund.

          • http://www.danshapiro.com/blog Dan Shapiro

            Please do share the names of attorneys who endorse this approach.

          • http://twitter.com/GruntFunds Slicing Pie

            Send me an email to mike@slicingpie.com and I’ll make an introduction

  • andrew bright

    The title is misleading. Calling it the “best way” is not correct as it will work in some situations, not all. I understand the idea though – simply marketing your own book.
    But don’t have to give people a wrong ideas that will not work for every one.

    • http://twitter.com/GruntFunds Slicing Pie

      Hi Andrew, thanks for the comment. Dynamic Equity splits are not widely used today because they are not widely understood, but I do believe it is by far the best way for the majority of bootstrapped start-ups. I’m on a mission to change the way people think about start-up equity. Articles like this, my book, speaking and assisting start-ups is how I hope to achieve this.

      • Toby Boss

        Your belief is wrong and I must say that yours is certainly not the best.

        Though, I must admit it has some good logic – cash-based or cash-equivalent-based valuation of relative contribution.

        Check for instance a Harvard research on splitting equity and a few others with sensible more practical approaches.

        • http://www.SlicingPie.com/ Mike Moyer

          Hi Toby,

          Harvard researchers cite several problems with traditional equity splits including splitting too early, splitting evenly and using static splits. The Slicing Pie method addresses all of those problems and more.

          -Mike

          • Toby Boss

            I’m sorry but your reply clearly shows you did not read or understand Harvard’s First Deal paper and what they prescribe as the optimal equity split.

            I leave you with your belief.

  • Ryan Dancey

    The problem with dynamic allocation is that it under-values required initial startup contributions, without which the company couldn’t have been created in the first place.

    For example, if I have a patent on which the whole company will be based, I could argue that I should get 100% of the equity – without my patent, there is no company. Obviously, that strategy fails if my co-founders want equity participation and not just salaries. So I have to divide the pie inequitably (from my perspective) based on the need to recruit and retain the talent I think necessary to make the company run.

    However, with dynamic allocation, if my patent becomes unimportant later because the company changes direction or changes technology, my co-founders would argue that my contribution should be discounted to 0%. Even though the company ITSELF wouldn’t exist without my patent contribution.

    While it may not be “fair” in the sense that the terminal valuation of the company might not reflect the founders’ contributions, I think that the only workable system is to allocate founders equity at the outset by negotiations between the parties, and then remain true to that allocation barring convincing a founder to voluntarily accept a reduction under “fairness” arguments if conditions materially change.

    Of course, as soon as 3rd party money comes in all the original calculations are likely to be thrown out the window anyway. The new source of money will likely have more to say about how founder’s equity will be allocated than the founders themselves, especially if they NEED that money to continue operations. All the dynamic scoring in the world won’t help when the choice is between giving up your equity in a recapitalization, and giving up your company because it runs out of capital.

    • http://twitter.com/GruntFunds Slicing Pie

      Your example is why the dynamic model is needed, it will accommodate extra value for ideas and it will adjust if the idea turns out to be unproductive. If a founder want’s to keep 100% of his or her company they can simply pay employees a fair market rate. If they are unable to pay, equity is a good alternative and the dynamic model will help determine a fair rate of equity.

      I’ve never heard of an investor reallocating a founder’s cap table. However, many investors will apply new terms to the stock (like a new vesting schedule). When real money comes on board the dynamic model could:”freeze” and new restrictions could be applied based on the terms of the investor.

  • http://about.me/justinknechtel Justin Knechtel

    I’m really intrigued by this. Just finished the free sample of the book and ended it with purchase from Amazon.

    I’m in the process of growing a blended customer / worker owned coop and am curious how this could fit within our model. Looking forward to the book.

    • http://twitter.com/GruntFunds Slicing Pie

      Thank you for your interest, please contact me if you have any questions!

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