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 GeekWire: The only wrong answer is 50/50: Calculating the co-founder equity split
Mike Moyer is the author of Slicing Pie, a 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.