Understanding Co-founder Equity — And Building A Startup With It 🤝
You've built a thriving business with one or more partners. Now it's time to decide who owns what!
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One of the most common questions among startup founders is who will own what percentage of the business. There are no easy answers to that question because every startup has different needs, goals, and circumstances.
This article talks about how to split equity among the founders of a startup, how to avoid making common mistakes, and more. But before we get into that, let's define "co-founder equity."
What Is Co-founder Equity?
Co-founders' equity refers to each founder's ownership stake in a company. It is generally calculated as a percentage representing how much each person contributes to the table.
On day one, this allocation only exists on paper and has no real value. However, they will convert to cold, hard cash once you receive funding or generate revenue. That's how you distribute the value of your business among its contributors.
How To Split Equity?
Before forming a startup team, deciding how you will distribute equity can be helpful. Factors that should influence this decision include:
Company's stage and structure
Contributions and benefits each founder bring
Salary of each founder
Expertise and experience of a founder
There are two ways to split equity with your startup team; equally and dynamically (unequally). Before discussing how to split the equity among your co-founders, consider what kind of split would work best for your startup.
Two Major Ways to Split Equity
1. Equal Equity Split
Equal split equity means that each founder receives an equal share of ownership of the company, regardless of their contributions. It involves dividing 100% of the equity shares by the number of co-founders who join the startup during the early stages.
In a company with five co-founders, each receives 20% equity. Instagram, for example, was famously sold to Facebook with 13 original employees splitting a 10 percent equity stake in the company, amounting to $100 million after the sale.
✅ Benefits of Equal Equity Splits
How come there are so many co-founders who split the equity equally? Below are some benefits you can expect:
By distributing equity equally, it encourages all founders to work as hard and produce as much. Even though one founder puts more effort, money, and time into your company, you still have work ahead of you.
The motivation of your co-founder is critical at any stage of building your company. For equal motivation, you should each expect to receive equal equity shares.
If you're the person who started the company, you bring your co-founder on board to build a technical product. Partnering with someone means you value their knowledge and abilities.
Their skills and knowledge are just as relevant to your company's success. Co-founders shouldn't receive less equity if they work too long on a project. If you do, this means you don't value them equally, which isn't (or shouldn't be) true.
❌ Disadvantages of Equal Equity Splits
In a startup company, not all founders bring the same value of materials. Some of its disadvantages are:
Equal equity splits can impact decisions and lead to stalemates. This situation is common for two-partner, 50-50 equity splits.
Before using a 50-50 equity split, you must agree on critical decisions about your company. Whenever you disagree on something, you can run into a roadblock.
For this reason, some founders opt for an almost-even equity split, like 51-49. There is only one co-founder who controls the decision-making for the company.
An equal equity split can also feel unfair. For instance, only one co-founder contributes more time and resources than the others.
The thing is, each co-founder in your company should share the work equally. Adding smaller co-founders with more specific roles might sometimes be necessary.
2. Dynamic Equity Split
A dynamic split allocates equity based on the contributions of founders. This process involves calculating individual contributions, such as time, compared to others on the team.
For example, the founders who provide 90% of the great ideas, early seed money, sweat equity, and other resources will receive 90% of the rewards in a dynamic equity model.
However, junior developers will only receive 2% of the compensation if they only provide 2% of these things. Through Dynamic Equity Split (DES), the Y-Productive company aims to achieve an equality principle where everyone can be a co-founder.
Also, dynamic equity splits make no assumptions about a company's future value. The only thing that matters is that everyone who contributed to your future success should receive an equal share of the profits. You can only achieve this with a dynamic equity split.
✅ Benefits of Dynamic Equity Splits
For various reasons, a dynamic split model allows you to divide equity more precisely.
You can divide equity differently to make all parties happy and avoid stalemates. This situation can either prevent poor decision-making or reward a founder.
Moreover, dynamic splits offer flexibility. They allow you to factor in many variables when calculating equity percentages.
Also, co-founders with very different roles often prefer this type of equity split.
❌ Disadvantages of Dynamic Equity Splits
A dynamic equity split only considers the current situation, which can be a problem.
For example, it doesn't make sense to give as much credit to a co-founder who works 100 hours but wastes time as someone who works 50 hours but makes a bigger difference.
Contributions that aren't made in the form of time or money may be challenging for the Dynamic Equity Splits system to measure. There are many decisions where the amount of time or money spent is not an accurate indicator of how much value was created. For example, building relationships.
This type of equity split does not address issues related to silent partners (those who invest only the funds a startup needs). Before anyone decides to use the DES system, they should examine the business model and its funding source.
💡Tips on Splitting Equity Among Co-founders
Below are the essential tips to follow when splitting equity among co-founders:
Split as evenly as you can;
Limit the number of co-founders;
A co-founder should complement your expertise, not copy it;
Give 10% of the company to the most important employees;
Include a vesting schedule.
📌 Additional Notes
As soon as you and your co-founders decide to work together on a startup project, you should draw up a founders' agreement that includes information about how equity will be split. This will prevent any disagreements down the road.
Suppose you and your co-founder agree to split equity 50/50 right now, but then one of you leaves the company before earning their share. A vesting schedule protects you both against this possibility by ensuring that each founder earns their equity over time instead of all at once.
Your vesting schedule is another important detail that you should include in your founders’ agreement.
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