It’s not an easy conversation to have.
Imagine that you and two of your friends have started a company; one founder has insider knowledge and contacts within the industry, one founder is a techie, and you had the idea.
You put your heads together and sketch the foundation of an exciting startup. You start getting momentum, everything’s looking good, and then – one founder asks how you’ll split the equity.
Now, that might seem like it’s a simple conversation. You’re all co-founders, working hard and driving your startup forward. Just split the equity evenly. Right? Besides, you’re all friends. Haggling over percentage points and whose contribution is worth more could derail your momentum.
In one sense, you’re right. But according to the Harvard Business Review, companies that have equal splits have more difficulty raising outside funding.
Why is that the case?
Well, if an investor looks at your capitalization table and sees an even split of equity, it tells them one thing: you were afraid to have a hard conversation. You’ve saved your relationship but potentially doomed the company.
Not all contributions are equal. You need to have an open and honest conversation, acknowledging all the founders’ worth and value, while keeping in mind that your cap table is your first impression on a potential investor.
Not only that, but you need to approach your founders’ relationship like a marriage. Lots of marriages end in divorce. You need to be prepared for what happens when your initial enthusiasm runs up against the everyday struggle of getting a startup off the ground. Think of your equity split and your cap table as your pre-nuptial agreement.
(Speaking of cap tables, once you’ve agreed on how to split your equity, you’re going to need to find the best cap table software to help you manage it effectively. But first, let’s take a look at how to have that difficult conversation.)
What is worth what?
You had the idea. Surely, that entitles you to the most equity. After all, without you, there wouldn’t be a startup. Right?
An idea is just the beginning. Facebook and Myspace had the same basic idea – but their different execution and delivery ensured that one grew while the other faded away.
You need to look at your founders and ask yourself, who’s taking the most risk on the startup? If one founder is giving up a high-paying, full-time job, while another founder is just working on the weekends, the first founder is taking on a lot more risk.
Which goes along with another important consideration – commitment. That founder helping out on the weekends is less committed than the founder working full-time, and again, his equity should reflect that fact.
Business knowledge and experience is another factor. Somebody who can open doors – and knows which doors to leave alone – is very valuable.
By this point, you might be wondering how you can compare all these intangibles. One way to do it is:
Weight each one
Conversation time. Write down all the factors that go into a startup (risk, idea, business knowledge, commitment, etc.) and rank how important each one is to your startup, from 1 to 10.
Once you’re all agreed, now rate yourselves from 1 to 10 – what and how much you bring to the table on each category. There will be back-and-forth and disagreements. Keep things objective and respectful.
Now, add up the weight of each category, compared to how much each founder brings to the startup, and you have your splits.
Right now, you’re in the honeymoon phase. Enthusiasm is high, everybody is on the same page and you’re all committed. But it could take years to get your startup off the ground. Life is unpredictable, and some founders, who are committed now, might change their priorities.
You need an exit plan for them.
The best way to do this is vesting. For example, every year that they’re still with the company, each founder gets 5%. After six years, all three founders have their full third of the company. That way, if a founder leaves after two years, they only leave with 10% of the company.
You can come up with other rules around leaving, but vesting ensures that founders leave happy. Even if they’ve left the company, hopefully, they will still act as mentors and advocates.
You’ve split the equity, now what?
Congratulations! You made it through a difficult conversation, and everybody’s happy with their share of the equity.
Now you need a cap table. A cap table shows your market value and the distribution of your equity. Not only is it important for your internal discussions – you need to decide how much equity to give future employees, and where it comes from – but it is also your first chance at a good impression with a potential investor.
For many startups, it’s just a document or spreadsheet. But things get complicated quickly. You’re going to have to incorporate things like share issuances, conversion from debt to equity, transfers, etc. And if you’re trying to keep track of it in a document, you’re going to lose all the advantages you gained from your conversation.
Keep your momentum going – get the best cap table management software available. Turn a plain document into a selling point. Show investors you weren’t afraid to have a difficult conversation, and what it gained you.
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