This October’s issue of INC. magazine has an interesting article about splitting founder’s equity.
15 years ago Atlanta-based Ockham Technologies had three founders. One founder had part of the original idea and was putting in sweat equity and cash. A second founder was putting in sweat equity and cash but wasn’t part of the original idea. A third founder was part of the idea and put in cash but no sweat equity. What type of split of the equity would have been “fair?”
How to split equity is one of the most important decisions a founding team will make. A Harvard Business School professor, Noam Wasserman, has spent 15 years studying more than 6,000 startups and has found that far too often a quick handshake follows a quick decision on the split. Nearly 40 percent of startup teams spend a day or less hammering out an agreement. A large number of the companies he studied chose an even-steven split.
Wasserman found that unhappiness almost triples when founders split equity equally by default. Founders who deserve more equity – because they had the original idea, have more relevant experience, or will take a larger role in the company – leave about 25 percent on the table when they agree to an even split. His suggestion: Consider founder contributions.
Wasserman’s research shows that founders who had the idea for the company get 10-15 more percentage points of equity than co-founders. (In a two way split, 55% to 45% for example.) Founders who have led other startups generally get 7 to 9 extra points, and the one who becomes CEO gets from 14 to 20 extra points.
Ideally, you should allow for unexpected contingencies such as changes in the business model or founders switching roles. Using if/then planning and vesting schedules are two ways to keep things flexible. A static split can set you up for disaster according to Wasserman.
Back to Ockham Technologies with their three-way equity split. They split roughly 45%, 30%, 25% and built in a trigger that would allow two of the founders to buy back stock from the third.
Timing can be important. Startups that decide on the split in their first month with little discussion are more likely to split evenly. These founders are too optimistic, lack information or want to avoid a contentious issue. Investors who believe a simple split does a poor job of appropriately rewarding founders may reduce their investment or insist the agreement be reworked before they invest. A quick even split “suggests that the founders don’t have the business maturity to have a tough dialogue” according to Wasserman. Waiting too long can create internal tension.
The best time to determine the split varies. In fast-changing industries, founders should establish principles they’ll use to draft an equity arrangement but split only when some of the uncertainties are resolved. The key is to develop an equity split that is clear, logical and respectful of what each founder’s contribution is.
Beyond the Article
When Norm Brodsky invests in a business he always insists on owning 51% of the voting stock until his investment is safe. After that control reverts to the entrepreneur. His reasoning is that he wants to have the final say as long as his money is at risk. Once the company is doing well enough to pay him back, he’s happy to turn the decision-making authority over to the person who got the company to that point.
He would never agree to a power-sharing arrangement. He feels only one person should have final say in a business. His point is that it should be absolutely clear who’s in charge, otherwise you’re guaranteeing constant tension in the company’s decision-making process.
The final decision maker should be the person who can’t be replaced. Though several people may help launch the business, there’s always one person driving the process – the entrepreneur. He admits he does not follow this rule when he funds a startup. That’s because these companies can’t get money elsewhere, so he’s the person who is irreplaceable. He won’t invest in a startup that doesn’t have an entrepreneur who can assume the role of ultimate decision maker once he has been repaid. When he invests in a company, everyone knows who’s boss.
And what about your business?
Where can you go to get help brainstorming the right equity split for your business or how much equity to give up to an outside investor? The Cumberland Business Incubator is one place. We’re here to help you with the issues you face in your business. We can’t do the legal work, but can refer you to attorneys that our clients have had good experiences with.
Call for an appointment – 931-456-4910 or email us at cbi@roanestate.edu.
See you soon –
