Dividing Startup Equity

For a startup, determining which founder receives what, and when, is tricky business. And critically important to survival.

Although it’s as much art as it is science, allocating the initial equity of a startup among the founders should be approached systematically. Like many early-stage founder decisions, initial equity allocation can have long-term consequences for the success of the venture. So, proceed with caution.

Let’s begin with two types of allocations that are usually wrong: Uber Lopsided Allocation and Commune Allocation.

Because it takes a team to build a company, any structure where one founder holds 90 percent or 95 percent of the equity, and the other founders each hold 1 percent or 2 percent, doesn’t work. Essentially, that’s Uber Lopsided Allocation.

Even if they agree initially, the microfounders (those holding the very small amounts of equity) realize pretty quickly that after a couple of rounds of dilution they’ll hold nothing of significance and the startup just isn’t worth their time and risk. The micro equity doesn’t garner any commitment.

The uber founder usually makes this mistake because he’s worried about having control after the seed and series A investor rounds. Having done the math, the uber founder sees that without holding a super majority of the equity at startup, he or she will be a minority shareholder after investors come into the picture.

This isn’t a real issue because of the way financing rounds are structured. Investors will require limits on management even when the founders control the equity. More importantly, this structure causes premature death of the startup.

With Commune Allocation, all founders are equal so everyone has an equal share of the company. Each founder’s initial equity percentage is reduced to a simple equation: 100 divided by the total number of founders.

Founders choose this allocation because of its simplicity; no thinking is required. The problem with this allocation is similar to the Uber Lopsided Allocation problem. Certain founders will, for whatever reason, contribute more to the success of the startup.  Those founders will realize that they’re not being adequately compensated for their contributions and their risk. So they move on or don’t contribute all of their efforts and, again, the startup fails or simply limps along.

The common problem with the uber and commune approaches highlights a more successful solution for founder initial equity allocation. The starting point should be one of value contribution and timing.

Take, for example, a founder providing startup funding. When a founder contributes cash to the startup, two things are undisputed: value received by the startup and timing of the receipt of that value. The startup receives a specific value (defined in dollars) at a specific time (when the money is in the bank account). These two concepts can be applied to other founder contributions and lead to an initial equity allocation.

Value, for non-cash contribution, must be the market value of the property and efforts contributed by each founder. First, the founders must determine what contributions—cash, property and labor—each founder will make and over what period of time they’ll be made.

Next, market values for the contributed property and labor are established. Of course, the difference between transferring property to the corporation and delivering services or labor is time. Labor is provided over a period of weeks or months. Property, on the other hand, is similar to cash. That is, the value is received by the startup at the time of transfer.

To equate the value of labor with the instant value of cash or property, the labor value has to be adjusted to reflect its periodic contributions. This is accomplished by determining the present value of the labor over the time period during which it will be rendered using a reasonable discount rate.

Take, for example, NewSup Inc., with Bob, Carol and Ted. Carol and Ted are contributing cash, property and labor worth $150,000. Bob is providing only labor to NewSup. He’ll be working for one year at a reduced salary of $10,000. If a market salary for Bob is $75,000 per year, Bob is contributing $65,000 over the year. Using an 8 percent discount rate and assuming Bob would be paid every two weeks, Bob’s labor contribution value is $62,568.

The first-pass founder equity initial equity allocation for each founder is the ratio of the founder’s effective contribution to the total effective contributions of all of the founders. Returning to NewSup, Bob’s contribution of $62,568 is divided by all of the NewSup founder’s effective contribution (Bob, Carol and Ted) of $212,568 to achieve a starting point for Bob’s equity interest at 29.43 percent.

Of course, equity allocation isn’t purely mathematical. And there are several other factors. Yet, this method does provide a reasonable starting point from which additions and subtractions based on more “soft” factors can be applied.

Editor’s note: Ed Alexander is founder of the Entrepreneurship Law Firm in Orlando and author of the book “10 Common and Costly Business Killing Legal Mistakes and How to Avoid Them.” He works regularly with the University of Central Florida’s business incubation program, among other regional  business clients,