27.04.2018 Cofounding, Lifehacks
Equity Split: A Conversation You Need to Have with Your Cofounders
“Selecting the right equity split is a life or death question – no kidding”, says Jana Nevrlka, author of the book “Cofounding the Right Way” and cofounding expert at F10. The example of Facebook – amongst many others – shows that the share of equity every cofounder holds is an essential element to get right.
The primary purpose of the equity share is to define ownership of the business which is very closely linked to reward, profit share and control. Unless agreed otherwise, in most legal systems and standard legal forms of companies, the ownership directly determines the control over the business. This means that voting rights are often proportionate to each cofounder’s equity share. Assigning equity also has a motivational element to it: if cofounders or employees benefit directly from growing the business and creating more value, they will be more motivated.
“The right time to talk about equity split of your future business is right as you start working together with someone”, recommends Jana. The two main options are fixed or dynamic equity splits. Both options as well as their respective advantages and disadvantages will be briefly discussed in the next paragraphs.
Fixed Equity Split
The pie – the company equity – is cut and the slices are distributed equally between the cofounders. In a world where it is known upfront that the slices truly and fairly represent the cofounders’ past, current and future contribution, it would be the most logical split. The main weakness of this solution, however, is that the world is constantly changing. Mark Zuckerberg’s initial equity split with Eduardo Saverin did not hold the growth and development of the company. The legal battle that followed when Zuckerberg attempted to reclaim his partner’s equity, including the negative publicity and damaged relationship, is a standard scenario. “What is not standard is that the company survived it”, comments Jana.
The contributions of the cofounders will most likely change over time with the result that the slices of the pie will not be fairly representing the cofounders’ contribution. Another weakness of this model is that once equity is allocated and fixed, the company might end up with cofounders owning equity but not contributing. “This is the worst case but not an uncommon scenario”, warns Jana. “If you go for fixed equity split, always combine it with vesting schedules.
Vesting is saying that the right to the equity in the business which was agreed between the cofounders will be acquired either a) over time and / or b) with reaching milestones. Time vesting helps to mitigate the risk of cofounders leaving the business after a few months with their full equity share. According to Jana “this is more common than you would want to know”. The typical time vesting is structured over a period of between two and four years. It can be divided proportionally and executed in set periods. “Unfortunately, pure time-based vesting – without combination with milestones or specific agreements on performance – is not protecting you for the case that the cofounder is staying with the business but not delivering”, says Jana.
This problem is addressed with milestones-based vesting which is often used in combination with time-based vesting. The challenge of milestones-based vesting is how to define the milestones concretely but flexibly enough. It needs to be discussed what to do if the parameters are no longer relevant. This model requires highly structured project plan estimation in a very dynamic business stage and risks not getting the milestones definition right beyond the short term.
Dynamic Equity Split
Against the backdrop of the challenges of fixed vesting mentioned above, dynamic equity split has become an increasingly popular alternative. It can either be dynamic by cofounders agreeing to renegotiate and verify their initial share later or dynamic by construction.
According to Jana, the most comprehensive dynamic equity split method is the Slicing Pie developed for early stage start-ups by Mike Moyer. The basic philosophy behind Slicing Pie is that when someone contributes to a start-up company and is not paid in full for their contribution, they are at risk of never being paid. They are betting on the future value created by the company. The amount they bet is equal to the unpaid portion of the fair market value of their contribution. Every day people place more bets in the form of money, time, relationships, facilities or supplies. This betting continues until the company breaks even or raises financing.
It is impossible to know in advance how much betting will be required before sufficient value is created. By keeping track of the contributions of every cofounder to the company, the method ensures that the split remains fair. In the Slicing Pie model, contributions are tracked using a fictional unit of at-risk contribution called ‘slices’. There is no fixed number of slices. At any given time, the formula below will calculate the cofounders’ fair shares:
Cofounder’s equity = cofounder’s slices / all slices
“The most frequent cofounder contribution is time, so you should agree on the fair market value of every partner’s time. The discussion alone is a very good check if the cofounding team has similar opinions about the approximate value of each other’s contributions”, states Jana.
The expert on cofounding emphasizes that there is no one size fits all. “Both fixed and dynamic equity splits have their strengths, times and purposes. What I wish for you is to be aware of all options you have.” Jana also recommends entrepreneurs to go through the following questions:
- Have we spent time and attention on the choice of equity split within the cofounding team?
- Did we consider the specific nature of the business (industry, geography, culture and strategy)?
- In case of choosing a fixed equity split: Did we include a dynamic element?
- When opting for a dynamic equity split: Does every cofounder understand and agree with the method and input parameters?
- Do we know what the expectations of each member on the cofounding team are?
- Have we talked about how we will address potential cofounder underperformance?
These insights on cofounding and equity split have been provided by cofounding expert Jana Nevrlka and author of the book “Cofounding the Right Way” during Masterclasses at F10 in Zurich.