Ways to Split Equity

Approaches to Splitting Equity

There are two main schools of thought regarding equity splits among founders:

1. Equal Split is a Bad Idea:

   • Some research suggests that companies with equal founder splits struggle to raise external finance, especially from venture capitalists (VCs).
   • The reasoning is that an inability of founders to honestly discuss and decide who brings more critical contributions signals to VCs that the founding team may not function effectively in decision-making, perceiving this as a negative indicator for investment.

2. Equal Split is Optimal:

   • This school argues that at the nascent stage of a startup, the future is highly uncertain, and most of the significant work lies ahead.
   • An unequal split might demotivate founders from giving their best effort to the company.

The Importance of Timing: When to Split Equity

The question is not merely how to split equity, but when. A significant majority of startups (73%) split equity right at the beginning, often based on a vague idea and before any real validation or clear trajectory for the company emerges. This early split has both benefits and downsides.

Benefits of an Early Split:

• Negotiation before High Stakes: Discussions happen when the company's value is low, making negotiations potentially less contentious.
• Attracting Key Players: It can help attract key team members when the company is small and equity is a more significant incentive.

Downsides of an Early Split:

• Misallocation: Without a clear understanding of future contributions or company direction, equity might be given to individuals who do not contribute effectively later.
• Anchoring Effect: An early split can set an unintended precedent, making it difficult to adjust equity distribution later, even if circumstances change.

When an Early Split is Suitable: An early split is generally suitable when co-founders have a pre-existing working relationship, especially from a previous venture. In such cases, there is high trust, familiarity with each other's skills, work ethic, and value contribution, which provides sufficient information for an informed early decision.

Benefits of a Late Split:

• Informed Decisions: Waiting allows founders to learn more about the venture's trajectory, market validation, and, crucially, about each other's work ethics and value contributions. This reduces uncertainty in allocation.

Downsides of a Late Split:

• Increased Anxiety: Deferring the decision for too long can create anxiety among founders about their future stake and return on effort.

When a Slightly Later Split is Beneficial: A slightly later split is particularly beneficial for first-time founders or "rookies" who are unfamiliar with the venture process and their co-founders' long-term contributions. It allows for a period of "courting" before a firm commitment. However, it's crucial not to delay it to the point where anxiety becomes detrimental.

Pitfalls and Best Practices in Equity Sharing

Equity disagreements can be detrimental, even nearly destroying successful companies like Apple and Facebook. To avoid such pitfalls, founders should:

• Allocate Sufficient Time for Discussion: Equity splits should not be rushed. Engage in multiple, spaced-out discussions (e.g., over several weeks with 3-4 sittings) to allow for reflection, external consultation, and better mutual understanding.
• Involve a Neutral Party (if needed): If negotiations get stuck, bringing in a trusted neutral authority can help mediate and facilitate an agreeable split.
• Ensure All Voices are Heard: Provide an opportunity for every co-founder, regardless of personality, to share their views, plans, and reservations openly.
• Discuss Conflict Resolution Mechanisms: Proactively discuss how future conflicts will be resolved while in a positive frame of mind, rather than waiting for disputes to arise under stress.
• Design a Flexible Equity Contract: The non-linear and unpredictable nature of venture development necessitates a flexible equity contract. Rigid agreements can be harmful.
  • Vesting Schedules: Implement milestone-based or time-based vesting for equity. This means shares are granted gradually over time or upon achieving specific goals, incentivizing founders to remain committed and contribute.
• Seek Legal Counsel: Do not attempt to draft equity contracts alone. Engage experienced legal professionals who can ensure all contingencies are covered and the agreement is legally sound.

In essence, equity is a highly flexible and valuable "joker" in the deck of cards for a startup. It is critical for attracting talent and capital and navigating uncertainty. Therefore, its distribution and ongoing management must be handled with utmost care and foresight.