Founder Equality vs. Equity – How to allocate founder shares when setting up a new company • Slash

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Founder Equality vs. Equity – How to allocate founder shares when setting up a new company

March 2, 2022

Starting a company is like a dream coming true. One of the most sensitive issues in the creation of a new company is agreeing on share allocation between the founding partners. 

The newly created company demands multiple minds to become successful. However, it is always wise to discuss each partner’s amount of shares ahead of the journey. Ego and desire are two factors that could turn negotiation upside down. So, how to handle such a sensitive discussion?

This article is to help you gain a quick understanding of founder equality vs. founder equity with examples of problems, potential solutions, and how to add founder protection inside your capitalization table.

Equality vs. Equity – What’s the Difference?

It becomes difficult to assign shares without understanding the meaning of equality and equity. In simple words:

  •       Equality means the equal distribution of shares.
  •       Equity means fairness based on founders’ contributions. Not every contribution may be made equal.

Some companies prefer using the “Equality” approach to distribute shares. That means, if there are two partners, each partner will get half of the share (50-50) or a variant of 51/49 to ensure one of the partners is ultimately in control and can break the vote.

But in ambitious organizations where the roadmap may require founders to wear many hats and reinvent themselves many times in order to achieve their vision, share distribution using the Equity approach may be more advantageous and wise. Still, it’s difficult due to its “subjective” nature. How to weight everyone’s contribution? 

Problems Assigning Shares

Share allocation negotiations among the founders of an early-stage company could be tricky sometimes, especially when they are unaware of each other’s professional work ethics and achievements.

The two most common problems found are:

Problem 1: perception of fairness  

For example, “Founder B” sees herself as a peer to “Founder A” and considers herself eligible for equal stakes. But on the other hand, “Founder C” is senior and more experienced, who desires to have more stakes than “Founder A” and “Founder B.” And “Founder B” won’t have any issues as long as she receives equal shares to “Founder A.”

So it is more like a “My Word Against Yours” situation, which makes negotiation a complex process. It is because one partner may disagree with another partner, making it a subjective discussion.

Problem 2: Business Consideration

The next problem is about deciding shares for each partner based on business objectives. But objective considerations sometimes don’t actually play an “objective” role and are unable to solve the problem.

A few examples of objective considerations are:

Past Track and Experience

Assigning shares could be decided by evaluating a partner’s experience and past track record.

The Importance of any particular Role

For example, a CFO in the early stages of a company with $0 money is perhaps not important as a CEO.

The Keeper’s Test

It means how the market perceives you or your partner. This objective consideration might also demand you to take the “Keeper’s Test.”

For example, if “Partner A”, ”“Partner B,” and “Partner C’  started a business, and “Partner B” decides to quit. As a result, Venture Capitalists decide not to invest because Partner B is no longer involved.  In such a scenario the value of Partner B is self-evident and he passed the “Keeper’s Test”.

The main idea of the keeper test is would you fight for someone to stay, or would you let them go? If you would fight, how hard would you fight? Would you fight until their demands are fulfilled or not?

Tips to establish Founders’ Equity 

Six techniques can help all the founders of a company come closer to each other, develop a shared vision, and build an empathetic understanding of each other’s position.

But before jumping over techniques, the core principles are the following:

  • Have deep empathy towards each partner’s point of views and what drives them to be in this venture 
  • Define the ideal capitalization table (cap table) along with roles for each partner and shared allocation per year
  • Clarify the swim lanes (or pathway) for each founder so they can give their best performance and remain empathetic, empowered and aligned with each other to achieve the shared vision

Useful concepts before we dig into the tips:

Founder Pool

This pool includes the first founders of the company. When fully diluted or vested, the founders’ pool is usually between 20-40% of the company shares depending on how many founders there are and how many investment rounds the company needed.

Management Pool

The management pool or ESOP counts managers and executives who became a part of the company later, or they have less essential roles. The management pool usually amounts to between 10% to 20% of the shares.

Investor Pool

Most venture backed companies would have somewhere between 40-60% of shares allocated to investors by the time the company exits, and all the shares are fully vested and diluted. 

6 Tips to establish equity

These tips will hopefully help you develop a deeper alignment with your co-founders. Share allocation shouldn’t be a zero-sum game: I win, you lose (or the other way around). If you’re into this for the long-term, you should find a way to establish a shared vision, make each other successful and unleash each other.

Deep Dive into Founders Motivation

You should know what motivates each founder. It could be elements, such as:

  • Personal goals – Could be money, learning, mission, status, etc.
  • Venture goals – Includes exit value, market, team size, awards, speech at Davos, annual turnover, and more.
  • How founders envision their role in the next 1 to 7 years. For example:

o   Year 1: COO

o   Year 3: CEO

o   Year 5: CEO

o   Year 7: Non-Executive

What Triggers Your Co-Founders

Likewise, you should know what de-motivates each of your founders, for example:

  • Lack of fairness
  • Fear that a co-founder would leave the company within 2 years
  • Not having enough share guarantees for the work contributed in the next 3 years
  • Lose control over the company and drop below 50% voting rights of the company
  • Drop below 50% equity
  • Have to raise a lot of money and deal with too many investors.

All these factors require deep alignment. Any insecurity within these factors could trigger a demotivation in any of the founders.

Understanding the Big Picture

Imagine yourself in the shoes of your co-founder, and consider:

  • Does the extra money matter? (Low, medium, and high range of exits after fully vested & diluted shares)
  • What if I exit at US$50M? Would that make me happy? Or would I seek a higher exit?
  • What if I only have 10% as a founder by the time I exit? Or, what if I only have 7% or 14%?
  • What if I have 10%, but “Founder B” has 12% by the time we both exit? Would I care?
  • I don’t want to exit. Instead, I want to increase my control and dividends.
  • I will stay because I want to maximize my own authenticity and long-term freedom with this company.

Based on this, you can evaluate the hot buttons and triggers among each founder and hopefully establish a common language and strategy.

Roles to Achieve Success

You should know what roles suit which founding member? Roles could be different depending on the company, industry, business model, market, vision, etc. For instance, roles would be different in a SaaS startup compared to a property development company.

For example, the following could be the roles in “Company A”:

Primary Roles: CEO, CTO, and CMO (founding shares may range from 20% to 40%)

Secondary Roles: CPO. CFO, COO, and CCO (share range from 0.5% to 5% for each role)

Similarly, the following could be the roles in “Company B”:

Primary Role: CEO, CTO, CFO, and CCO (share range from 10% to 25%)

Secondary Role: CPP, CFO, COO, and Chief of Staff (share range from 0.5% to 3% per role)

Being realistic about what roles will be needed to make the company a success, goes some way to plan for the future and set realistic expectations about what share allocation each of the founders can expect.

Skill Confidence and Motivation

Start by ranking your founders’ confidence and motivation for executing required roles as the “last room” (final owner and decision-maker) from low-medium-high.

It is usually illustrated with the help of a 3×3 matrix.

  • Confidence: Low – Medium – High
  • Motivation: Low – Medium – High 

Imagine there are 7 to 8 roles that need to be fulfilled between the founders, consider that the following ranking will help you understand whether or not a founding member can step up into a particular role:

  • High Skill / High Motivation = Ideally suitable for the role
  • Low Skill / Low Motivation = Temporary suitable for the role until the startup can find/afford someone else
  • Low Skill = Not suitable regardless of motivation
  • Medium Skill = Could take the position if highly motivated and if other founders are “OK” to give that person a chance

Define Swim Lane

Define swim lanes for all the founding members of what roles a founder may evolve into over the next 1-3-5-7 years, identify overlaps and conflicts, and try to find a reasonable consensus. For example, “Founder B,” who aims to become the CEO within the fifth year, now could be:

  • CTO at Year 1
  • CPO + CTO at Year 3
  • COO at Year 5
  • CEO at Year 7

4 Ways to Protect Integrity of the Capitalization Table

You can secure the cap table by:

Vesting Schedule

For example, Erik has had up to a 10% share of the company over 5 years. His five-year vesting is:

  • Year 1: 10%
  • Year 2: 20%
  • Year 3: 20%
  • Year 4: 25%
  • Year 5: 25%

So, if Erik quits after “Year 2”, he would only have 30% (Year 1 + Year 2). Likewise, if he leaves the company after “Year 3”, he would have 50 % (Year 1 + Year 2 + Year 3). This vesting schedule would incentivize a founder to stay for the “long haul” with the company assuming the company valuation keeps growing.

Time-based Vesting and Performance-based Vesting 

There are 2 distinct vesting mechanisms: time-based and performance-based.

Time-based vesting assumes that someone receives shares based on their full-time length of service to the company. For example, over 5 years a founder gets 50% of their allotted shares “just” by working for the company.

Performance-based shares stipulates certain business milestones or KPIs for a founder to hit, in order to obtain shares. For example, of a founder grows the company to US$10M ARR or expands the company to USA, then he/she gets another +10% of shares.

It can be wise for co-founders to adopt a vesting schedule so they optimize for the long-term success of the company. Such a founder vesting schedule would likely be administered and governed through a shareholder agreement or a side-letter. 

Claw Back

Clawback means that previously allocated shares would be returned to the company vesting pool. This protects founders and investors from other shareholders who under-perform, leave early or behave in an unacceptable way. 

Partial Early Exit Option

One of the useful methods to see if someone is committed for the long-term is to offer them some money now if they quit today. If they do, their commitment is limited and arguably it may be good that they just left.

This principle can be utilized when offering co-founders the option to exit early, at a low-exit value. This can be handy in a scenario where you have many co-founders (say 4+) or some co-founders that are not as committed as you expected. For example, at year 1, your company can buy out Erik (one of the founders) at 25% of their Year 1 time-based vesting allocation in cash.

Although the offer is made in cash, the amount is still small. And most importantly, it will filter out Erik, confirming his intentions to leave the organization.

Conclusion

Equity is all about fairness when allocating shares to the founders. Hopefully some of the tips we shared here can help you establish a more equitable share split.

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