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A template for founder equity splits
You can study cap tables like a geologist studies sedimentary rock. The top layers are made up of freshly laid down preferred shares, maybe a recently-expanded ESOP. Below that are past investors, perhaps SAFEs that converted. Then Angel investors.
At the bottom is a bedrock of common shares where founders initially divided up the pie. That’s the layer I’m interested in.
The majority of founders split up equity within one month of starting their company. But what was the actual thought process that went into it?
After all, it’s now set in stone.
I found myself doing some sedimentology recenty when I came across a few unusual cap tables. Some founders had left or were no longer full-time but they still owned large chunks of shares. Actually, this is not that unusual.
This became an issue with new investors who felt that the ‘dead’ parts of the cap table would mean active founders were under-incentivized.
I ended up recommending The Founder’s Dilemmas by Noam Wasserman. It’s an excellent book about the dynamics and tensions in founding teams. There are chapters on solo founders vs teams, wealth vs control and everything entrepreneurs should think about before dividing up the equity.
Highly recommended before you start a company.
But just as useful to navigate tricky issues with existing cap tables, like having to renegotiate a split that no longer makes sense.
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What could go wrong?
Let’s start with some of the downsides of getting your equity split wrong.
Did one founder get more shares for coming up with the idea? That will feel less fair if you pivot to a new idea.
Was one founder not able to fulfill the role you expected? Maybe they received a technical co-founder’s share but you ended up needing to hire a CTO.
Or did their level of commitment change? Eg dropping to part-time or leaving. This is common.
These pitfalls create two types of problems.
Internally, they breed resentment that can harm or kill your company if they are not resolved. These are very tough to renegotiate once they are set.
Externally, investors will be concerned about “dead equity” on your cap table, meaning shares owned by people who are not building or investing. That takes (future) money off the table that could be incentivizing active participants.
Unknown unknowns - rewarding the past versus the future.
It’s not easy to get an initial founder split right. But even if it’s done well it only captures what’s known at the very start of a company, when most of the future is uncertain.
In Donald Rumsfeld’s words, it’s not the known unknowns you should worry about. It’s the unknown unknowns.
You do not know what your product or market is. You will probably pivot, which might make past contributions irrelevant. Your team will almost certainly change, potentially drastically. The future destiny of your company could be an IPO or a profitable consulting business (or neither).
The right mindset when dividing initial equity is to focus more about future contributions vs past ones. Base the split on what you expect each founder to contribute over the long-term and put these expectations down on paper.
The temptation is to reward the initial founders for coming up with an idea and deciding to start a company. This is not the right approach because no one has done anything yet.
All founders should vest their initial shares over time, eg 4 years, or even more. Even if there isn’t an external reason to do so yet. This values future contributions over past ones and protects the company if someone leaves.
How much is an idea worth?
According to Wasserman, the “idea premium” is in the 5-25% range. That means in actual practice the idea generator highly values their contribution.
It seems fair to compensate someone for coming up with the idea. After all, you’re only here because of that idea.
But do not over-compensate for an idea because it is guaranteed to change, and you might abandon it altogether. Think of the idea as a North Star vs proprietary IP. How much would you pay for a North Star?
An exception to this is if someone contributes IP to the project. Of course that assumes it’s valuable and you end up using it (which you’ll only know in the future)!
A template for founder equity splits
Wasserman’s idea of a phased approach is still the best framework I’ve come across. I adapted one of his real-world examples and turned it into a template.
This only covers the initial founder split, not options or future equity grants.
The overall idea is to divide equity based on each founder’s expected contribution in the future. Here’s how to use it.
1. Define the phases
Define phases you think are relevant for the early stages of your business. The template has milestones but you could make yours based on set dates or funds raised.
Simply describing future phases helps put the founding team on the right path. You’re still at the start line and the hard work is ahead of you. That’s what will earn you most of the equity.
2. Set expectations
Most co-founders do not explicitly state what they expect of each other. This is bad.
Defining roles and expected contributions is the first step in effective teamwork. You’ll probably need to argue over the value of each contribution. However difficult that conversation is, it will be even harder if you have to do it later.
This is a fair structure in case a co-founder leaves, reduces their time or even if you have to
3. Decide on vesting vs milestones
There are two approaches you can take once you’ve filled in the template.
You can use the template to calculate a fair split (that’s the “weighted split”) then vest those shares over time. The time period should be at least as long as it will take to complete the phases and ideally longer. Even a vesting period of 4 years seems short considering how long much startups take to exit.
Another approach (the bottom spreadsheet) is to treat each phase as a milestone. When you achieve the milestone you grant the equity. But I would still recommend attaching a vesting schedule, perhaps shorter, to these equity grants.
In both cases you still need to evaluate each co-founder’s actual contribution. Again, these are tough conversations to have but worthwhile. Like a sprint retrospective.
What to do when you inherit a bad cap table
Fixing a bad cap table is not impossible. You can use the same template to have a conversation around re-allocating shares. This comes down to adjusting the weights on past phases.
For example, imagine you’ve just joined a startup as CEO. You’re negotiating your equity stake and anticipating that future investors will object to the dead equity on your cap table.
Put the past phases, which could be milestones or prior funding, into the template. Add the most important future phases you think will put the company on the path to success. Then add a weight to each past and future phase.
Whether you weight past contributions as 20% or 50%, you’re now focusing the negotiation on future investments you need to make, not sunk costs.