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This allocation is so critical and pressing that teams often push themselves to make a decision very early on, with very little information. In fact, a 2016 study, T. & N. Wasserman, The First Deal: The Division of Founder Equity in New Ventures, found that 73% of teams split the equity within the first month of the startup, at the heights of the uncertainty about their startup’s strategy and business model, their roles in it, and their levels of commitment to it. Most of the teams barely spent any time discussing the split, avoiding having the difficult conversations necessary to really understand each other’s potential contributions and intentions. And the majority of them split it statically – meaning the teams didn’t allow for future adjustments as new information emerged about contributions and commitment. This is a classic fallacy that we see too often for first time founders and is highlighted in the Wasserman study.
The study refers to teams who split equity equally, without much discussion as “Quick
Handshake” teams. The analysis showed that Quick Handshake teams incurred a significant penalty when raising their first round of financing, either in reduced ability to raise the round or in lower average valuations if they did raise. It's important to note that was only the cost in terms of financing; within the founding teams themselves, the destructive tensions caused by a bad split are often even more devastating.
How can founders avoid the angst, destructive tension, and legal problems that come with a bad equity split? The hard-learned advice was to adopt something more “organic” – something that takes seriously the remaining uncertainties and is able to adjust to their occurrence. The most common “organic” approach is to adopt vesting, in which the individual has to earn his or her equity stake instead of being granted it fully at the time of the split. In the U.S., this vesting is almost always time-based, but about 10% of teams adopt milestone-based vesting, which requires clearly-definable milestones, a concrete division of labor within the team, and other characteristics lacking in many founding teams. Vesting is a huge improvement over the static splits that pervade Silicon Valley. However, in many cases, time is a weak proxy for the creation of value in a startup, making it an imperfect basis on which to split.
To avoid these typical pitfalls for cofounders, an excellent resource on the topic of equity distributions for startups is the Slicing Pie manual. Slicing Pie is a universal, one-size-fits all model that creates a perfectly fair equity split in an early-stage, bootstrapped start-up company.
Allocation of shares should be a simple formula based on the principle that a person's percentage share of the equity should always be equal to that person's share of the at-risk contributions.
What are "At-risk contributions" in this formula? They include time, money, ideas, relationships, supplies, equipment, facilities or anything else someone provides without full payment of it's fair market value. Every day people contribute more and more to a startup in hopes that it will someday generate a profit, go public or sell. Because contributions are constantly being made, the model should be dynamic, and not a simple static split. The model self-adjusts to stay fair as circumstances change.
There are two basic types of contributions to be considered in the calculations. Cash contributions consume cash, non-cash contributions do not. Time, for instance, is a non-cash contribution whereas a reimbursed expense is a cash contribution. The model behind Slicing Pie normalizes cash and non-cash contributions by converting to a fictional unit called a "Slice." A slice represents a normalized at-risk contributions. A slice is similar in many ways to a poker chip.
Here's the basic formula to be utilized:
An individuals % share = individual's Slices ÷ all Slices
At any given time, the above formula from Slicing Pie will provide a perfect equity split. The formula applies until the company breaks even or raises enough capital to pay participants for their contributions. At this point the split "freezes" and subsequently determines the distribution of dividends or the proceeds of a sale.
Not only does Slicing Pie determine a perfect equity split, but also it will help you calculate a fair buyout price, if any, when someone leaves the company before breakeven. This is better covered in our article entitled, "Thinking About the End- Equity Buyout Agreements".
Hopefully, this article has provided you with enough curiosity to really think through your approach for approaching equity allocation for your startup. Our attorneys are ready to help you work through these issues with your co-founders. We highly recommend that you purchase a copy of the Slicing Pie Manual, but you can access a free sample of the Slicing Pie Manual by Mike Moyer here.