Splitting Equity Between Founders

I’ve always wondered how equity distribution is decided between founders. Recently I’ve had several opportunities to discover for myself.

Gather around the fireplace, coders of spirit. It’s time for…

Stories of Equity

First Story: “Al”

“Al”, a long-time friend of mine, had just quit his day job.

In the past we’ve had informal discussions about teaming together and shooting for the startup dream, but no real work was ever done.

I approached Al with a proposition, only to find out he was already teamed up with another friend of his, and they have been working together for several weeks.

Al and his friend did not wish to add another “tech person” to the founding team, so they offered me to join for substantially less equity (around 5%). Let’s stop this story here for now.

Second Story: “Ben”

A very talented friend of mine, “Ben”, decided to finally bring into existence his ambitious vision of a better Internet infrastructure.

While I was abroad, Ben teamed up with another friend of his, and started churning. When I returned and came into the picture, they’ve already been working for a couple of weeks (sound familiar? Story of my life). Ben offered me to join in, and the next two weeks were spent coding clojure frantically.

After a coding sprint, I decided to pause and discuss some business aspects. One of the issues that obviously had to come up was equity distribution, and Ben proposed a partition of 25% to me, 25% to Ben’s friend and 50% for himself.

Let’s stop here. I’ve shallowly described two situations in which I was offered a non-trivial equity distribution, and I believe it is important that I share with you my thoughts at the time.

Slicing the pie

I initially had a hard time making up my mind of these proposals. At the first stages of a startup, when you haven’t even got a business plan, measurable aspects such as time and money are vague or altogether absent. You are left with licking your finger and putting it up against the wind, which I like to call reverse Luftgesheft.

In Yiddish, Luftgesheft translates literally to “Air Business”. In context, it alludes to the cunning methods used by Jews in eastern Europe to make profit despite extremely oppressive racial laws. Making business “out of thin air”.

Distributing startup equity is a reverse Luftgesheft in the sense that I’m trying to asses a business that does not yet exist.The cold, hard math is that 5% of unknown, remains unknown. 25%? Equally unknown.

Well, after trying to size up the potential value of these would-be companies, I came up with a simple realization that helped me greatly: I’m not in it (just) for the money (although, to a certain degree I am).This might not sound like big news, but in the exit-oriented startup culture of Israel, many entrepreneurs are looking for their “big hit” in order to retire at 25.

I can now name several other reasons for starting my own business: I like the independence. It sounds like a great adventure. I also want to belong to the community of great entrepreneurs which I meet and read.

Starting a business is a lengthy process. Its end comes after either building a self-sustainable business, or selling out. So, instead of thinking about the end-point (unknown income after unknown time), I should be asking myself about the journey.

The questions I started asking myself were along the lines of –

  • Is there a mutual commitment between co-founders? As in, everyone receives his proportional share
  • Will I enjoy this type of job in 3 years from now? As in, the line of business isn’t a total bore
  • If the company fails, did I acquire useful experience in the process?

I summarize these guiding questions as commitment and experience.

Stories of Equity, revisited

When narrating the above stories, I was focusing at what I saw at the time: It was all dry numbers. Change the perspective, and the stories change. Now these are stories of people, and relationships.

“Al”

Al and I were colleagues for many years. In some aspects, Al is much better than me. For example, he has the ability to read twice as many blogs as me, plays with new technology as if it was lego and can write a post where every word is a link. I suspect his productivity is somewhat related to having a forgiving spouse, but it’s too late to take back my vows now :).

I, however, have my own set of advantages. I won’t blow my own horn, but let’s say that overall I believe me and Al are (professionally) at eye-level. Therefore, by offering me about 1/10th of his own share, he was effectively making a very small commitment to me.With little more than an idea ahead, it looked like a long, bumpy road up ahead. I would be working my ass off, living and dieing by the deadlines, and all along receiving a tenth of the reward.

Regarding professional experience, the area of interest the company was involved in was databases. This is an area I have plenty of knowledge in, but less interest nowadays. As far as interesting experience, the valuable experience for me would be walking through the whole process of building a company, acquiring customers, hiring employees etc. For that, I needed to have a say in deciding the company’s future. I wasn’t offered such a status.

For these reasons, I decided to decline the offer. To this day, I hold “Al” in the highest regard as an extremely talented individual. I have no doubt he will ultimately end up successful & wealthy.

“Ben”

My friend “Ben” has the mental ability of “leaping” forward both in vision and in technical difficulties. He has a long list of personal achievements, including winning coding contests, working for successful start-up companies and academic success. I’ve always considered Ben slightly superior to me.

However, working together for two weeks has changed my self esteem for the better. The vision Ben presented to me of the venture was obscure. While it was clear what he was trying to achieve technically  in the very short term, the long-term details were fuzzy. For example, he had only a whimsical notion of what could be actually “sold”. When discussing the feature list for the product, he was using the words “generic” and “flexible” in extremely wide contexts. It was alarming.

I felt that within the triad, I would be the “devil’s advocate”: The skeptical, down-to-earth force that would hold attack sessions, posing difficult questions and role-playing and imaginary company considering a purchase. This contribution was acknowledged by Ben as vital to the future of the company.

Apart from being technically gifted, Ben is also highly charismatic. I was comfortable having him drive front-seat, as long as I was sitting second. I needed that seat to hit the breaks every time he would sore to the clouds. To ensure I was being offered the second-seat position I was looking at discussion dynamics, role allocation and equity distribution.

My offer of splitting equity around 48-32-20 (Ben-me-his friend accordingly) was initially considered, but ultimately rejected. As time and discussion progressed, I realized that in most key aspects, Ben considered me and his other friend to be on equal terms. Seeing that this other friend was zealously walking Ben’s path, I did not wish to place myself facing a constant 2-to-1 coalition.

I politely declined the offer.

Conclusions

The fact that Al was my colleague, and that I had spent 2 weeks working closely with Ben, helped me asses the situation both in my personal value to the company and what I should expect as a reward in experience. No one can tell what would have happened would I have went through with one of these offers.

Al has spent most of the past year refining his ideas and building a small advisory board. It’s not going as fast as I would have expected. Ben has recently given up and shut down his business. I myself am now invested in a different venture. This time it’s a simple 50-50. I guess that works best for me.

After giving the issue some thought, I think I can summarize with the following points:

  • Unless there are extremely odd circumstances, equal distribution works best (especially when you start working weekends/overtime)
  • At the initial phase, if you’re unsure, it’s best to work together for a couple of weeks, and agree that up to a certain point you could split up, no strings attached (that includes IP!)
  • If you feel your partner is asking for too much, try looking beyond equity – there’s something else bothering you

I have found little blogging material on the subject, please feel free to share your own experiences, either via links or using the comments section.

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Posted Saturday, March 27th, 2010 under Growing Software.

7 comments

  1. Well, I hope you learned you are awesome. I’m actually a little jealous, as it seems you have a much more interesting adventure. With all this time spent getting off the ground, sometimes I get the thinking I chose the technology/market too soon. Databases and IT aren’t half as interesting as some of the stuff going on out there.
    But, I guess the grass is always greener…

    Oh, yeah, and a link, obviously. 😉
    http://www.youtube.com/watch?v=ULjCSK0oOlI

  2. Good post ! I would of done the same in your shoes.

    I started a venture with an established business man. His offer was 30% for developing a prototype. But he had a track record of two successful ventures, powerful connections and he actually researched the field and had solid leads. – Sadly that didn’t go in the end. We started about a year too late.

    But generally, when teaming up with a biz guy, 90% of the initial risk is on you. You have to waste month in building the product before he really gets down to the business of proving his worth and commitment.

    So if anything, I would love to see it go 90% to technical co-founder. And once the prototype is done. The Biz guy is slowly getting an increased share of the IP depending on progress. :)

  3. Boris, progress or milestone based vesting is a great idea. Note, however, that if one of you has 90% from the get-go, the other one is merely the first employee.

    A different way to attack this is by using vesting for Founders:
    At the beginning neither of you have any shares in the company.
    As per milestones/time spent/money spent or any other method you feel comfortable with, each co-founder gains shares as progress continues. If one is more committed than the other, or more important, the vesting will prove it over time.

    This is actually quite easy to set up, as long as you can agree – in advance – how to measure progress.

  4. My issues is when the Technical co-founder needs to invest a few months of work to get a prototype.

    In the end of that (lets say 6 month) period. I would say he owns the majority of the IP. And only now the “vesting” should start for the Biz guy.

    We had the same problem with a designer. In the very beginning he needed to invest 2 weeks of his time. Followed by 2month of my dev time and followed by lots of Marketing & Sales.

    Since we both (me & biz guy) were commited, we didn’t feel that giving the designer a major share was fair.

    Solution ? Pricing.

    To prototype (how much it costs each of us, in time wasted):
    * Designer – 2weeks – 2K$ (12%)
    * Programmer – 2months – 8K$ (44%)
    * Biz dev – 2months – 8K$ (44%)

    (In the end we decided to pay our money to the designer and go 50/50) but I think the “price of time invested – until prototype” can be a good measure.

  5. Great example. Shifting everything to money makes effort easier to compare (agreeing on price isn’t always easy, but it’s easier than comparing oranges and apples).
    And you are right. If you can, have the BizDev’s share only start vesting when he starts working.

    • I think monetization is difficult since you should be looking 3 years into the future for the equity distribution. It’s 95% gut feeling. That’s why IMO you should try to find someone good and 50-50 it.

  6. 50/50 is great until you can not agree or come to a happy medium on something. A 50/50 should be 51/49 and of course the high goes to the CEO.

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