The Formula for the Perfect Cofounder Equity Split

Posted by Guest Author /August 20, 2014 / Advisors, Cofounder Advice, Entrepreneurial Advice, FounderTalk, How To

Mike Moyer is currently the managing director of Lake Shark Ventures, a company that provides growth consulting and early-stage investments to startups. He wrote several business-related books including Slicing Pie: Funding Your Company Without Funds and Trade Show Samurai: The Four Core Arts for Capturing Leads. He is also an adjunct faculty member at Northwestern University and the University of Chicago’s Booth School of Business. 

Screen Shot 2014-08-19 at 4.53.19 PMI once started a company, called BlipNut. The idea was to create a universal commenting system for the Internet that was completely anonymous. People could post comments on any web page that could be read by others. Like many tech entrepreneurs, I figured I was only a few short years away from a glorious IPO. Also like many tech entrepreneurs, I needed a technical cofounder and I had very little understanding of the actual scope of the work.

Learning my Lesson

I searched high and low for the right technical cofounder and I found one who was equally excited about the concept. We negotiated a 65/35 equity split where I was the majority shareholder. All I had to do was sit back and wait until the software was ready. I waited and waited and waited. Nothing was ever produced and after several months the programmer backed out because he had too many other paying clients and could not concentrate on the job. So I searched and found another guy. This time I wanted to make sure he had plenty of incentive for what was obviously a big job. I offered him 75% of the equity. He was eager to agree and went off to build the product. About a week and a half later the product was complete—exactly as I had envisioned it. It was going to take a lot more work to market the product than it was to create it, but I only owned 25%. He did two weeks of work that was behind him and I had months of work that was ahead of me. So, we decided to hire a marketing guy and give him equity too. The developer thought I should give him part of my equity because it was marketing help and not development help. To make a short story shorter—the company failed. This wasn’t the first time, nor the last time, I made equity decisions that adversely affected the outcome of the company and I’m not the first person, nor the last person, to make such stupid mistakes. Equity allocation problems are often at the core of founder disagreements in startup companies all over the world. Mistakes are made every single day. Now I know better.

Getting it Right

In order to get your equity deal right with your cofounders, employees, investors and anyone else you want to cut in you need two basic things:

    1. First, you need a logical framework to govern the allocation of equity or profit interest to the various players. A good structure is based on the logical value of inputs (start with fair market value), provides a premium for risk taken (which is high) and works dynamically meaning that the allocation will change as the inputs change.
    2. Second, you need a logical framework to govern the recovery of equity from individuals when they separate from the company. A good structure will recognize that the company’s right to recover equity will depend on the nature of the separation from the employee. In some cases separation is the fault of the employee (like not doing their job), in other cases separation is the fault of the company (like a layoff). Both the company and the employee deserve protection from the others’ bad decisions.

When you have these two components you will have a common understanding of how each participant is treated when it comes to the allocation of equity or profit interest in the company. You are well on your way to working in an environment where people are treated fairly for the actual contributions they make instead of lop-sided negotiations based on empty promises of future contributions.

Art vs. Science

Most equity splits today are more art than science with people relying on many well-meaning (and often intelligent and experienced) advisors whose formulas weigh inputs based on ideas, experience, skills, relationships and time commitment. These are all important factors and should be taken into account in your allocation framework. However, the most common missing ingredient is the dynamic feature that allows the allocation to self-adjust over time. And, the second most common missing ingredient is the entire recovery framework—people have a tendency to think the team will stay together for the duration. My personal understanding of this two-part framework has transformed the way I think about equity, fairness and business in general. My book, Slicing Pie, outlines a dynamic framework that includes all the rules for calculating the perfect equity split. It’s called a Grunt Fund and entrepreneurs all over the world use them to make sure they are treating their team fairly.

Worry-Free Working Together

Today when I go into business with someone I don’t worry about the equity split. I simply apply the Grunt Fund framework and rest assured that my contributions to the company will earn me exactly what I deserve to earn just like every other contributor.

 

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