{"id":6832,"date":"2022-03-02T21:56:37","date_gmt":"2022-03-02T13:56:37","guid":{"rendered":"https:\/\/slash.bravefactor.com\/?post_type=resources&#038;p=6832"},"modified":"2024-01-30T16:37:18","modified_gmt":"2024-01-30T08:37:18","slug":"founder-equality-vs-equity-how-to-allocate-founder-shares-when-setting-up-a-new-company","status":"publish","type":"resources","link":"https:\/\/slash.co\/articles\/founder-equality-vs-equity-how-to-allocate-founder-shares-when-setting-up-a-new-company\/","title":{"rendered":"Founder equality vs equity \u2013 how to allocate founder shares when setting up a new company"},"content":{"rendered":"<p><span style=\"font-weight: 400;\">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.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">The newly created company demands multiple minds to become successful. However, it is always wise to discuss each partner&#8217;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?<\/span><\/p>\n<p><span style=\"font-weight: 400;\">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.<\/span><\/p>\n<h2>Equality vs equity \u2013 what\u2019s the difference?<\/h2>\n<p><span style=\"font-weight: 400;\">It becomes difficult to assign shares without understanding the meaning of equality and equity. In simple words:<\/span><\/p>\n<ul>\n<li><b>Equality<\/b><span style=\"font-weight: 400;\"> means the equal distribution of shares.<\/span><\/li>\n<li><b>Equity<\/b><span style=\"font-weight: 400;\"> means fairness based on founders\u2019 contributions. Not every contribution may be made equal.<\/span><\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">Some companies prefer using the \u201cEquality\u201d 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.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">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\u2019s difficult due to its \u201csubjective\u201d nature. How to weight everyone\u2019s contribution?\u00a0<\/span><\/p>\n<h2>Problems assigning shares<\/h2>\n<p><span style=\"font-weight: 400;\">Share allocation negotiations among the founders of an early-stage company could be tricky sometimes, especially when they are unaware of each other\u2019s professional work ethics and achievements.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">The two most common problems found are:<\/span><\/p>\n<h3>Problem 1: perception of fairness<\/h3>\n<p><span style=\"font-weight: 400;\">For example, \u201cFounder B\u201d sees herself as a peer to \u201cFounder A\u201d and considers herself eligible for equal stakes. But on the other hand, \u201cFounder C\u201d is senior and more experienced, who desires to have more stakes than \u201cFounder A\u201d and \u201cFounder B.\u201d And \u201cFounder B\u201d won\u2019t have any issues as long as she receives equal shares to \u201cFounder A.\u201d<\/span><\/p>\n<p><span style=\"font-weight: 400;\">So it is more like a \u201cMy Word Against Yours\u201d situation, which makes negotiation a complex process. It is because one partner may disagree with another partner, making it a subjective discussion.<\/span><\/p>\n<h3>Problem 2: business consideration<\/h3>\n<p><span style=\"font-weight: 400;\">The next problem is about deciding shares for each partner based on business objectives. But objective considerations sometimes don\u2019t actually play an \u201cobjective\u201d role and are unable to solve the problem.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">A few examples of objective considerations are: past track experience, importance of any particular role, and the keeper&#8217;s test. <\/span>Assigning shares could be decided by evaluating a partner\u2019s experience and past track record. It&#8217;s also important to consider the particular role importance, f<span style=\"font-weight: 400;\">or example a CFO in the early stages of a company with $0 money is perhaps not important as a CEO. Next would be the keeper&#8217;s test, <\/span><span style=\"font-weight: 400;\">means how the market perceives you or your partner. This objective consideration might also demand you to take the \u201cKeeper\u2019s Test.\u201d<\/span><\/p>\n<p><span style=\"font-weight: 400;\">For example, if \u201cPartner A&#8221;, \u201d\u201cPartner B,\u201d and \u201cPartner C&#8217;\u00a0 started a business, and \u201cPartner B\u201d decides to quit. As a result, Venture Capitalists decide not to invest because Partner B is no longer involved.\u00a0 In such a scenario the value of Partner B is self-evident and he passed the \u201cKeeper\u2019s Test\u201d.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">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?<\/span><\/p>\n<p><b>Tips to establish founders\u2019 equity\u00a0<\/b><\/p>\n<p><span style=\"font-weight: 400;\">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\u2019s position.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">But before jumping over techniques, the core principles are the following:<\/span><\/p>\n<ul>\n<li><span style=\"font-weight: 400;\">Have deep empathy towards each partner\u2019s point of views and what drives them to be in this venture\u00a0<\/span><\/li>\n<li><span style=\"font-weight: 400;\">Define the ideal capitalization table (cap table) along with roles for each partner and shared allocation per year<\/span><\/li>\n<li><span style=\"font-weight: 400;\">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<\/span><\/li>\n<\/ul>\n<h3>Useful concepts before we dig into the tips:<\/h3>\n<p>Founder pool<\/p>\n<p><span style=\"font-weight: 400;\">This pool includes the first founders of the company. When fully diluted or vested, the founders\u2019 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.<\/span><\/p>\n<p>Management pool<\/p>\n<p><span style=\"font-weight: 400;\">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.<\/span><\/p>\n<p>Investor pool<\/p>\n<p><span style=\"font-weight: 400;\">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.\u00a0<\/span><\/p>\n<h2>6 tips to establish equity<\/h2>\n<p><span style=\"font-weight: 400;\">These tips will hopefully help you develop a deeper alignment with your co-founders. Share allocation shouldn\u2019t be a zero-sum game: I win, you lose (or the other way around). If you\u2019re into this for the long-term, you should find a way to establish a shared vision, make each other successful and unleash each other.<\/span><\/p>\n<h3>Deep dive into founders motivation<\/h3>\n<p><span style=\"font-weight: 400;\">You should know what motivates each founder. It could be elements, such as:<\/span><\/p>\n<ul>\n<li><span style=\"font-weight: 400;\">Personal goals \u2013 Could be money, learning, mission, status, etc.<\/span><\/li>\n<li><span style=\"font-weight: 400;\">Venture goals \u2013 Includes exit value, market, team size, awards, speech at Davos, annual turnover, and more.<\/span><\/li>\n<li><span style=\"font-weight: 400;\">How founders envision their role in the next 1 to 7 years. For example: y<\/span>ear 1 as a COO, y<span style=\"font-weight: 400;\">ear 3-5 as a CEO, and y<\/span>ear 7 as a Non-Executive role.<\/li>\n<\/ul>\n<h3>What triggers your co-founders?<\/h3>\n<p><span style=\"font-weight: 400;\">Likewise, you should know what de-motivates each of your founders, for example:<\/span><\/p>\n<ul>\n<li><span style=\"font-weight: 400;\">Lack of fairness<\/span><\/li>\n<li><span style=\"font-weight: 400;\">Fear that a co-founder would leave the company within 2 years<\/span><\/li>\n<li><span style=\"font-weight: 400;\">Not having enough share guarantees for the work contributed in the next 3 years<\/span><\/li>\n<li><span style=\"font-weight: 400;\">Lose control over the company and drop below 50% voting rights of the company<\/span><\/li>\n<li><span style=\"font-weight: 400;\">Drop below 50% equity<\/span><\/li>\n<li><span style=\"font-weight: 400;\">Have to raise a lot of money and deal with too many investors.<\/span><\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">All these factors require deep alignment. Any insecurity within these factors could trigger a demotivation in any of the founders.<\/span><\/p>\n<h3>Understanding the big picture<\/h3>\n<p><span style=\"font-weight: 400;\">Imagine yourself in the shoes of your co-founder, and consider:<\/span><\/p>\n<ul>\n<li><span style=\"font-weight: 400;\">Does the extra money matter? (Low, medium, and high range of exits after fully vested &amp; diluted shares)<\/span><\/li>\n<li><span style=\"font-weight: 400;\">What if I exit at US$50M? Would that make me happy? Or would I seek a higher exit?<\/span><\/li>\n<li><span style=\"font-weight: 400;\">What if I only have 10% as a founder by the time I exit? Or, what if I only have 7% or 14%?<\/span><\/li>\n<li><span style=\"font-weight: 400;\">What if I have 10%, but \u201cFounder B\u201d has 12% by the time we both exit? Would I care?<\/span><\/li>\n<li><span style=\"font-weight: 400;\">I don\u2019t want to exit. Instead, I want to increase my control and dividends.<\/span><\/li>\n<li><span style=\"font-weight: 400;\">I will stay because I want to maximize my own authenticity and long-term freedom with this company.<\/span><\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">Based on this, you can evaluate the hot buttons and triggers among each founder and hopefully establish a common language and strategy.<\/span><\/p>\n<h3>Roles to achieve success<\/h3>\n<p><span style=\"font-weight: 400;\">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.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">For example, the following could be the roles in \u201cCompany A\u201d:<\/span><\/p>\n<ul>\n<li><b>Primary Roles<\/b><span style=\"font-weight: 400;\">: CEO, CTO, and CMO (founding shares may range from 20% to 40%)<\/span><\/li>\n<li><b>Secondary Roles<\/b><span style=\"font-weight: 400;\">: CPO. CFO, COO, and CCO (share range from 0.5% to 5% for each role)<\/span><\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">Similarly, the following could be the roles in \u201cCompany B\u201d:<\/span><\/p>\n<ul>\n<li><b>Primary Role<\/b><span style=\"font-weight: 400;\">: CEO, CTO, CFO, and CCO (share range from 10% to 25%)<\/span><\/li>\n<li><b>Secondary Role<\/b><span style=\"font-weight: 400;\">: CPP, CFO, COO, and Chief of Staff (share range from 0.5% to 3% per role)<\/span><\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">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.<\/span><\/p>\n<h3>Skill confidence and motivation<\/h3>\n<p><span style=\"font-weight: 400;\">Start by ranking your founders\u2019 confidence and motivation for executing required roles as the \u201clast room\u201d (final owner and decision-maker) from low-medium-high.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">It is usually illustrated with the help of a 3&#215;3 matrix.<\/span><\/p>\n<ul>\n<li><b>Confidence: <\/b><span style=\"font-weight: 400;\">Low \u2013 Medium \u2013 High<\/span><\/li>\n<li><b>Motivation<\/b><span style=\"font-weight: 400;\">: Low \u2013 Medium \u2013 High\u00a0<\/span><\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">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:<\/span><\/p>\n<ul>\n<li><b>High skill \/ high motivation<\/b><span style=\"font-weight: 400;\"> = Ideally suitable for the role<\/span><\/li>\n<li><b>Low skill \/ low motivation<\/b><span style=\"font-weight: 400;\"> = Temporary suitable for the role until the startup can find\/afford someone else<\/span><\/li>\n<li><b>Low skill<\/b><span style=\"font-weight: 400;\"> = Not suitable regardless of motivation<\/span><\/li>\n<li><b>Medium skill<\/b><span style=\"font-weight: 400;\"> = Could take the position if highly motivated and if other founders are \u201cOK\u201d to give that person a chance<\/span><\/li>\n<\/ul>\n<h3>Define swim lane<\/h3>\n<p><span style=\"font-weight: 400;\">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, \u201cFounder B,\u201d who aims to become the CEO within the fifth year, now could be:<\/span><\/p>\n<ul>\n<li><span style=\"font-weight: 400;\">CTO at Year 1<\/span><\/li>\n<li><span style=\"font-weight: 400;\">CPO + CTO at Year 3<\/span><\/li>\n<li><span style=\"font-weight: 400;\">COO at Year 5<\/span><\/li>\n<li><span style=\"font-weight: 400;\">CEO at Year 7<\/span><\/li>\n<\/ul>\n<h2>4 ways to protect integrity of the capitalization table<\/h2>\n<p><span style=\"font-weight: 400;\">You can secure the cap table by:<\/span><\/p>\n<h3>Vesting schedule<\/h3>\n<p><span style=\"font-weight: 400;\">For example, Erik has had up to a 10% share of the company over 5 years. His five-year vesting is:<\/span><\/p>\n<ul>\n<li><span style=\"font-weight: 400;\">Year 1: 10%<\/span><\/li>\n<li><span style=\"font-weight: 400;\">Year 2: 20%<\/span><\/li>\n<li><span style=\"font-weight: 400;\">Year 3: 20%<\/span><\/li>\n<li><span style=\"font-weight: 400;\">Year 4: 25%<\/span><\/li>\n<li><span style=\"font-weight: 400;\">Year 5: 25%<\/span><\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">So, if Erik quits after \u201cYear 2\u201d, he would only have 30% (Year 1 + Year 2). Likewise, if he leaves the company after \u201cYear 3\u201d, he would have 50<\/span> <span style=\"font-weight: 400;\">% (Year 1 + Year 2 + Year 3). This vesting schedule would incentivize a founder to stay for the \u201clong haul\u201d with the company assuming the company valuation keeps growing.<\/span><\/p>\n<h3>Time-based vesting and performance-based vesting<\/h3>\n<p><span style=\"font-weight: 400;\">There are 2 distinct vesting mechanisms: time-based and performance-based.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">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 \u201cjust\u201d by working for the company.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">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.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">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.\u00a0<\/span><\/p>\n<h3>Claw back<\/h3>\n<p><span style=\"font-weight: 400;\">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.\u00a0<\/span><\/p>\n<p><b>Partial early exit option<\/b><\/p>\n<p><span style=\"font-weight: 400;\">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.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">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.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">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.<\/span><\/p>\n<h2>Conclusion<\/h2>\n<p><span style=\"font-weight: 400;\">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.<\/span><\/p>\n","protected":false},"featured_media":12245,"parent":0,"template":"","resource-topic":[58],"resource-type":[43],"class_list":["post-6832","resources","type-resources","status-publish","has-post-thumbnail","hentry","resource-topic-product-market-fit","resource-type-articles"],"_links":{"self":[{"href":"https:\/\/slash.co\/wp-json\/wp\/v2\/resources\/6832","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/slash.co\/wp-json\/wp\/v2\/resources"}],"about":[{"href":"https:\/\/slash.co\/wp-json\/wp\/v2\/types\/resources"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/slash.co\/wp-json\/wp\/v2\/media\/12245"}],"wp:attachment":[{"href":"https:\/\/slash.co\/wp-json\/wp\/v2\/media?parent=6832"}],"wp:term":[{"taxonomy":"resource-topic","embeddable":true,"href":"https:\/\/slash.co\/wp-json\/wp\/v2\/resource-topic?post=6832"},{"taxonomy":"resource-type","embeddable":true,"href":"https:\/\/slash.co\/wp-json\/wp\/v2\/resource-type?post=6832"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}