Splitting equity is typically the first business challenge that founders face. The first hours, days or months of a start-up are exhilarating – intense brainstorming sessions shape the product and market research reveals the size of the nut you’re cracking. You and your partner(s) are excited and decide to take the leap and start a company. How will the equity (or ownership) of the company be divided? Most founding partners simply split the pie evenly, so two partners own 50% each, three own 33.3% each, etc.
Recently, a friend came to me with this problem. He was working on a mobile application with two people and they had not yet decided how to split the equity. He also needed to attract talent, so keeping equity on the side was necessary. For the first hour, we just threw numbers out there and framed everything from the vantage point of “what would my friend be left with.” We eventually drafted a structure but it just did not feel right. It was formed from a hunch and WITHOUT any analysis. It could not be defended.
I thought about the meeting for a day or two. There just had to be a better way to split the pie. So, here is what I came up with. It is a two step approach that, first, weights the functions of the company and, second, applies a percent score that each founder brings regarding that specific function. I have shared the template on Google Docs, so feel free to use. (If you have trouble finding it, the title is: Framework for Calculating Equity in a Start-up.) Here are additional thoughts on this approach.
In terms of my friend’s start-up, I defined the functions/components as the initial idea, technology, business development and business operations. I applied a weight to each component. Since ideas are, well, just ideas, I gave that a 10% weighting. Technology got a 50% weighting due to the fact this was a mobile application that would live or die by the design of the product. Business operations and business development were equally weighted at 20%. It was then up to my friend to figure out what percent of each function the founders brought to the table. Using my friend as an example, he had the initial idea and was going to be responsible for for all business development and half of business operations. Thus, his stake should be worth 40% (100% of idea @ 10% + 100% of biz dev @ 20% + 50% of biz ops @ 20%).
This approach creates a defensible split based on analysis of the company and the strength of the partners. It is important, however, to not simply accept the end number as gospel. After all, we cannot forget the last time analysts put full-faith into models (see Rating Agencies 2008). So before you go use this model, here are a few key notes:
First, the founders should decide together what each function of the company is worth. Doing so, increases buy-in to the process.
Second, remember that there are subsets for each function. Take technology, for example. There is a need for user interface talent, database talent, Android/iOS talent, etc. If need be, use the template to calculate the value for specific subsets and then use a second template for the full company view.
Third, use the modeled number as a starting point. I suggest being creative and using milestone approach to divvying out equity. Take for example a company that needs to fulfill 30% of technology talent. It would be crazy to recruit a partner and give that person 30% from the start. Instead, give him 5% and a plan to obtain the additional 25% by hitting two or three milestones. This way you are protected from an under-performing partner controlling a disproportionate amount of the company. Here is a great article about this very topic.