How can you divide something that doesn’t exist?

Founders’ equity isn’t about rewarding the past

Credit: M.H. Jeeves

Waverly Deutsch

Waverly Deutsch | Aug 16, 2017

Sections Entrepreneurship

One of the most common questions I hear from entrepreneurs is, how should we allocate equity across our founding team? This question is difficult to answer—so much so that entrepreneurship scholars and practitioners debate it continually in books, blog posts, and articles. A Google search on the term “allocating founder equity” offers 400 results. Questions include: Is splitting equity equally across team members fair, or just a shortcut to avoid important but uncomfortable decision making? Can you allocate equity dynamically? When in the start-up process should entrepreneurs tackle this question? 

One solution to this problem was featured in the most-recent issue of Chicago Booth Review, in an excerpt from The Slicing Pie Handbook: Perfectly Fair Equity Splits for Bootstrapped Startups, by Chicago Booth’s Mike Moyer. The idea, as I see it, is that all equity is earned dynamically by creating value for the company through cash, sweat, connections, and resources. Each of these is translated into a dollar value and tracked over time. At any given moment, the equity owned by a team member is proportional to the fair-market value of that person’s contributions. Sounds fair, right? 

Yes, if everyone can agree on a fair-market dollar value for ideas, introductions, resources, and each person’s time and risk level—and, and this is the biggest problem with the model, if you only need a capitalization table to allocate profit sharing or the proceeds of an exit. A capitalization table, or cap table, details who owns a company, how many shares each entity owns, whether those shares are common stock or a preferred class that has specific privileges and rights, and how many shares are outstanding in the company at a specific moment in time.

I disagree with Mike on a basic premise of his methodology: founders are not slicing pie. Slicing pie implies that something exists to slice up, but early in a start-up’s existence, when founders have to wrestle with the emotional and critical question of equity allocation, often a business doesn’t really exist. Without a fully developed product, enough revenue to cover expenses, and someone willing to buy the business, the economic value of the company in question is zero, or even negative. And mathematics tells us that you can divide zero into as many slices as you want, but you will still have zero.

Mike acknowledges that his model is for companies that are bootstrapping or self-funding growth and, for this scenario, Slicing Pie provides an innovative and creative way for small companies to think about equity. But, for companies that need to raise outside capital: at the point when investors require you to submit a current cap table, they don’t want an equity allocation that is about rewarding the past—they are looking for one that will motivate the best people to build value moving forward. Mike says that at this stage, the current cap table is produced and the Slicing Pie allocation technique should be discontinued. However, inevitably for an early-stage start-up with a first-generation product and a handful of customers, a Slicing Pie cap table will overcompensate those involved in product development—which constitutes the majority of what’s required at the beginning of starting a company—but undervalue the very necessary skills, connections, and experience of the people responsible for generating revenue or the human resource, organizational, and management expertise needed for the company to scale.

What about other methodologies for founders’-equity allocation specifically aimed at start-ups seeking venture-capital financing? Various academics, experts, and venture capitalists have created online calculators or offered formulas to guide founders through this process with an eye to creating an initial cap table that is forward looking— designed to use equity as a tool to build future value rather than to reward sunk costs and past contributions. The online calculators that have appeared from foundrs.com, Gust, Founder Solutions, and other websites are designed for starting the equity discussion in the context of building future value, but, caveat emptor, they aren’t perfect. In the tech-biased world of Silicon Valley, the technical talent and development work needed to create a product, or enable a service, or underpin the dual-sided network are also weighted more heavily than the business-building skills and activities required later in the process. (Dual-sided networks, a common business model these days, require a tech platform to do matchmaking and enable transactions.)

To test these calculators, I modeled a three-person founding team based on a common profile of my Booth students: first-time entrepreneurs with some start-up experience as employees at early-stage companies. The CEO is responsible for originating the idea, bringing the founding team together, and leading the charge to raise funds. The CTO builds the product and manages the development team, and the CMO/sales lead has the market expertise, user insight, connections with influencers and journalists, and primary responsibility for bringing on early customers. In my model, all three founders forgo good-paying jobs to work full time for the start-up, and all contribute equally to the initial capital. 

All these prescriptive methodologies are fundamentally flawed—because business is not one size fits all.

I plugged these assumptions into three calculators designed to allocate equity. The most-extreme case of tech bias, overrewarding the person with technical expertise, came from Gust, which awarded the CTO 47 percent, the CEO 29 percent, and the go-to-market leader 24 percent of equity. Foundrs.com and Founder Solutions offered a more balanced split, giving the CEO some bump for coming up with the idea. Foundrs.com suggested 43 percent to the CEO, 35 percent to the CTO, and 21 percent to the CMO/sales lead. Founder Solutions’ mix was 40 percent/31 percent/29 percent for the CEO, CTO, and CMO. 

But these tools had some quirks. Founder Solutions’ calculator asks four questions about start-up experience but only one question about experience in the relevant industry. It asks about prior founding experience, the biggest success of that prior start-up, past employment in a start-up, and participation in an accelerator. (Although really, is participation in an accelerator a metric that indicates anything meaningful about creating value in a new venture moving forward?) Meanwhile, foundrs.com doesn’t ask about industry experience at all, and neither site’s calculator factors in previous management experience. Further, since they assume that technology is at the core of your value proposition, the sites are even less useful if you are starting a retail, product, or service-based company.

So all these prescriptive methodologies are fundamentally flawed—because business is not one size fits all. A better framework might start with what market data tell us in retrospect about the allocation of founders’ equity. But here entrepreneurs will find a dearth of good data. The one data set specific to this subject I’ve found is from 2007, was collected by Brad Feld and Jason Mendelson of the Foundry Group, and is published on their blog, Ask the VC. Feld and Mendelson say the data come from their experience as well as from industry metrics they track, and represent companies from early stage to more mature; however, they do not specify the number of companies their data points represent. Nevertheless, the data paint an interesting picture of the compensation, in both cash and equity, of founding teams. The data are clearly from well-funded companies that moved management team salaries into market-competitive ranges, well beyond what’s paid in the take-no-salary, sweat-equity days. 

For our prototypical team of CEO, CTO, and CMO, the data reveal results that are a little different from the percentages spit out by the online calculators. The CEO had more than twice the CTO’s equity and three times the CMO’s. The market values leadership and management over technology, but technology over marketing and sales.

Feld and Mendelson also share data for people who didn’t found the company. We see that when an executive joined the team at a later stage, cash compensation for some roles increased slightly, but equity plummeted. 

A prototypical executive team’s stakes

A prototypical executive team’s stakes

These numbers represent ownership percentages after some rounds of investment that, over time, dilute both founders’ and management equity. When working backward from a successful exit, what percent of a company should founders expect to own when all is said and done? Sammy Abdullah of Blossom Street Ventures collected the S-1 filings for 79 tech companies that had an initial public offering, and looked at how much equity the founders had been able to retain. He published his findings on the Blossom Street Ventures blog. While some notable outliers such as Facebook’s Mark Zuckerberg and Workday’s David Duffield owned more than 50 percent of their companies at the time of their IPOs, Abdullah finds that the average total ownership stake of founders was 17 percent, with venture investors owning an average of 56 percent of the company, and smaller investors and employees holding 27 percent. In such a scenario, 17 percent founders’ equity split across our three-person founding team might mean something like 8 percent for our CEO, 5 percent for our CTO, and 4 percent for our CMO/sales leader—more or less in line with the relative shares shown by Feld and Mendelson.

What about the future employees of our start-up team? If the team goes down the typical venture-capital path, the founders will be required to dilute their own stakes to create an options pool to help them acquire top talent. How will this pool be spent? AngelList, a website for start-ups, has an enormous data set of jobs offered by growth companies, and the site allows users to evaluate open positions by the cash compensation and salary being offered. Looking at critical skill sets such as technology development, sales, marketing, and business development, founders can acquire clues for how they will end up allocating the options pool as the company grows—and how much they will pay employees. I compared job opportunities across three cities—San Francisco, Chicago, and New York—to look at the implications of geography on both cash compensation and equity participation. Early-stage employees seemed to command between half a percent and 1 percent of a company, with the notable exception of developers in Chicago, who secured on average nearly 2 percent equity, much more than their peers elsewhere. In fact, early-stage employees seemed to trade off cash compensation for equity in Chicago across the board, while, unsurprisingly, salaries are highest in San Francisco.

What does this have to do with allocating founders’ equity? These employment data again validate the trend that as companies mature, they’ll have to use equity to compensate talent—and in particular, technical talent, as opposed to business talent.

Hash out allocations together, over drinks

So, what is the best way to allocate founders’ equity? All of the data point to a framework that, first, rewards the creator of the idea and the CEO more than the other founders. Beyond that, it values technology talent over other contributions, and it awards meaningful stakes to all full-time members of the team. Divisions such as 65 percent for the CEO/idea guy, 30 percent for the CTO, and 5 percent for the finance, business development, sales, or marketing expert (and I see proposals that reflect initial founder greed all too often) are recipes for misaligned incentives and resentment across the board—but so are equal splits that do not reflect market realities. I recommend that founding team members sit down over a round of their favorite adult beverages and hash out allocations together. (Alcohol can help lubricate this conversation, but a good conversation can certainly be had without it.) I tell entrepreneurs four things about this conversation:

  1. You will overvalue your contribution and undervalue the contribution of others. So will your fellow team members.
  2. You need to have this discussion early in your founding process. If you cannot wrestle with this really hard and important decision while your company is basically worthless, it will only get more difficult when there is meaningful value at stake.
  3. You have reached success when everyone is equally unhappy but feels that the process and outcome is “fair” to all.
  4. If you cannot get to agreement, that is a strong red flag that these team members will have problems working together on this company in the future.

Future-proofing your equity split

In Slicing Pie, Mike correctly points out that it is impossible to predict the value someone will add. How can founders make sure that their equity allocations don’t reward someone who doesn’t pull her weight, or undercompensate a superstar? When you come up with your “fair” allocation, it will work only if the team stays together and builds a great company. What happens if one of you gets a job offer that is too good to pass up? Or if your CTO founder turns out to be a great coder but not much of an architect or isn’t capable of managing a team of developers? You need a mechanism to recapture some of his equity to award it to an incoming team member who will fill the hole created. 

Venture capitalists have two great tools that entrepreneurs can adopt to future-proof their equity split. The first is vesting. All founders should immediately agree to a four-year vesting schedule, and there should be a cliff, which means that no one who walks away in the near future gets to take equity with them. A cliff isn’t necessary if you have been working together for a few years; but if the venture is less than 18 months old, you need to require a one-year commitment from anyone who will own founders’ equity. At the end of one year, everyone owns one-quarter of their founders’ shares. Thereafter you earn one thirty-sixth per month. Entrepreneurs who hope to raise capital from professional investors should get used to this, since those investors will institute a vesting schedule. Having one in advance of raising funds makes for a clear conversation with an exiting team member about how much founders’ equity he has earned and how much remains with the company. 

The second tool is the options pool, shares that are set aside by the company to be awarded to employees as part of their compensation packages. Your founders’ shares are not necessarily the only equity you will have in your company. Four or five years into a venture, as founders vest their initial equity, investors often want to increase incentives for key members to stay committed to and engaged with a company. To motivate founders, the board of directors can decide to grant new shares from the options pool to rebalance allocations. This is an effective way to make sure that as people add more value, they are appropriately compensated. Options are not the same as founders’ shares. They come with a price tag—the strike price—so are only meaningful if the team is increasing the value of the company and thereby the per-share price of the stock. But for high-growth companies that raise a lot of outside capital, substantially diluting initial founders’ stakes in the process, options pools are a good way to allow founders to keep earning equity.

I am convinced there is no one right way to award founders’ equity. You cannot use a calculator or a formula—committing to a start-up is more art, passion, and vision than science, ratios, and rationality. You and your team members will make mistakes, so be open to adjustments. But ultimately, you must choose other founders whom you trust, respect, and admire. With a team like this—one that puts the needs of the company above the needs of each individual—allocating equity becomes a process that can help establish the ground rules for how you want to work together and the values you want your company to reflect.