Using Nursery School Lessons in Founder Equity Splits
Equity is the treasure of every startup. Giving away equity requires an understanding of the company’s value and future growth prospects. These valuation-based equity transactions and funding rounds take place after an even more important point on the startup timeline: the founder equity split.
You may be at the stage in your startup where you discuss splitting the company’s equity between the co-founders. This is often a touchy subject for entrepreneurs, especially when the co-founders are good friends or family. My advice for those undertaking equity splits stems from my 2 years spent in nursery school. If I learned anything, it’s that fairness prevails above all. If you find yourself calculating equity split percentages to the hundredth place, take a step back and contemplate whether a precise number is a fair number. Further, it may be fair for you but unfair to your co-founders. Grievances now will certainly resurface in the future, especially through hardship, like the trough of sorrow.
When negotiating equity splits in the first couple years of a startup, co-founders often argue they deserve a greater proportion of the split for a variety of reasons. The most cited argument is “I came up with the idea for the company, so I deserve more equity.” For those that support this idea, I will remind you that startups are all about execution, not ideas. Another co-founder can just as easily argue that the idea would not have come to fruition without their execution. This circular argument only ends poorly, with both parties frustrated with the other for “not understanding” their contribution to the team.
Important to remember is the correlation that motivation has to greater equity. If a founder allocates a disproportionate amount of equity to themselves for having the original business idea, their co-founders will be less motivated to execute. The founder with the idea may have gotten more equity, but that equity is worth nothing without a team that cares enough to appropriately implement.
According to Y Combinator, the average company takes 7 to 10 years to build significant value. Equity splits are often negotiated within the first 2 to 3 years of a company’s existence. A founders’ work in the first year should not justify disproportionate equity ownership because this is only the start of a long and strenuous road ahead. Equity considerations should place a higher weight on expected future efforts rather than past.
The points made above aren’t saying you should always split equity 50/50. Rather, equity should be split as equally and as fairly as possible, using relevant and significant variables to move the needle. Below are a few important considerations for making this decision:
Future Contributions: What are the expected roles and contributions of each of the co-founders in the business? How will their efforts impact the growth and success of the company? This question requires founders to identify which of their co-founders will be full-time or part-time. If they are part-time – working a full-time job concurrently – it is reasonable to allocate less equity to them.
Compensation: Which co-founders will be foregoing a salary, and which will receive one alongside equity? Those working without salary carry greater risk working with the company and, therefore, may be reasonably compensated with greater equity.
Control: Who will be the alpha of the co-founders? Especially when starting a business with a friend, it is beneficial to have one person with veto power. This may sound unfair, but it has proven to prevent some of the most successful companies from failing due to fallout. Most notably, Apple’s Steve Jobs allocated a controlling equity stake to himself over Steve Wozniak. Netflix’s Reed Hastings did the same with his co-founder, Marc Randolph. Control can be accurately assessed by considering all other variables first.
Regardless of how you split your founder equity, be sure that everyone vests. Picture this: you and your best friend start a company and split the equity 50/50. Two years into the startup, your friend decides he wants to work a blue-collar job and leaves, taking his 50% equity stake with him. Problems like these arise all the time and often lead to ruined friendships and company failures. The most common vesting schedule in the startup world is 4 years with a 1-year cliff. This means that every co-founder must wait 1 year to start receiving their ownership stake in the company, which will be vested to them over the next four years. With this protection, if a co-founder quits within the first year, no equity is lost in the company. Some startups go as far as replacing time-based vesting with milestones, rewarding co-founders with equity based on company success.
If you find yourself Googling every method in existence to best split equity between your co-founders, take a step back and remember what you learned in Nursery school: fairness above all.
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