Laying the Legal Groundwork: How to Split Startup Ownership?

Laying the Legal Groundwork: How to Split Startup Ownership?

If you’ve recently started a new company with a co-founder, or multiple co-founders, splitting your company’s equity is one the first major decisions you’ll make as a founding team. There are many variables to consider when making this decision, and choosing wisely on how to split the equity can have significant positive outcomes later on.

New entrepreneurs have time and again gone through this founder equity split decision process however, it is still common to hear of founding teams that end up with significant inequality between their co-founders.

Sometimes the reasonings for this are understandable, but often the unequal distribution of equity in the business’s early-stages can lead to problems down the line.

Where It Starts Vs. Where It Goes

There are numerous reasons behind a lopsided split of startup equity ownership. These can include a co-founder having the idea for the company, starting at the company before another co-founder, working full-time while the others only work part-time, or even being more experienced than the other founding team members. While all of these points are valid, one large consideration is the worth of a startup.

Most companies will take up to 10 years to be something worth a great deal. An unequal split in co-founder equity in the first year can seem punishing to those with a lesser amount in the later years where the company truly thrives. The more valuable the company becomes, the more pronounced the perceived inequity can seem.

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Motivation Is Key

Unsurprisingly, many startups fail. The ones that don’t fail require an enormous amount of work across multiple years to succeed. If equity is a primary motivator, giving your co-founders and key employees a larger amount of it gives them more to work toward and also means that they have more on the line if the company fails.

Fueling your co-founders motivation to succeed is often worth more than having your startup fail and your equity worth precious little.

Valuing Your Co-Founders

An equity split is not a one-to-one comparison of how much a CEO values their employees, but it certainly can say a lot about how your co-founders are perceived. It can also be an excellent way to show how highly the CEO values relationships and individual contributions to the company.

If the amount of responsibility and equity, or number of shares, that a co-founder receives is minimal, employees and those external to the company who learn of this could potentially view them as less important and less talented than they may be. This can lead to problems with investors worrying about “dead weight” team members. If you do not value your co-founders, others are likely to not value them as well.

Thinking Vs. Doing

Many unequal splits in equity have to do with one individual having had the idea for the company. Startups are notoriously hard work, making them a place where the work done should be valued more than simply an idea. The work done getting your product or service on the market is often more important than the idea that started the process.

Setting a Vesting Schedule

Deciding on the amount of equity each co-founder receives is something you must do. Setting a vesting schedule for your founder shares isn’t; however, it is often highly recommended. Simply put, vesting gives employees the right to benefits provided by their employer over a certain period. Although this definition is specific to employees, vesting also applies to founders.

Setting a vesting schedule means deciding on a specific period that must pass before a founder has the rights to some or all of their shares even after leaving the company. Vesting is an excellent thing to consider because it’s designed to get founders to commit to the business for at least a few years and make the most of the sweat equity the founders put into the startup. In other words, vesting incentivizes co-founders and employees to remain at the company rather than quit quickly and take a portion of it with them.

Setting a vesting schedule involves determining a cliff, which establishes the time that must pass before anyone who owns shares in the company actually has the rights to them. It’s common for startups to establish a four-year or three-year vesting schedule with a one-year cliff.

While this may sound confusing initially, it simply means a co-founder will receive their share of equity over four years and must work for the company for one full year before receiving the first quarter of their equity.

If they leave the company before the year has passed, they won’t receive any of their equity. However, if they go after three years of being at the startup, they will receive three-quarters of their share of the company, which they usually accrue based on a month-by-month basis after the one-year cliff has passed.

So consider setting a vesting schedule! It will likely benefit you greatly in the beginning and in the long run, keeping co-founders dedicated to the growth of the business.

Keeping Track of Equity

After you’ve established how to divide equity among you and your co-founders, any other company owners, and any early employees you’ve brought on, you’ll want to keep track of the equity distribution. Equity is tracked by the number of shares a person has in the company, and you can keep track of this using a capitalization table, also known as a cap table.

A cap table, in short, is a spreadsheet that lists each shareholder’s percentage of ownership in the company. More specifically, it lists all the startup’s securities, such as common and preferred shares, and who owns what.

It’s essential to create a table and keep it updated because it will be a crucial document in several ways. Suppose you ever decide to raise a round of funding with angel investors, individual venture capitalists, venture capital firms, or more traditional institutional investors. In that case, it will be necessary to present the cap table and update it as you bring on investors who now own a certain percentage of equity in the business. The cap table will also track the equity dilution investors/shareholders will experience as more shares are issued.

Make sure you fully understand what a cap table is and how to create and manage one. It will make your startup journey less bumpy and more organized.

The Long Road Ahead

As said before, early-stage startups go through many growing pains, and often take years to become truly valuable. A split that is close to even can make it so that those by your side want to be with you for the long haul without putting the company in a deadlock if disputes eventually occur.

You will likely be spending an enormous amount of time with your fellow startup founders, working to bring your vision to fruition. Make sure to value them accordingly. If you do not believe your partner to be worth an even share, then perhaps it is better to find a different partner that you believe to be worth it.