Equity allocation in a startup

Since you have your startup idea and the team of cofounders in place, it’s important to discuss the equity ownership for the founders.  Often, company founders delay having this discussions in the mistaken assumption that this will simply go away and that they won’t have to bite the bullet.  Unfortunately, this makes it fester and get worse, since by not talking about it, it remains in everyone’s mind and their ideas of how much they should get crystallises.  The uncertainly of how much equity the founders will ultimately get also distracts from the real business of going ahead and making the startup come alive and move from idea to reality.  The right time to have the conversation and ultimately crystallise the equity proportion of cofounders is as soon as the team decides to move forward with the startup.

Distribution of equity is tricky in the best of circumstances.  Tech teams often completely underestimate the value of go-to-market and manufacture (particularly if manufacture is a core element of the startup).  Due to this, the equity allocation from the tech founders’ perspective to the other team-members (business and manufacture) tends to be far less than proportional, assuming all founders come together at the same time to found the company.  However, it needs to be kept in mind that equity allocation also a reflection of the relevance of the three tenets of what ultimately can make the startup a success.

But equity allocation is tricky business, since you don’t always know at the time of founding how much effort the various team members will actually put in over a period of time in the foreseeable future, specially when the going gets tough and the team members need to work for free for much longer than they anticipated.

The second component is loyalty to the vision.  Often, tech founders, who are ostensibly the ones who generate the idea behind the startup, tend to be less than loyal to the idea.  This is when conflicts of interests occur.  This is particularly when tech founders continue to stay at their research institutes.  Funding opportunities, which are few and far in between, often come in as either/or, where the tech founders within research and the startup have to decide which one to support.  This is where loyalty to the vision comes back to roost.

To mitigate the risk of giving away too much equity in the beginning, a sound option is to have a multi-year split, where each year, the co-founders ‘earn’ some of the equity from the common pool.  In this way, any founder who is not fully aligned with the vision and walks away does so with a proportionally smaller amount of equity, and the remaining equity can then be used to attract others who join the company in future.

It is important to consider the tax implications of getting equity upfront and having to earn it.  This is because if the perceived value of the company increases when you get entitled to your next round of equity, you don’t really want the next round of equity to be taxed, given that it’s still paper, and not wealth till you can sell the equity.

It’s also important to separate the equity allocation of founders from future investors, since you don’t want the investors to get a larger proportion of the company if any founder loses his allocation.  This can do far more than give the investor more shares; it can tilt the balance of ownership and decision-making, to the detriment of the founders.

In summary, equity is your opportunity to share in the success of your startup, as it achieves your vision.  It is also your opportunity to gain an incredible amount of wealth.  Finalising it crystallises the joint foundation of what the team members are trying to create and focusses their energy on the real challenges that lie ahead.