The Ownership Structure of New Ventures – How to distribute equity between the members of a founding team

Ownership structure of new ventures can be tricky.

Large, established corporations can attract the best talent with generous and lucrative incentives and cushy perks.

Startups don’t have that luxury.

Instead, they rely primarily on sharing equity in the venture.

Equity is non-cash compensation that represents an ownership share of a company.

Because few ventures are solo operations, this decision can get complicated fast.

At face value, it may seem as though an equal split across the board is the fairest distribution of equity—indeed, it works well for some ventures—but it is rarely the most equitable in the eyes of team members.

Often the contributions made by members of the team are not equivalent, or due to their nature may be difficult to compare directly.

  • How do you compare the value of a founding member who has contributed more money than other members to the value of a founding member who has contributed very little money but worked very hard?
  • And should the founding member who originated the concept receive a significantly higher share of equity?

There is no single answer that satisfies all of those questions, and ultimately the answer comes down to the outcome of the conversations that you and your founding team conduct.

For many ventures, the “who owns what” conversation is something that no one looks forward to.

As conversations go, it requires healthy doses of candor and transparency, is often carried out in several rounds and requires that emotions be left at the door.

Equity Distribution

Ownership Structure equity distribution

The easiest way to distribute equity between the members of a founding team is to simply give each member of the team the same amount of equity, but that rarely occurs.

To be honest, an even split is rarely seen by members of the team as the most equitable way to distribute equity in a startup, and they will waste no time pleading their case.

  • “This company was my idea!”
  • “Cofounder X has been working for two months. I have been working for six months!”
  • “I didn’t take a salary for three months, but during that time cofounder N did!”
  • “Cofounder Y’s experience doesn’t come close to mine!”
  • “I have raised thousands of dollars, plus I brought on cofounder Z!”

As you can see, equity distribution is more of an art than a science.

The sheer range of unique circumstances that can and will arise means that no one method of uneven equity distribution is a one-size-fits-all solution.

But consider these common methods of determining who gets what:

Ideation

Especially popular for technology-based startups, the person or people who contributed most to the venture’s value proposition claim a larger portion of its equity.

This makes perfect sense in situations where it is reasonable to say that the venture wouldn’t exist at all if it weren’t for the efforts of some cofounders over others.

On the other hand, the value of ideas lies in their execution.

Simply having had the idea for the business may not be enough to warrant a higher equity share.

Salary Replacement

In some cases, members of the founding team will agree to take a higher share of the startup’s equity in lieu of drawing a higher (or any) salary.

The motivation to do so is the belief that as the company grows and increases in value, the higher equity share will make up for the lost direct compensation.

Equity sharing based on salary replacement is great for the health of a young startup—less money paid in salaries and wages means more to reinvest in the company—and it incentivizes those founding team members who elect to take salary replacement to continue to work hard.

The bigger and stronger they build the company, the bigger their payoff.

Additionally, salary replacement agreements between founding members send a positive message to investors.

If there are members of the team who believe so strongly in this opportunity that they are willing to accept a slashed salary, that is a great sign.

Other Contribution Considerations

Equity Distribution in a startup

Uneven distribution can be based on any number of other considerations related to a team member’s contribution to the effort.

It is ultimately up to the team as a whole to come to an agreement.

Other contribution considerations could include:

  • The true market value of each founder’s true contribution to the venture
  • The opportunity cost that a cofounder has faced
  • The active role of each cofounder in attracting and presenting to potential investors
  • The amount of seed capital contributed by each cofounder
  • Future contributions that will be made by cofounders

“Should our team use an equity split calculator?”

equity split calculator

An equity calculator is a software program that calculates an equity split based on a number of factors.

The makeup of the founding team complete with contributions is plugged into the program and it produces a recommended equity split.

While this may seem like a fair and impartial process, it is really only acceptable if everyone on the founding team is behind the results one hundred percent.

Additionally, everyone on the founding team will have to

  • work closely together,
  • trust one another,
  • and rely on one another with complete confidence.

Is it better to trust solidifying that relationship with a software program or through discussion?

Key Questions Regarding Owner Equity

Ownership Structure owner equity in startups

A full, comprehensive look at the best way to divvy up owner equity is well beyond the scope of this article.

As I said at the top of this section, it is an art more than a science, and it depends almost entirely on the conversations your team members have and the conclusions that are reached through the discussion process.

That being said, here are a few final questions you may have regarding the equity split process.

When is the best time to discuss ownership structures?

There’s no time like the present.

Of course, it has been said that when equity split decisions are rushed into that cofounders can be considered equal in the sense that they are equally unhappy.

Discussions relating to equity splits should certainly occur before things are too far underway with the venture, but they also should not be rushed.

Taking your time and understanding the…

  • commitment level,
  • goals,
  • and aspirations

…of various founding team members will help everyone craft a more equitable agreement.

On the other hand, waiting until it is too late can cause strife that destabilizes and sends a young venture off track.

The bottom line?

Take your time and do it right, but start thinking about it now.

What happens if more members are added to the founding team?

If more members are added to the founding team after equity ownership has been decided and it is agreed that this new member should receive equity, then the overall equity percentage that each existing member owns will decreasea venture cannot be owned more than one hundred percent.

This is known as dilution.

Because startups don’t have the resources to attract the best talent with high salaries or other direct perks, equity in the venture is often used as an enticement.

To avoid issues down the road, a common practice is to reserve a portion of the venture’s equity for this purpose.

What happens if a founding member wants to leave the team?

There are a number of reasons why a founding team member may ultimately want to leave the founding team.

Exactly what happens next depends on the nature of your agreement.

An approach that puts the needs of the venture firstand protects every member of the founding team—is the creation of a vesting schedule.

A vesting schedule dictates a time period over which equity shares are distributed.

This is important for ventures no matter how equity is split.

A standard vesting schedule will release equity options over a period of five or so years, and this prevents a founder from dumping their shares of the company and leaving the team within the first year.

Do We Need a Lawyer?

During the discussion process where founding team members figure out an equitable split, an experienced startup lawyer can provide helpful counsel, although this is often not strictly necessary.

When it comes time to finalize the consensus decision, however, it is a good idea to bring a lawyer with startup experience on board.

An experienced startup lawyer can not only help finalize equity split decisions, but can help

  • navigate foundational HR aspects,
  • help ensure regulatory compliance if applicable,
  • help finalize your legal entity classification,
  • and in some cases can even be a helpful ally in the hunt for funding.

Summary

Many investors consider the founding team to be more important than the opportunity itself.

They often consider their investment a “bet on the jockey, not the horse.”

Starting your business with a team is far superior to starting it alone.

Teams …

  • can share in the burden of running a startup,
  • contribute to a more robust decision-making process,
  • bring complementary skills to the table,
  • carry more credibility with investors,
  • and have access to a larger professional network than an entrepreneur who is working alone.

When working out the details of your founding team, ensure that some key aspects are formalized early in the foundation process.

It is important to nail down

  • what each member of the founding team will do to contribute to the success of the business;
  • what sets of activities, processes, and other functions each member of the founding team will be responsible for;
  • and the extent to which each founding member is accountable for accomplishing their assignments.

It is also important to determine the ways in which key decision-making procedures will be carried out by the team, such as

  • establishing which decisions should be put to a vote and which can be handled by individual team members,
  • the procedure for removing a team member should the need arise,
  • and which members should be involved in which business processes as the venture moves forward.

There is not a specific numerical answer to the question “How big should my founding team be?”

The answer should instead reflect the skills you and your team already bring to the table, as well as any gaps that may still exist.

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