You have come up with a great startup idea. You have spent months vetting the idea with dozens of customer interviews. You have even written some code to build a quick and dirty prototype.
However, when you met with some angel investors to getting funding for your company, they told you that you need to have a business co-founder. Luckily, it turns out that your college classmate who has an MBA really likes the idea and wants to join the effort.
He wants to join as a founder and get founder equity. But it doesn’t seem fair to split the equity 50/50. After all, you came up with the idea and did a lot of work to get the idea off the ground.
So, how much equity should you give your co-founder so that he feels motivated to join and work long hours to make the company successful?
This is a question that I commonly get asked by founders as they build out their management team. There is no magic formula that you can plug numbers into that will spit out an equitable founder equity split.
However, in this article, I can share the general principles that you can apply to come up with a reasonable equity split that you can use for the basis of negotiation with your co-founder.
Employee option pool
Before you split up equity with your co-founder(s), you need to first set aside an Employee Option Pool to grant options to employees that you hire. Most VCs will require you to set aside between 15 to 20 per cent of the company’s equity for an option pool.
The best way to determine this percentage is to develop a budget outlining how many employees you plan to hire in the next two years and assigning how much equity you would give to each position.
For example, members of your management team might get between two to three per cent of equity whereas entry-level employees would get between 0.1 to 0.2 per cent equity.
Also Read: SEA tech founders playbook: A to Z of becoming a fundraising legend (Part 2)
Cash investment
If you and/or your co-founder(s) are planning on investing actual cash into the company, it should be treated like any other outside investment. You can then select an appropriate valuation for the company and then calculate the equity that each of you would get as a result.
To determine an appropriate valuation for the company, you can consult with local angel investors to get their feedback on the company’s valuation based on the team and the progress you have made.
Let’s say that you invested S$50,000 into the company and your co-founder invested nothing and you valued the company at a S$1 million valuation. You should get $50,000/$1,050,000 or around five per cent of the company. The remaining equity can then be divided based on the rules outlined below.
Idea development
Ideas can be a dime a dozen as a startup’s success will depend largely on execution. However, if you have spent a few months seriously validating the idea before recruiting a co-founder, then you should get some credit for developing the idea.
Or perhaps, you are a technical founder and you have already developed a prototype for your idea. Idea validation should get you a five to 10 per cent premium whereas IP development should get you a 20-25 per cent premium depending on how much time you have invested in developing the IP.
CEO’s role
If there are two co-founders, you can’t split the equity 50/50 as you could end up in a tie in deciding contentious issues. Since the CEO is the final arbiter of decisions, he or she should receive more equity.
Investors also value the CEO role compared to other roles in the company and will grant more equity to a CEO if they are hiring an external CEO. The CEO should get a five per cent premium for taking on that role.
Doing the math
Let’s take the example so far to see how the equity should be split up. The two founders both start off with a 50/50 split in terms of shares or 50 shares each out of 100 shares. Since you are the CEO, you get an additional five shares.
You have also done the idea validation and built out a prototype – as a result, you should get an additional 25 shares. So, you end up with 50+5+25 = 80 shares and your co-founder ends up with 50 shares. This means that you get 80/130 = 62 per cent and your co-founder gets 38 per cent of the founder’s equity.
However, you still need to account for the employee option pool and the equity you should get for investing S$50,000 in the company. This means that you allocate 20 per cent to the option pool, another five per cent for your investment leaving 75 per cent of founder equity to split up.
You will get 62 per cent* 75 per cent or 47 per cent and your co-founder will get 28 per cent. Your total equity stake will now be 47 + 5 = 52 per cent and your co-founder will get 28 per cent. This means that you get twice the equity as your co-founder which seems fair.
Utilising a neutral arbiter
You can do all the math in the world to come up with an equitable equity split. However, you could still end up in a difficult negotiation with your co-founder(s). I, therefore, recommend that you find an experienced and well-respected founder or investor to come up with the equity split recommendation that all of you have to abide by.
That person can interview each of the co-founders to understand their contributions and then recommend the equity split that you should follow. This will result in significantly less contention and bad feelings among the founders.
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