Four Things to Consider When Splitting Equity

Splitting equity in an early stage startup lends itself to strange conversations. Hopefully this post will make those conversations less strange.

After providing valuation services to 2,000+ venture-backed startups, we’ve seen a lot of cap tables and talked to a lot of executive teams. We also conduct an ongoing survey from our executives and we’ve seen the following trends:

There’s always drama in figuring out how to distribute equity in a startup, and we’ve often been asked: “how much equity should I give out?” That’s why we wanted to put the following analysis together, using our Equity Advisor tool built on our survey data.

Before we get into it, I want to recognize that splitting equity is difficult because, at its core, it involves two very difficult things:

  • Arguing your self worth against others.
  • Predicting the future.

Some people are good at the first one, almost no one can do the second one. In a sense, splitting equity is about as hard as it gets.

With that caveat, there are two main schools of thought on this:

The YC Way: About Equal

Michael Seibel (of Y Combinator) has a great post about this and, in short, his point is that you should split startup equity equally because:

  • It takes 7 to 10 years to build a company of great value.
  • The more motivated the founders, the higher the chance of success.
  • If you don’t value your co-founders, neither will anyone else.
  • Startups are about execution, not about ideas.
  • Equity should be split equally because all the work is ahead of you.

Michael was the co-founder of multiple very successful startups, and he’s a full-time partner at YC and the CEO of the YC accelerator program. He knows what he’s talking about.

The Slicing Pie Way: Count and estimate everything!

There’s a book and a school of thought that has been going around called “Slicing Pie.” It suggests “a simple formula based on the principle that a person's % share of the equity should always be equal to that person's share of the at-risk contributions.” That may sound like a good method for splitting equity, but the formula is anything but “simple” when you are trying to value intangible contributions. If you go down the rabbit hole of Slicing Pie, you get to a place where you’re calculating hours of contribution, projected hours, value of IP, value of a referral, discounting for risk, etc., etc., etc. This is effectively an accounting and valuation exercise.

As a CPA and a CFA who has done accounting and valuation for a decade, and has spent the better part of that decade with private companies, I can guarantee you that assessing the value of intangibles is far from easy. It’s a house-of-cards of assumptions, based on limited data and, at best, biased inputs.

More importantly, if you “grant” shares as folks “create value” there are tax consequences for the recipient at the time of grant. If you “vest” as folks “create value” you’ll have to deal with insane vesting schedules. You have to be super nimble when starting a company, and you don’t know everything that needs to be “done” (a lot of it is about exploration and course correction). You can’t tell your CTO that “5% of their position vests when the first product is shipped”. What is a “product”? What is”shipped”? What if you ship an MVP, and learn everyone hates it. Do you continue to build “the real thing”? Did the initial shares actually vest? What if the MVP ships, people love some features, and hate most others. What if the build is great, but the designs are shit? Is that the true work of a CTO? Was that worth 5% of your company? I can go on.

Marriage

When it comes to creating a company and co-founder and executive relationships, references to marriage and family are probably the best analogies. When thinking about having a family, you and your partner don’t think about the value of a dollar earned vs. the value of joy and group growth. In a functioning, happy family, it’s understood that you are all on the same team. The definition of a “win” is clear, and everyone knows what they should be doing to achieve those wins.

A new company is the same way. You can spend your time focusing on how to allocate shares in a startup, or you can spend your time finding the right people who agree with how to win and can contribute to winning. I’d recommend the latter.

Data

It’s helpful to look back at the results of the survey:

Based on actual data from the market, what we’ve learned is that the most telling differentiator of how much to grant is less about the actual grant, but to first figure out who you’re dealing with and at what stage. This at least helps you to place folks in the right bucket.

The stage is obvious, so the only question becomes, are you hiring a C-Suite, a VP, or a Staff?

The VP bucket is anyone that take 6 - 9+ months to find and/or replace. Use that as a barometer. The Staff is anyone below that. The “C-suite” is interesting: You can think of it quantitatively and qualitatively.

In a quantitative way, you can think about someone who spends way too much time, doesn’t expect much in terms of salary (is long-equity) and is willing to spend a large chunk of their life on the problem.

In a qualitative way, you can run the Chicken or Pig framework. Think like you’re about to make a bacon-and-egg breakfast. The chickens are involved, but the pig is committed. You want a bunch of pigs.

Like other decisions involving multiple parties, when figuring out how to allocate shares in a startup, you want to use a combination of rule of thumb (i.e. typical startup equity distribution as people have done it in the past), market data (e.g. equity range for startup employees, which we’re happy to share with you via our Equity Advisor tool), and negotiations/analytics.

Hopefully, you’ll find the right team to build your venture with.

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Four Things to Consider When Splitting Equity