How cofounders should think about equity splits when launching a new venture?
Cofounder splits can end up being one of the most important factors for startups and entrepreneurs.
There are a variety of common pitfalls, which if overlooked and ruin everything else.
While a smart start can provide excellent advantages and a superior path to growth.
So, what are the mistakes and dangers to avoid? What elements should be at the top of your mind when structuring a new company?
What are the impacts of different splits? Who can help you get this pivotal part of the process right?
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What Are Cofounder Equity Splits?
Cofounder equity splits refer to how business partners divvy up ownership when they form a new company.
Specifically, how many shares each cofounder receives or is entitled to.
If you are a solo entrepreneur, then you may issue yourself 100% of the shares, and own and control the entire company.
With two co-founders, one may take at least a 51% stake, and the other 49%.
It gets more and more complex the more owners you have. Even more so if you end up issuing different classes of shares, with different rights.
Different forms of entities may allow owners to take profits and dividends in direct relation to their shares. Or the amount of capital invested or to establish an alternative arrangement.
For some, this seems like an inconsequential step that they just click through to get going, and assume that they will tweak or fix later.
It isn’t always that easy. Equity structure can be impactful on a startup in many ways that first-time entrepreneurs can’t foresee yet.
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Common Issues With Cofounder Equity Splits
Let’s take a look at some of the most common issues when it comes to cofounder equity splits.
Don’t Let It Bog You Down
While this foundational part of your enterprise should be given adequate thought and attention, you also cannot afford to let it slow you down.
Some repeat entrepreneurs are quite confident, make decisions fast, and can get a new company incorporated and launched in a day.
Other first-time entrepreneurs can languish for months over simple steps like this and compiling business plans.
If you let that happen you will most certainly see your first-move advantage go to your competitors.
Along with much of the venture capital you were hoping to land.
Understand what is important, get help structuring it correctly, and keep making progress. Learn how co-founders should think about equity splits.
No Stock Pools Left For Other Purposes
Once you start hiring, consulting experts, and trying to raise money for your startup you will quickly discover the need and value of giving out more shares to other parties.
That is going to be a roadblock, or slow you down and complicate things if you have already issued all of your shares.
Some or all of the cofounders are going to have to begin giving up their stocks.
You can imagine that not everyone is going to like that, or agree on how it should be done.
It can be much wiser to establish pools of stock and shares to be issued and given out.
Or sold to other parties as you grow through these stages of business.
Voting Rights & Control
Equity splits directly dictate voting rights and control over the business and business decisions.
Giving all cofounders equal shares and voting rights can prove problematic in this respect. Especially, with an even number of cofounders.
For example, four cofounders with 25% of the business each, means none have a majority share or can make a final decision.
Or if you have a 50/50 split, and you and your cofounder are deadlocked, then nothing can be done.
It could be a stalemate that sinks your business.
No matter how well you get along right now, don’t expect everyone to agree on every business or financial decision.
If you have many founders, then this can become a messy and drawn-out, and contentious process.
That is every time you have to make a basic business decision or sign a document.
If no individual founder owns 10% or more of the business, none will have what is recognized as a controlling interest to make decisions on behalf of the company.
If this is your idea and business baby, you may want to control the majority of the equity (at least 51%).
And divvy up the remaining founding shares to your initial partners.
Or after reading this and consulting with a startup advisor and attorney you may find it wisest to simply hire other talent and executives in a traditional way instead of giving them equity.
Sharing ownership of a company presents many liabilities.
Ownership percentages certainly dictate who can make financial decisions for the company.
It determines which individuals can take on debt in the company’s name, and oblige it and its assets to repayments.
Be sure you fully trust anyone with at least a 10% stake in your business to make these decisions.
Even without consulting you or your direct approval.
They can also have control over company bank accounts.
They will have the power to spend company money or even empty out and close business bank accounts. Or remove you from access to your banking accounts.
They may also hold the power to approve other investors coming in later, or to block them and starve your startup of funding.
Especially if it means giving up more of their shares.
Without the proper clauses and wording in your articles of incorporation and organization and bylaws, they may sell their equity in your company to anyone they like. Like your ex-spouse or leading competitor.
Some individuals can turn out to be bad actors as well.
A rogue cofounder can damage the corporate reputation by their actions or comments in the media.
If they get in personal financial trouble through a divorce, car accident, or lawsuit, that can impact the company and finances.
Or what happens if one cofounder gets addicted to drugs and completely goes off the rails?
Eliminate these situations by understanding how co-founders should think about equity splits.
Value Throughout Their Ownership
One of the most common problems with splitting equity with cofounders is how much value each goes on to deliver over the lifetime of their ownership.
For example; you start out with four co-founders with equal splits, yet you are the only one who is working full time without a paycheck for two years.
Then you may get a little bitter about giving up three-quarters of your profit every month.
Or some cofounders may decide they no longer want to work on this anymore after two months.
However, they want to go get a full-time job with benefits, and still keep 30% of the shares and profits, forever.
As your company evolves and grows your needs will change too.
Bringing on a cofounder who knows how to build a website, so you can get up and running fast, without having to pay a web designer may sound smart at first.
Though that website could end up costing you over $1B over time.
That is, if they offer little ongoing value and you end up hiring a whole design and engineering team anyway.
What measures are you going to have in place to account for not everyone pulling their weight?
Or leaving early and being a drain on profits, equity, and the future plans and potential of your startup?
How Many Cofounders Should You Have?
Founding teams of all sizes have proven they can be highly successful.
Many solo entrepreneurs have built great and hugely valuable companies. So have groups of five or more cofounders.
These of course may be the exceptions. There are advantages and disadvantages to varying numbers of cofounders in a startup.
Understanding them will give you a fair overview of how cofounders should think about equity splits.
The Pros & Cons Of Different Sizes Of Founding Teams
Being the only founder gives you all the control to design and build what you want, how you want.
Of course, eventually, you will probably end up giving up a sizable amount of equity to others, including investors to keep on growing and competing.
Solo entrepreneurs can present more of a risk to investors as well.
If everything is riding on one individual, and something happens to them, the entire investment can be wasted.
This structure can also make starting out more expensive, as you’ll have to hire all the talent you need.
This can often be the sweet spot. It provides enough coverage to handle all the startup skills you need.
Such as one technical co-founder and product designer, one marketing expert, and one with business or domain-specific expertise.
This can lower your hiring expenses and overheads. It can be much preferred by professional investors.
It may provide more continuity in the company no matter what happens in the future.
5 Or More Cofounders
Once you hit four or more cofounders, equity splits and decision-making can get really complicated.
This can be more of a risk for the business and its investors. There is a smaller pie to split with others which may bring in more value.
Chances of the business falling apart due to cofounder disagreements can be much higher.
This can all affect the ability to attract talent, capital, and more. As well as the ability to focus and execute.
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Cofounder Equity Splits: Other Things To Consider
Some of the factors to consider when working out how cofounders should think about equity splits include the following.
Employee Stock Pools
How much equity will you set aside for recruiting key talent and executives, including RSU, stock options, etc.?
It’s going to be far easier if you set aside these stocks in advance.
It is quite common to give startup advisors equity as well.
This may be due to wanting to get ahead fast, with great help, but without having to shell out thousands in cash upfront.
This may be especially helpful when it comes to fundraising consultants.
Or you may wish to offer celebrity advisors equity in exchange for the credibility that they can add to your company.
Investors are going to want equity too.
Early investors and those committing large amounts of capital are going to want substantial amounts of equity.
Think of the long term. This isn’t just about raising a seed round. You may need to make it all the way through a Series E funding round.
The more your ownership is depleted and diluted, the less you will get out when you exit.
If you don’t plan this well, along with carefully watching the terms at each step of the way, then you could sell your startup for $40B. And barely walk away with a dime.
Ability To Scale
How will you balance maintaining enough control to make sure things are done right, versus preserving and enabling your ability to scale?
Do you prefer a big piece of a small pie or a small piece of a much larger pie?
Is impact more important to you than just the dollars, or vice versa?
Your Growth Path
Which cofounders are really going to keep adding value? Which roles and at and what scale?
Which are willing to sacrifice full time and a salary now? Which will be replaced later?
Which will bring in the most capital contributions at the beginning?
Vesting Over Time
One of the best ways to overcome and balance many of these issues is to have the equivalent of probation periods for cofounders.
Their equity and shares could be held for a couple of years, and earned over time.
This can eliminate those who end up leaving early or not being a good fit later on.
There may be a lot more to how cofounders should think about equity splits than you may think.
Getting this right can make a big difference throughout the life of your venture.
Get legal help and the input of startup advisors, with both fundraising and M&A in mind. Then get to executing on the next stage.
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