Splitting Cofounder Equity Fairly: What High-Performing Founding Teams Do Differently

Splitting cofounder equity fairly is a complex issue that can significantly impact the startup’s future. How you shape the company’s ownership structure can influence the strength of cofounder long-term relationships. You’ll either fortify them or set them up for conflict and eventual failure.

When drafting the cofounders’ agreement, you’ll prioritize how equity is allocated among the partners and ensure that it is equitable. An equitable distribution does not necessarily mean equal shares; it simply ensures that each cofounder feels valued and recognized.

You’ll develop an equity allocation framework based on each cofounder’s contributions and other factors. Also, account for their individual goals and objectives from the partnership. Don’t forget that the startup’s success relies on avoiding internal conflicts and legal issues.

Understanding What an Equity Split Is

An equity split determines how the cofounders share ownership stakes in the company. It defines the percentage of the company each partner owns, which directly affects their share of the assets and liabilities. The percentage also influences control and decision-making rights.

Splitting cofounder equity fairly during the initial stages of company building is advisable. You’ll iron out these details early, particularly before starting operations and raising external capital.

As the company scales and new investors, employees, and partners join, their roles and capital contributions affect equity. Accordingly, you’ll revisit the agreement and reorganize the equity structure to accommodate the new entrants.

Equity ownership for cofounders and investors is expressed in terms of stock options or shares, while employees receive option pools. This equity and ownership stake serves as a financial incentive, motivating the holders to work toward the company’s success.

The stock each stakeholder owns also compensates them for the risk they carry from investing in a startup. This stake entitles them to a share of the company’s profits and a say in decision-making. Of course, their voting rights are in proportion to their ownership stake.

Most importantly, equity assures holders of returns when they exit the company. Around 26% of new companies start out as a solopreneurship, in which case equity splits are immaterial. However, the remaining 74% must approach equity allocation strategically and with a forward-thinking perspective.

The allocation should provide a robust foundation for the startup, ensuring stability as it progresses through subsequent growth stages and funding rounds. Equity split frameworks create provisions for future talent acquisition and incentivizing investors.

Investors are not only concerned with the equity they can own but also with how cofounders share ownership and compensation. Their internal dynamics and alignment can impact long-term success.

Splitting Cofounder Equity Fairly – The Experts’ Perspective

How should cofounders split equity? Should everyone get an equal share? Who gets preference — the core founders or new partners who bring valuable skill sets and capital to the table?

Answering these questions can be controversial, but doing so early can eliminate much of the conflict and confusion. The experts at Y Combinator recommend an equal or near-equal allocation among the partners. Their advice is grounded in sound arguments. Here’s what they have to say.

Expert Reasoning

• Many startups make the mistake of allocating a larger share of the equity among the founders. However, building a company that delivers great value and substantial profits typically takes at least seven to 10 years. The efforts that go into scaling the company in the later years justify awarding equal equity to the people who make it happen.
• A higher equity stake that cofounders and employees hold indicates their value to investors. If a cofounder holds just 10% or 20% of the equity, it could create the impression that their work isn’t impactful within the organization. Or that they aren’t very good at their job. Don’t forget that the team, its accomplishments, and talent play a significant role in its long-term success. You need to project a strong, highly skilled team, which justifies their large equity stake. That’s how you’ll incentivize investors to provide capital.
• Building a startup involves much more than an initial business concept. Ultimately, it’s about how those ideas transform into a minimum viable product (MVP) and product-market fit. In short, it’s about execution and the other partners who generated adequate traction. This is why awarding a substantial equity stake to the first founder doesn’t really make sense.
• Nearly 90% of startups fail, with at least 20% failing in their first year. Interestingly, this figure steadily rises over the subsequent years, and just 30% survive beyond the 10th year. Equity allocation serves as motivation to keep going despite setbacks. You’re encouraging the team to keep going with the expectation of rich rewards once the company succeeds.
• Not all founders have the full skill set to build a company on their own. They must rely on other cofounders and team members to fill gaps in their capabilities. Offering adequate equity attracts the talent they absolutely need.

The Solution

Ensure that you’re splitting cofounder equity fairly by offering equal or near-equal ownership stakes. Founders should view their partners as valuable contributors to the company’s growth, supported by sound decision-making and execution. They should receive an equitable share in its success.

At the same time, you’ll secure the company’s interests in the event that a cofounder or employee chooses to exit. A great solution is to establish reasonable vesting schedules—for instance, a four-year vesting schedule with a one-year cliff.

As a result, if a partner owns 40% of the company, they receive nothing if they leave within a year. However, if they leave or are fired after a year, they get 25% of the stock. Each month the partner or employee remains with the company, they steadily accumulate more equity.

At the end of four years, they can earn 100% of the stock allocation. This strategy enables you to test if team members are a good fit and interested in remaining for extended periods. If the partnership does not work out, you can repair the damage within a year without harming the company.

Yet another strategy is to have only the founder/CEO hold a board seat before a major funding round. You’ll reduce the risk of disputes during decision-making, particularly when you need to terminate some team members.

Factors that Influence Equity Allocation

Several factors can influence the framework you adopt for splitting cofounder equity fairly. Decisions center on each partner’s contributions, expectations, responsibilities, roles, needs, and preferences. Here’s what you need to know:

Contributions

• A founder who starts the company with bootstrapped capital supplemented by money from friends and family requires a larger stake.
• Cofounders bring various skill sets, strengths, and capabilities to the company. For instance, one may contribute technical skills and product development, while another may build the market strategy to acquire customers. Rare and unique expertise may warrant a bigger share.
• The ownership stake defines each partner’s roles and duties. These roles also determine their time commitment to the company’s operations. Cofounders who dedicate their entire working hours to the company, now and in the foreseeable future, claim more equity. That is in contrast to partners who work only part-time, such as on weekends and limited hours.
• Access to networks and personal connections is a significant asset for a fledgling startup. These assets can influence fundraising success and building a customer base. Cofounders who attract further capital and business to the company can command a higher equity stake.
• At times, contributions can extend beyond physical assets. For instance, emotional intelligence and the ability to remain positive in the face of setbacks and hurdles. You’ll need people who can keep the team motivated and remain focused on the big picture.
• Your startup benefits significantly from prestige and a team member’s track record of building and exiting startups. Investors are more inclined to back the company solely because of their presence.

Risk Tolerance and Other Factors

• Each cofounder has a different risk tolerance on both the professional and personal levels. This tolerance influences their ability and willingness to make critical key decisions, and consequently, the equity they can claim.
• Every cofounder has varying exit strategy preferences. For some, their exit could be tied to a profitable acquisition within a fixed interval. But for others, it could be linked to a successful initial public offering (IPO). The duration for which team members expect to remain with the company affects their equity stake.
• The ownership stake will be higher for cofounders who assume greater legal responsibilities. These may include fiduciary, regulatory compliance, or other legal issues.
• Few startups account for the opportunity loss that cofounders incur when building the company. Some may quit a job paying a substantial salary. Others may give up a lucrative investment to divert resources to the startup. You could factor the quantitative value of these losses into equity allocation.

Because every startup is unique, you can’t use a standardized approach when splitting cofounder equity fairly. The key here is open dialog and a framework that aligns with the company’s and cofounders’ needs and priorities.

Keep in mind that storytelling is everything in fundraising. In this regard, for a winning pitch deck to help you here, take a look at the template created by Peter Thiel, Silicon Valley legend (see it here), that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

Remember to unlock the pitch deck template that founders worldwide are using to raise millions below.

Methods for Splitting Equity Stakes Among Cofounders

The most common strategy for splitting cofounder equity fairly is to have a vesting schedule, as explained earlier. However, the appropriate approach to managing your allotment may involve a blend of methods. Or, a hybrid model. Here’s what you need to know.

Equity Splits for Cofounders

• Resolving equal allotment challenges with weighted contributions: As discussed in the foregoing sections, this approach can appear unfair when cofounders contribute differently to the startup. Varying levels of responsibilities, time, expertise, and effort invested can create conflicts. Disagreements over voting rights, decision-making, and governance issues can also arise. The solution is to quantify each contribution and agree on an equity allocation accordingly.
• Dynamic or adjustable allotment: This method accounts for a growing company’s evolving needs. You’ll develop a framework based on defined milestones. For instance, product development, revenue, and the number of customers acquired. This model provides flexibility in equity calculations to account for market conditions, dynamic strategies, and changing contributions. It also ensures cofounders earn their equity by meeting milestones. At the same time, it secures the company from unexpected and premature departures.
• The company’s key performance indicators (KPIs) can also influence the equity allocation. In this method, cofounders agree to allocate equity each time the company achieves predetermined objectives or metrics. Essentially, this is a performance-driven model. For instance, awarding stock for building a new product portfolio or breaking into a new market.
• Role-based allotment: Cofounders typically fit different roles in the company, such as CEO, CFO, CTO, and COO. These roles are assigned to varying equity tiers. Accordingly, the CEO receives the largest equity stake among the executives.
• Pre-negotiated agreements: In this framework, the cofounders agree to a selection of criteria and conditions under which each can purchase/sell equity. It enables them to purchase shares from the company or from their cofounders, thereby increasing their stake. The biggest advantage of this strategy is that it prevents unnecessary dilution and keeps ownership within the company.

Equity for Employees

Setting up an option pool is a prerequisite for successful company building. Setting aside stock for employees secures the cofounder equity split and protects the company from dilution. At the same time, you’ll leverage the flexibility to recruit top talent and skill sets.

Options pools are also under close investor scrutiny, and having them enhances your capital-raising efforts. Many startups also use a point-based system to reward employees. Each contribution and milestone earns points that can be used to increase the number of shares they receive.

The Takeaway!

Splitting cofounder equity fairly requires open communication among stakeholders and careful consideration of the relevant factors. Be aware of the pros and cons of the different methods for calculating equity and arrive at an agreement.

Your objective is to design a framework tailored to the company’s and cofounders’ needs—not just today, but also for the future as the company scales and evolves. Be mindful of potential conflicts and disagreements, and implement fail-safe measures to prevent them.

You may also find our free library of business templates interesting. There, you will find every single template you need to build and scale your business completely, all for free. See it here.