Splitting Equity in a Startup

by Ry Walker

We've had many very interesting conversations with entrepreneurs about "equity." It comes up just about every meeting, as we explore the idea of offering services for equity.

The most common quote we hear is "it's better to own a smaller part of a bigger pie" as a justification for sharing equity. Everyone laughs and nods their head, but know there is a lot more complexity lurking below, making that answer a bit uncomfortable.

Taking equity as an employee or vendor

When you ask an employee (or vendor) to take equity instead of cash, you are asking them to become an angel investor in the venture.

Risk — The Angel Capital Education Foundation reports that angel investors get an average return of 2.6x their investment, in an average 3.5 years. However, 75% of returns come from 10% of investments, and the higher the return, the longer it takes to get to cash. This is backed up by The Oxford Handbook of Entrepreneurial Finance, which reports the median time to successful exits is 5.8 years, compared to 3.5 years for negative exits.

VC fund managers have a saying for this: "lemons ripen faster than plums."

It's reasonable to assume that 10% of early-stage ventures will eventually have a meaningful "exit" (where angel investors are returned a significant amount of cash), and you may wait 10 or more years for that exit.

Reward — Taking equity in a venture causes you to really care about your work. Maybe more deeply than ever before. Caring is a "good thing" not only for the venture, but for you. You'll think deeply about problems, solutions, and become a champion for efficiency. You will grow tremendously in new directions. Odds are against you striking it rich, but the personal growth is reward enough, if you think about the opportunity in the right way.

Responsibility — Owning something is a lot of responsibility. You're now a steward for customers, employees, and other stakeholders.

Are you better off just taking cash for your efforts? Maybe. Often, that's not an option. Most of the time, there's no cash to pay anyone. Or there'd be someone else willing to take fill your "sweat equity" spot.

Of course, you can always say "no", and spend your time doing "services for cash" gigs.

Giving equity as a founder

What if you're the founder? Do you want to share the pie?

By sharing equity, you are reducing your potential financial reward, power, responsibility, and risk.

Done correctly, though, you are enabling alignment of interests, and spark valuable conversations about decisions.

It's all a continuum

We are considering opportunities where we may own 0%, 5%, 20%, 40%, 70%, or even 100% of the venture.

Thinking about equity across that continuum has influenced how we feel about equity.

Rob McDonald from The Brandery reinforces with us that later investors want the primary founder to have control (and motivation) of the business through seed and multiple rounds of subsequent investment. If we take too much equity, it could scare away investment dollars.

While we see opportunities at every level of equity, we recognize the increasing risk and responsibility, the higher our share of a venture is.

Choose co-founders wisely

Rob McDonald recently shared his top four non-legal mistakes that kill companies, and first on that list was "Assembling the B Team" — hiring friends, and not ensuring a diversity of quality skill sets.

Taking on an equity partner is like making a hire, but with permanency. Ensure you really like the person.

You really need the complimentary skill sets, but also the same mind set about diving in.

Mark McAndrew says he very often sees founders who think they know one another, and believe they are on the same page. But only in the throes and stresses of getting a company off the ground do the irreconcialable difference come to light.

Start ups are really hard, so you really need to be confident that the team you assemble to go into battle with is the right team.

More tips on choosing co-founders here and here.

If you have doubts, walk away.

Vesting is important

While issuing equity is a great tool in an entrepreneurs belt, it should be done with care.

Enter vesting arrangements. To protect the interests of all parties involved, and ensure reward matches contribution over the long-term, we strongly recommend using vesting, even among founders.

There are many things that can happen during the course of a start up, such as changing priorities, relocations, and other life events.

Nothing can be more cancerous to a startup than the lazy, absent or unproductive "founder". Chris Dixon wrote a really good piece on founder vesting. And Dan Shapiro wrote a more detailed discussion on the topic.

Thanks to Mark McAndrew, Rob McDonald, and Jacob Shidler for reading drafts of this and contributing valuable feedback.

Photo Credit: ktLaurel cc

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