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Beginning a startup can be quite an overwhelming process. This is because of the fact that founders need to make many significant decisions. They need to decide the markets which they intend to serve. Also, the product mix needs to be decided.
It is also important that a company chooses its financing and investors carefully. However, there is another important decision that forms the base of the entire company. This is the decision about how the equity needs to be split amongst the various cofounders. This is a strategic decision and can have a long-term impact on the future of the company.
A lot of the startups fail because the key members of the company are not able to amicably work with each other. Even companies like Facebook landed in court because of a dispute between founders Mark Zuckerberg and Eduardo Saverin about how the equity of the business needs to be split. Hence, it is important for the founders to make this decision after careful consideration.
Some of the points which need to be taken into account while making the changes are as follows:
Whenever a business is created, founders have to contribute a lot of different things. Some founders contribute more capital. On the other hand, another founder could contribute more time. A third founder may have the expertise required to execute the project and it is possible that a fourth one has the contacts and network required to attract customers and investors. It is possible that these different roles may be split amongst the same founders.
In many cases, it is not easy to assign a monetary value to the contributions of the founders. Also, because of thinking bias, each founder assigns a higher mental value to their own contributions than they do for others. Also, these contributions can keep on changing over time and no one is actually keeping track.
As a result, all founders have very different perceptions of what all the other founders are contributing to the business. Since the founders have to work as a closely-knit team, these conversations can be considered to be offensive as well. This is the reason that, in the beginning, founders are not generally concerned with the distribution of equity. However, when the startup starts succeeding over the years, the amounts grow larger and this is when disputes arise.
The first decision that co-founders need to make is whether they want to split the equity equally or in proportion to their efforts. Now, this decision is ideally personal and should have no impact on the growth of the company but it does have an impact.
Empirical studies have shown that startup companies in which the shares are equally split amongst the co-founders have a lesser chance of succeeding. This is because a lot of these companies are not professional and tend to include their friends and family as co-founders instead of finding the right man for the job. Also, it shows that the team has not carefully negotiated the share amongst each other which is perceived as a lack of negotiation skills.
Investors often avoid companies where the equity is equally split amongst founders. They want the co-founders to have the difficult conversation, iron out their differences, and be on the same page.
Ideally, an equal distribution would be unfair. Instead, the distribution should be equitable and based on the respective inputs that each co-founder brings to the table. This process begins by discussing with the co-founders and assigning a monetary value to each activity. For instance, if a founder is working 40 hour weeks whereas another is working a 10 hour week for the company, their contributions should be prorated monetarily. Once the input calculation is done, the allocation of equity can be done in the same proportion.
Another important factor to consider is the fact that decisions regarding equity distribution do not need to be taken immediately. Instead, they should be taken over a period of time. This is because, at the beginning of the process, the founders only intend to put in their efforts in the form of inputs. They should be rewarded with actual equity only after the efforts have been put in and results have been obtained.
It is common for startup companies to have a vesting schedule. This means that they start with a particular percentage of equity distribution amongst the co-founders. However, after a fixed period of time, the company issues more shares. These more shares are issued if predetermined parameters are met. This means that if the co-founder in charge of sales has executed his or her target, then they will get a higher percentage of shares that year. Now, since new shares are issued each year, the percentage of shares amongst co-founders can keep changing on a year or year basis. After a certain period of time, the vesting of additional shares can be stopped and the final distribution of equity amongst the co-founders can be obtained. This method allows the co-founders who put in maximum efforts to obtain maximum equity.
The bottom line is that the distribution of equity amongst co-founders is a strategic issue that is often downplayed in startups. Startups need to take cognizance of the fact that this is a crucial issue. They must create systems that allow them to scientifically allocate the equity amongst co-founders.
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