equity, partnersAt our small startup, we have four partners. One of the partners has made it clear that after one year, regardless of what happens with our company, he would like to return to school to complete his software engineering degree.
Since he is not committing to this company for the long haul, the three others, including myself, think it would be fair if he received 10% of the company, while the remaining three take 30% each. He thinks he should still receive 25%, but is willing to take 20% as acknowledgement that he will be leaving.
Does anyone have any suggestions - especially from experience - on how to approach this and how to do it fairly?
First off, Joel’s guide:
This is such a common question here and elsewhere that I will attempt to write the world’s most canonical answer to this question. Hopefully in the future when someone on answers.onstartups asks how to split up the ownership of their new company, you can simply point to this answer.
The most important principle: Fairness, and the perception of fairness, is much more valuable than owning a large stake. Almost everything that can go wrong in a startup will go wrong, and one of the biggest things that can go wrong is huge, angry, shouting matches between the founders as to who worked harder, who owns more, whose idea was it anyway, etc. That is why I would always rather split a new company 50-50 with a friend than insist on owning 60% because “it was my idea,” or because “I was more experienced” or anything else. Why? Because if I split the company 60-40, the company is going to fail when we argue ourselves to death. And if you just say, “to heck with it, we can NEVER figure out what the correct split is, so let’s just be pals and go 50-50,” you’ll stay friends and the company will survive.
Thus, I present you with Joel’s Totally Fair Method to Divide Up The Ownership of Any Startup.
For simplicity sake, I’m going to start by assuming that you are not going to raise venture capital and you are not going to have outside investors. Later, I’ll explain how to deal with venture capital, but for now assume no investors.
Also for simplicity sake, let’s temporarily assume that the founders all quit their jobs and start working on the new company full time at the same time. Later, I’ll explain how to deal with founders who do not start at the same time.
Here’s the principle. As your company grows, you tend to add people in “layers”.
The top layer is the first founder or founders. There may be 1, 2, 3, or more of you, but you all start working about the same time, and you all take the same risk… quitting your jobs to go work for a new and unproven company.
The second layer is the first real employees. By the time you hire this layer, you’ve got cash coming in from somewhere (investors or customers–doesn’t matter). These people didn’t take as much risk because they got a salary from day one, and honestly, they didn’t start the company, they joined it as a job.
The third layer are later employees. By the time they joined the company, it was going pretty well.
For many companies, each “layer” will be approximately one year long. By the time your company is big enough to sell to Google or go public or whatever, you probably have about 6 layers: the founders and roughly five layers of employees. Each successive layer is larger. There might be two founders, five early employees in layer 2, 25 employees in layer 3, and 200 employees in layer 4. The later layers took less risk.
OK, now here’s how you use that information:
The founders should end up with about 50% of the company, total. Each of the next five layers should end up with about 10% of the company, split equally among everyone in the layer.
Example:
Two founders start the company. They each take 2500 shares. There are 5000 shares outstanding, so each founder owns half.
They hire four employees in year one. These four employees each take 250 shares. There are 6000 shares outstanding.
They hire another 20 employees in year two. Each one takes 50 shares. They get fewer shares because they took less risk, and they get 50 shares because we’re giving each layer 1000 shares to divide up.
By the time the company has six layers, you have given out 10,000 shares. Each founder ends up owning 25%. Each employee layer owns 10% collectively. The earliest employees who took the most risk own the most shares.
Make sense? You don’t have to follow this exact formula but the basic idea is that you set up “stripes” of seniority, where the top stripe took the most risk and the bottom stripe took the least, and each “stripe” shares an equal number of shares, which magically gives employees more shares for joining early.
A slightly different way to use the stripes is for seniority. Your top stripe is the founders, below that you reserve a whole stripe for the fancy CEO that you recruited who insisted on owning 10%, the stripe below that is for the early employees and also the top managers, etc. However you organize the stripes, it should be simple and clear and easy to understand and not prone to arguments.
Now that we have a fair system set out, there is one important principle. You must have vesting. Preferably 4 or 5 years. Nobody earns their shares until they’ve stayed with the company for a year. A good vesting schedule is 25% in the first year, 2% each additional month. Otherwise your co-founder is going to quit after three weeks and show up, 7 years later, claiming he owns 25% of the company. It never makes sense to give anyone equity without vesting. This is an extremely common mistake and it’s terrible when it happens. You have these companies where 3 cofounders have been working day and night for five years, and then you discover there’s some jerk that quit after two weeks and he still thinks he owns 25% of the company for his two weeks of work.
Now, let me clear up some little things that often complicate the picture.
What happens if you raise an investment? The investment can come from anywhere… an angel, a VC, or someone’s dad. Basically, the answer is simple: the investment just dilutes everyone.
Using the example from above… we’re two founders, we gave ourselves 2500 shares each, so we each own 50%, and now we go to a VC and he offers to give us a million dollars in exchange for 1/3rd of the company.
1/3rd of the company is 2500 shares. So you make another 2500 shares and give them to the VC. He owns 1/3rd and you each own 1/3rd. That’s all there is to it.
What happens if not all the early employees need to take a salary? A lot of times you have one founder who has a little bit of money saved up, so she decides to go without a salary for a while, while the other founder, who needs the money, takes a salary. It is tempting just to give the founder who went without pay more shares to make up for it. The trouble is that you can never figure out the right amount of shares to give. This is just going to cause conflicts. Don’t resolve these problems with shares. Instead, just keep a ledger of how much you paid each of the founders, and if someone goes without salary, give them an IOU. Later, when you have money, you’ll pay them back in cash. In a few years when the money comes rolling in, or even after the first VC investment, you can pay back each founder so that each founder has taken exactly the same amount of salary from the company.
Shouldn’t I get more equity because it was my idea? No. Ideas are pretty much worthless. It is not worth the arguments it would cause to pay someone in equity for an idea. If one of you had the idea but you both quit your jobs and started working at the same time, you should both get the same amount of equity. Working on the company is what causes value, not thinking up some crazy invention in the shower.
What if one of the founders doesn’t work full time on the company? Then they’re not a founder. In my book nobody who is not working full time counts as a founder. Anyone who holds on to their day job gets a salary or IOUs, but not equity. If they hang onto that day job until the VC puts in funding and then comes to work for the company full time, they didn’t take nearly as much risk and they deserve to receive equity along with the first layer of employees.
What if someone contributes equipment or other valuable goods (patents, domain names, etc) to the company? Great. Pay for that in cash or IOUs, not shares. Figure out the right price for that computer they brought with them, or their clever word-processing patent, and give them an IOU to be paid off when you’re doing well. Trying to buy things with equity at this early stage just creates inequality, arguments, and unfairness.
How much should the investors own vs. the founders and employees? That depends on market conditions. Realistically, if the investors end up owning more than 50%, the founders are going to feel like sharecroppers and lose motivation, so good investors don’t get greedy that way. If the company can bootstrap without investors, the founders and employees might end up owning 100% of the company. Interestingly enough, the pressure is pretty strong to keep things balanced between investors and founders/employees; an old rule of thumb was that at IPO time (when you had hired all the employees and raised as much money as you were going to raise) the investors would have 50% and the founders/employees would have 50%, but with hot Internet companies in 2011, investors may end up owning a lot less than 50%.
Conclusion
There is no one-size-fits-all solution to this problem, but anything you can do to make it simple, transparent, straightforward, and, above-all, fair, will make your company much more likely to be successful.
Now, for your specific question, he should have 25%, vested over four years with the first 1/4th of that arriving at the end of the first year. In other words, he gets 6.25% if he stays only one year, 12.5% if he stays two in full, 18.75% if he stays three in full, and the full 25% if he stays four (or when the company exits and the founder is still around.)
I very much agree with Joel’s point on founder disputes: you cannot afford to have discussions about fairness in a startup. So put everyone under the same terms, and leave it to your cofounder to decide if he ultimately wants to leave after a year or not.
If he doesn’t leave, cool – no disputes and everyone is on the same terms.
If he does leave, cool as well – 6.25% it is just like everybody else, and nobody is disgruntled because one cofounder got an outsized chunk of the company for having stayed a single year.
I have been involved in so many start-ups and this is a very common problem.
The important factor is that he will be working full time like everyone else. So he should be entitled to his quarter of equity. Then when he gets to the end of the year, he is entitled to selling his share to all other founders or someone new with lots of money.
You can also agree that your shares are not sell-able and needs to be returned to the other partners. You still share any profit equally. So if he leave, he will get his cut of the year’s profit, and basically loose his share. This is not an option if you will be creating value, like building a software system or engineering a product. Then he will need to be allowed to sell his share (but the other founders gets priority choice, and equally, one partner cannot buy all).
But if your business is doing well, he will most probably stick around and then have equal opportunity as the rest, and study part time.
Investing Resources:
Because not everyone will be putting in the same amount of work-load. It is advisable to see any money investments and time investments as big loans. It should be repaid when money arrives.
A large oversight for “investing founders” to see is that “time” is also an investment, and “investing founders” will mostly supply a once-off lump sum of cash, and then sit back while the “working founders” work days and nights to make the business a success. And most probably the “working founders” will work more hours in money worth over the year, than what that “investing founder” put in in the first place.
Also you will almost always get that some work harder (more overtime) than the rest, so that is why each person’s hours need to be tracked and paid out when the business is a success. This way everyone gets back what they put in.
This also resolves the issue with part-time working founders. They may add enough value in leadership and helping resolve issues, that they were key to the success, but you also don’t want to just ignore the guy that left his day job and put all the hours in to get the product delivered successfully. So paying each back for what they put in initially is important.
And remember that in this new company everyone is worth the same rate. Age and experience is not a factor. If it was, you should not be partners, and rather hire people to do the work and pay them what they are worth in the market.
But the key is that all founding members must have equal equity. If a member has less, and he will always be looking at what the rest are doing and try to do less than that for his lesser share. Also being founders is about the team pooling resources and working together to make a success, and you normally want everyone to be evenly successful.
Also decide what you consider a “founder” because if a “founder” only contributes something once (like a product, assets or products), he enabled the success but he did not actively contribute to it. And a “founder” like that would only get a portion of the equity for that. (You would think that you just need to pay him for the resource, but he did take a risk and for that he needs some share)
Example: We had a very good developer help write a software program for us, but he did not contribute to the rest of the tasks of running the company, so we only offered him 20% share for his work.
Exclusions:
This argument of giving everyone equal share and paying back what they put in, does not apply to large companies that are created solely on investments from investors. Where all the working people are hired, from management to lower levels. In this case, your investment amount determines your share.
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