Hot Seat

Chapter 4. Sharing Shares

The question of equity brings out the most fundamental differences, perceptions, and values in an aspiring startup. In fact, the equity question, more than any other, may strangle a young company before it can even get started. Of course, as discussed earlier, a quick death may be better than the long and drawn-out alternative.

But before we get to that...

Who’s a Founder?

It seems like an obvious question, and it’s one whose answer we have to agree on before we can talk about how much equity “founders” should get.

But as straightforward as the question sounds, in practice, it’s a tricky matter. The founder moniker is black and white, but reality is all shades of gray. Setting aside the philosophical question and focusing on the more useful economic one, though, there is a simple way of looking at it: founders are people who expose themselves to the highest risk in the company’s lifetime.

There are, quite roughly, three stages in every company’s life:

Stage 1: Founding

The only money the company has at this stage is what the team puts in. The team gets no money out of the company. The most probable outcome is that the company will fail: the team will lose all the money they put in, plus lost salary–plus they will also have to find jobs.

Stage 2: Startup

The company now has money, either from investors or from revenue, and the team gets some of that money every month (hooray for salaries!). The salaries are probably less than what the team members would get at a big company. There’s a significant risk that the company will fail and they’ll have to find new jobs, and when they do, they’ll have lost the difference between the startup salary and what they might have been able to get from a bigger company or a more mature startup.

Stage 3: Real company

At this stage, the team members get salaries similar to what they’d get at other, equivalent jobs. It’s less likely that the company will fail, and if it does, the downside for the team is just having to find new jobs.

Here’s a simple rule of thumb: if you’re working for a company that’s so young it can’t pay you, you’re a founder. If you are drawing a salary on your first day at work, you’re not.

What’s a Founder Worth?

We’ve just defined a founder as someone who works for a company that can’t afford to pay her. A founder’s primary job, then, is to get her company some money—either by raising investment or by generating revenue. So, founders are valued by two things:

• Their likely contribution to the cause of getting the company some money

• The market value of their overall skills and reputation

The first of these is fair. The second is economics. Both are essential.

How to value these intangibles, though, is a terrible problem to sort through. It’s emotional and subjective, and the results can be immense and impactful. To make it easier, I’ve put together a simple “pick a path” approach to allocating equity.

This approach is based on my personal experience advising startups. It was also informed by the outstanding research of Dr. Noam Wasserman, a Harvard Business School professor whose data on the subject is second to none.¹ One caveat: when I talked to Dr. Wasserman about the challenge of allocating equity fairly, he pointed out that both his data and my experience are fundamentally just observations of the market as it is; nobody’s done A/B experiments to test different approaches and measure what leads to better outcomes. But market rates are a good place to start.

A Formula for Equity

To start out with, give every founder 100 shares.

Somebody’s got to get things started (5%)

Some startups are born running, with all of the founders on board from the beginning. But in others, there’s one leader who recruits the rest of the team. Whoever rounded up the cofounders and talked everyone into joining the team should add 5% to her holdings. If you were previously 100/100/100, you’re now 105/100/100.

Ideas are precious, but dwarfed by execution (5%)

Paul Graham of Y Combinator once pointed out that there’s no market for startup ideas, which is a good economic indicator that they have no value. While “zero” may not be the actual value, it is the surprising truth that the startup’s key idea, its precious reason for existence, isn’t worth that much to anyone besides the person who thought of it.

That said, the startup has to do something. And while the idea may morph and change, it does define the future of the company in a way that’s hard to ignore.

If the founding team is a wellspring of ideas and you decide on one collectively,² you can ignore this 5% adjustment because everyone contributed more or less equally. Likewise, if you have two or three great ideas that are battling for your team’s passion and investment, you can skip the 5% adjustment—everyone’s contributing at the idea level, and “rewarding the winner” with an equity bonus will just escalate the argument. And if your startup is pursuing a services-type strategy, where you build whatever customers ask for while you learn more about the space, you should—you guessed it—ignore this 5% adjustment as well.

But if one founder brought a fully formed idea to the group, well researched and thought through, and persuaded everyone else to follow through on it, that person should increase her shareholdings by 5% (so if she had 105 shares before, she now has 110.25). However, if the idea is implemented, or patented, or otherwise has some execution behind it, then move on to the next point...

The first step is the hardest (5%–25%)

Creating a difficult-to-replicate beachhead can give a fledgling company direction and credibility. It can help with revenue and with financing. It can make the difference between being unfundable and having your pick of top investors.

If someone brings a concrete start to the company—a critical, filed patent (not a provisional), a compelling demo, an early version of the product, a key customer, or something else that means much of the work toward financing or revenue is already done—that person gets a boost of 5%–25%. The key consideration to decide the exact percentage is, “How much closer does this get us to revenue or financing?”

CEO gets more (5%)

Granted, given that this is a book about CEOs, this may seem like pandering. But custom, prudence, and economics dictate that the person in the hot seat is rewarded with a greater equity stake.

This is often fiercely objected to by other founders. They generally field eminently reasonable arguments:

• The CEO job is not necessarily harder than the other jobs.

• The founder holding the CEO job is not a more worthwhile, valuable, or skilled person than the other founders.

• The person with the CEO job has never done it before, and may not turn out to be very good at actually doing the job.

These are all often true. However, the average CEO, according to Prof. Wasserman, owns 10%–15% more of the company after accounting for a variety of factors. The market’s pretty clear that CEOs get more.

While appeal to tradition may seem shallow, being cognizant of market realities is not. Compensation for a great CEO is higher than compensation for other executive roles in a company.³

And what if your cofounders are not sure you’re a great CEO? Because you may be a first-time chief executive, that’s not an unreasonable concern. Of course, this is a concern for the other founders who are new to their C-level titles as well. But the answer to this objection is easy: if you turn out not to be a great CEO, either you will be replaced (losing the bulk of your stock because of founder vesting, as described in the next chapter), or the company will fail (rendering your stock worthless). So, founders should be awarded stock based on the assumption that they’re going to be outstanding at what they do, put founder vesting in place in case that assumption is wrong, and move forward.

I’ve occasionally heard the objection that the cofounder(s) don’t trust the CEO with a majority stake and want to keep it 50/50 even as an insurance policy of sorts. To those folks I posit this: the CEO will have the ability to fire them and/or destroy the company. If they don’t trust the CEO with the majority of the shares, why are they making that person the CEO?

Full-time commitment is expensive (200%)

A pig and a chicken are close friends. One day, the chicken, seized by the entrepreneurial spirit, rushes up to the pig, feathers aflutter.

“Pig!” the chicken says. “I have an amazing idea!”

“What is it, friend?” the gentle pig replies.

“We should go into business together! It would be a brilliant partnership. We would call the restaurant ‘Bacon and Eggs.’”

The pig ponders the proposal for what seems like a long time. Finally, he sighs, and shakes his head.

“What’s wrong, Pig? You haven’t seen my PowerPoint yet! I’ve got an amazing hockey stick growth curve...”

“That’s not it, my fondest companion,” the pig replies. “I’m afraid the partnership would be doomed to fail. In a restaurant called ‘Bacon and Eggs,’ I would be committed, but you would only be involved.”⁴

If you’re working on the startup full time while your cofounder is working part time, you’re the pig. Not only are you putting more time and work in, but you’re risking a lot more if the project fails. Consider this: if the company fails, you have no source of income and no idea what you’re going to do next, and your most recent résumé entry is “launched a failed company.”⁵ Your friend with the backup plan, on the other hand, is switching hobbies.

What’s worse, part-time cofounders are an actual liability when it comes to raising an investment. Investors do not care for dilettante entrepreneurs, and with good reason. Why invest in a part-cofounder when you can get a whole one? When you pitch an investor, you’re competing with every other deal they consider doing. The other deals have full-time founders.

Semi-founders are semi-flakey. Despite promises and assurances that they will really, truly commit when the funding goes through, quitting the day job when the moment is at hand can be more difficult than they expect, and cold feet are common.

Part-time founders create greater team risk. Full-time founders have been working together full time and have had more opportunities for the aforementioned early bankruptcy. When they see a full-time team, investors know you’ve already cleared some hard hurdles together that part-timers may have jogged around. Investors would rather you work out your issues on your dime, not theirs.

Part-time founders are often legally bound to their current employers, too. Rarely, companies get mad when founders leave. Frequently, founders are sloppy and found their new businesses in ways that may inadvertently assign intellectual property to their current employers. Those problems become apparent five years later when a huge sale of the company is held up because the provenance of the startup’s original idea is brought into question. This is a whole hot kettle of mess that’s easily avoided when the founder’s separation is history.

Part-time founders send a bad signal. If the founders won’t commit, why should investors? Many investors see the lack of full-time commitment to the company as... well, a lack of commitment. They want to see founders “all in” before they are willing to put their money behind their bet.

Cofounder equivocating will be expensive. If there are any part-timers, add 200% to the shareholdings of all the full-timers.

Reputation is the most precious asset of all (50%–500%+)

If your goal is to get investment, some people make that much easier. If you’re a first-time entrepreneur partnering with someone who’s already successfully raised VC dollars, that person is a lot more investable than you are. In the extreme, some entrepreneurs are so “investable” that their involvement is a guarantee of raising funds. (It’s easy to identify them: ask the investors who know them best, “Would you back this person no matter what she did?” If the answer is “Yes,” then they are that kind of super.) These super-preneurs essentially remove all the risk of the “founding” stage, so you should expect that they get the lion’s share of the equity from this stage. If this strikes you as wrong, imagine someone like Sheryl Sandberg or Mark Cuban committing to a new venture full time and cofounding it with someone who’s never started a company before. It wouldn’t be a 50/50 split.

This point doesn’t apply to most founding teams, but when it does, expect the super-preneur to take an extra 50%–500% or more, depending on just how much more significant her reputation is than her cofounders’.

Treat cash like an investment (% varies)

Ideally, each founder contributes an equal amount to the company. That, plus their labor, earns them their “founder shares.” It’s possible, though, that one founder may put in significantly more. The reward for that is high, as it’s the earliest, riskiest investment. That founder will get more equity.

To determine how much more, you’ll want to do a rough valuation of your company. Remember, this number will be low, because it’s pre-seed stage. Talk to a good startup attorney about a reasonable value for your company, and work from there. For example, you might be told that comparable companies are being valued at about $450K in family and friends rounds.⁶ In this case, a $50K investment would warrant an additional 10%. There are more structured ways to manage founder investments, ranging from revolving credit lines with interest and warrants to convertible debt that converts into common shares. But these all mean increased legal bills and, more importantly, complex cap tables⁷—something that can scare off outside investment. As a general rule, investors expect that founders have settled their equity positions and have no outstanding IOUs when the financing starts.

The final accounting

At this point, you’ll have something like 200/150/250. Just add up the shares (600, in this example) and divide each person’s holdings by that number to get their ownership: 33%, 25%, 42%.

Why Not 50/50?

A number of brilliant people have advocated for even splits—like entrepreneur and blogger Joel Spolsky. He wrote a thoughtful piece⁸ about dividing company ownership that concluded the right approach is even-steven, splitting 50/50 for two cofounders, 33/33/33 for three, and so on.

But there are two subtle issues raised by advocates of 50/50 that merit considering. First, 50/50 splitters often advocate for this number as “fair.” They hold this up as a key virtue—in Joe’s words, “Fairness, and the perception of fairness, is much more valuable than owning a large stake.” This is true; fairness is a virtue worth pursuing.

But a 50/50 split confuses “fair” with “easy.” If you’ve had two successful exits and have an extensive network that includes a VC firm offering to back whatever you do next, while your four cofounders are fresh out of college,⁹ it’s easy but not fair to split the equity evenly. It’s fair but not easy to reach a more accurate split. 50/50 is fair and easy when my twin kindergartners divide up the last banana, but “fair” and “easy” are generally in opposition in more complex divisions of value.

Second, splitters advocate avoiding conflict so you don’t (in Joel’s words) “argue yourselves to death.” Avoiding arguing yourselves to death is one of the biggest challenges at the early stage, so it’s easy to get on board here. But while it’s the right problem to consider, avoiding the discussion is the wrong solution. If you’re going to argue yourselves to death, do it now when you don’t have investors and, worse, employees (“Mom and Dad are fighting again”). Remember the virtues of an early bankruptcy, and instead of postponing your problems, learn to problem-solve together, now, by facing the hard issues. Don’t do it later, on others’ dimes, when the stakes are so much higher.

If you’ve completed the whole exercise and still want to do 50/50, that’s OK. Just do one more thing: give or sell one share to someone else. Pick a trusted advisor or mentor. You now have a tiebreaker. You can’t paralyze the company through indecision—that one person will keep you honest and make sure you reach agreement, because if you don’t, you’re going to be giving away control of the decision to your tiebreaker.

No matter which way you do it, this is going to be painful. It’s going to involve excruciating conversations. You will not finish it in one sitting. You will not feel good about the process.

But you must get used to hard questions. You must get used to trusting each other. You must get used to the idea that you’re all different, not all equal. You need to decouple your egos from the day-to-day process of making business decisions. You must have the difficult discussions about responsibilities, contributions, roles, and compensation. You must do it before you make commitments to investors and employees. And if you find that the only way you can get a decision made is by compromising on an outcome that neither party thinks is the right one, then you need to stop now, before the price of failure climbs higher.

There’s no way around it—you’re going to have to split the baby, but it doesn’t require the wisdom of Solomon to get it right. Take your time, keep a level head, and remember: this is just the first of the decisions you’ll be making together for the rest of your company’s life!

¹ As long as we’re being honest, Dr. Wasserman’s book discussing his research, The Founder’s Dilemmas (Princeton University Press, 2013), is so good that I won’t fault you for putting down this book and reading that one first.

² For example, using the methodology in the previous chapter.

³ One notable exception: the most senior sales executives will generally have a larger paycheck than anyone—if they’re very, very good.

⁴ For more about this tired joke, see its Wikipedia entry.

⁵ If this is your actual résumé entry, you may want to consider an absence of marketing ability as a contributing factor to your company’s unfortunate demise.

⁶ This is a good test of whether you’ve got the right lawyer. If your attorney can’t give you a half-dozen recent comparables for startups at your stage, then you’re dealing with someone who doesn’t have enough domain expertise to represent you well. In fact, good startup attorneys will not only work with startups themselves, but have a robust startup practice in their firm. As a result, they can draw on dozens of recent financings from internal data and give you a very accurate target range.

⁷ “Cap table” is an abbreviation for capitalization table, the spreadsheet that shows who owns which shares of the company. It’s also a shorthand for the shareholder composition, as in “There are a lot of angels in the cap table.”

⁸ Joel Spolsky, “Where Twitter and Facebook Went Wrong: A Fair Way To Divide Up Ownership Of Any New Company,” Business Insider, April 14th, 2011.

⁹ Not a hypothetical; this happened at an actual startup (that had an exit over $50M a few years later).