Founders’ Stock – Dividing the Pie
I am often asked by founders to help provide some guidance in connection with dividing up the initial equity of a startup among the founding group. Here are some thoughts.
My advice starts with the need for the founders to understand that there are no rigid rules in allocating equity among founders – the best approach is one that (i) balances the pre-formation and anticipated future contributions (cash, property, IP, intellectual capital and effort) of each founder, (ii) provides each founder with incentives for hard work and retention over an extended period of time, (iii) recognizes other opportunities that founders may have given up to participate in the startup, and (iv) divides the anticipated future awards of the business “fairly.” Key point: don’t be greedy. Each founder has an interest in balancing the factors above in a way that all founders feel is “fair,” with the result being a founding group that is motivated and aligned in their interests and in their desire to work together in a highly collaborative manner. Importantly, note that “fairness” does not necessarily mean each founder gets the same ownership percentage – it just means that the all founders “feel good” about how the group balanced the factors above to get to the final allocation of stock among the founders.
Best to have this discussion as early as possible in the process of developing a business so that misalignments among the founders, if any, can be identified and addressed. Such a discussion should also include a discussion about vesting of the founders stock (see my post on the importance of vesting of founders stock). The objective here is to get all founders on the same page (from an ownership standpoint) as early as possible in the business development stage. Importantly, addressing these matters early helps to avoid the “lost founder” problem – namely, a person who materially contributed to the development of the business but was cast aside or voluntarily departed before the startup was formed and the equity was allocated. Such a person carries with him or her the potential to bring a claim against the startup at some point in the future (as you might imagine, this will often occur at the worst of times, such as when the company is closing a venture round or proceeding towards a sale or IPO) alleging that such person “earned” a piece of the company by virtue of his/her material contributions to the business prior to formation. Obviously, this is a problem to be avoided.
Consideration should also be given by the founders as to how they intend to incentivize future employees with an ownership stake in the business. At the outset, the founders will collectively own 100% of the capital stock of the startup (obviously, there being no other owners of the business upon formation other than the founders). Shortly thereafter, however, the startup will need to bring on additional key employees and will likely need (and want) to incentivize them with an ownership stake in the startup. An option or other form of equity plan is often established upon formation that anticipates the equity to be granted to these key hires and sets aside a portion (often between 15-30%) of the ownership of the business for this purpose. As equity is allocated out of this plan to key hires, the founders’ ownership interests in the company become diluted. As a result, the founders should consider how such dilution will impact the founders’ initial ownership allocation – again, with the goal of making sure that all founders fully understand their ownership stakes in the startup and the fact that such ownership stake will be diluted over time by new hires and, of course, in capital raising transactions.
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