Keys for distributing equity

Regardless of the type of corporation of the startup, there inevitably arrives a moment when the development team has to decide how to distribute the company’s political and economic rights; that is, what percentage of the company each partner gets. On many occasions, be it because of the pressure of getting financing, or to avoid uncomfortable conversations with your partners, or due to a pure lack of awareness, the division of the company is done in a very unprofessional way. My experience is that the mistakes made in distributing equity become enormous internal problems in the future which can take the company up a dead-end alley that, in the best-case scenario, requires traumatic solutions that require people to come in or leave, or, in the worst-case scenario, ends up closing the startup.

After having gone through this situation personally, and having lived others’ up close, in this post I’m going to share some keys that have helped me understand and establish a tried method to not only avoid these situations, but rather to make sure your startup has an attractive cap table, referring to the distribution of property among the partners, which allows for growth and the incorporation of new partners without any setbacks.

The value of the company is called equity. The ownership of this value is distributed among the partners via shares or equivalent term depending on the type of the company. Without getting into formal judicial definitions, what’s important from the point of view of the entrepreneur is that you’re distributing the value of the company. Specifically, the equity of a startup represents its future value. This idea is fundamental for understanding the spirit with which its allocation should be managed. Therefore, if this means distributing the potential future value, it will be necessary to identify who is going to contribute value and distribute the ownership equitably between them. Here again, the term equitably is essential, because if the distribution does not represent the value to be contributed by each partner, problems will arise in no time. It’s not a coincidence that the value of the property is called “equity”.

But the question here is, how to quantify the value? To help us identify and quantify the value of the contribution, I turn to the startup value chain. According to this model, the value is divided into five intimately related sections:

  • vision.
  • execution.
  • customers.
  • financing.
  • leadership.

Attending to each division, and knowing that the five elements are necessary, it seems reasonable to distribute a priori 20% of the equity to each of them, while obviously being able to adjust the weight for each specific case. In my experience, this simple criterion is what most faithfully represents the process of creating value in a startup and is the most effective in the long term.

However, even though this distribution model is useful for the initial distribution among the entrepreneurial team, it’s a good idea to bear in mind that in the future, there are going to be investing partners, managers, and key employees. Below, I’m going to go deeper into this model so that everyone can fit in.

Overview of equity distribution

The simplest and most conventional way to divide equity is in three big groups:

  • founders.
  • investors.
  • employees (options pool).

When creating the company, it’s most likely that the founders will have 100% of the equity. As time goes by and the startup grows, the founders’ share will be diluted (they’ll get a smaller and smaller percentage of the company) because they’ll cede it to new investors and employees. As the startup grows and incorporates new partners, the founders will continue to get an ever smaller share until the time comes when the majority of the ownership is in investors’ hands.

During this period, it is supposed that the company will have increased in value, and the founding team will have gone from having 100% of something that was worth very little to having 20-30% of something worth quite a lot. The crux of the matter is to always bear in mind that as long as the company wants to continue growing, equity must represent the future value to be built. And here, value does not mean economic value. Although in the end the equity will be quantified with money, actually, it is the consequence of offering the value produced in the startup to its customers.This second value, which is none other than the construction of the vision, is the essence of your startup and has the potential to transform reality and the world.

How to distribute among the founders

Once we’ve divided up the equity between the founding team, the investors, and the employees, and we know what percentage to apply to each group, we’re going to divide up the pie piece given to the founders. For this, we again turn to the startup value chain. The first step is to weigh up each one of the five links. This will depend on the type of startup. If, for example, it’s a one with a large technological base, the execution area should probably have more weight. In any case, this decision must be taken by the founding team, as it is the team that best knows where the company’s greatest challenges lie. The next chart shows each with a weight of 20%, that is, the founders have decided that each of the areas is equally important.

The next step is for the founder team to agree how much each one of the founders contributes to each one of the five links. This is a very important conversation, which must be entered into with integrity and sincerity. In general, the startup will come out of this meeting stronger, with aligned vision and expectations. The exercise is done by assigning ten points among the developers to be distributed among the different areas. For example, in the above chart, you can see that of the 10 points for vision, 7 are contributed by Founder 1 and 3 by Founder 2, and that Founder 3 contributes nothing to this area. The total for each area must add up to 10. Depending on the calculations for each link, and what each founder contributes to each, we’ll have what percentage would be a fair distribution for each founder (the last row of the table).

It may also happen that you all are surprised by the value each one thinks they contribute to the startup. If the conversation gets difficult, and it’s taking you too long to reach a consensus, it’s not worth it to try to force the situation. In any case, it’s unlikely that the startup can survive such a circumstance.

How to distribute among the investors

The share that each of the investors gets is a rule of three between the money they invest and the value of the company. That is, if your startup is valued at €800,000 and the investor invests €200,000, they will receive a share of 200,000 / (200,000+800,000) = 20%. The value of your startup before the investor adds their money is called pre-money value, which in this example would be €800,000. The value after the investor’s entry, that is, after the close of the round, is called post-money value, in our example, €1,000,000.

Obviously, calculating the percentage that belongs to each investor is very simple. The big challenge is trying to convince the investor to invest in your company and agree on a value. This process is complicated and can take between one and six months, including pitches, metrics, business plans, team meetings, due diligence, etc. Going back to the 5 links in the value chain, an investor contributes primarily to the area of financing, and probably also to marketing, with their network of contacts, or even to leadership if they have entrepreneurship background. According to how the five areas are calculated, and keeping a clear image of what the investor is contributing, this will give you a percentage to negotiate.

Another key part of the negotiations with investors is the partners’ agreement, which defines and regulates the rights and duties of the partners, their share in the equity, the administrative bodies, and everything that has to do with the workings of the startup. The partners’ agreement is a concept that is sufficiently complex enough to warrant several articles. I mention it here because in addition to what we talked about earlier, it also defines the type of shares that each partner has. Not all shares are equal; there are several types:

  • ordinary. These are normal; they give the bearer the right to vote in the Shareholders’ Meeting and to the profits corresponding to the percentage of equity.
  • preferred. These have the right to receive dividends preferentially, which, depending on the partners’ agreement, can be accumulative (if no dividend is paid, it is accumulated into next year’s). However, they may not have the right to vote.
  • silent. They don’t have the right to vote in the Shareholders’ Meetings, but they usually have the right to a minimum dividend.
  • privileged. These give greater voting rights to their bearers, meaning they have more decision-making power.

Therefore, when distributing equity, you have to keep in mind the type of shares and the partners’ agreement. My advice here is still the same. The distribution of equity, the rights, and the duties have to line up with the building of future value, as well as the common good of all the partners and employees. I’ve seen partners take advantage of the ignorance of other partners in legal matters to tip the balance in their favor, hiding their strategies behind complex partners’ pacts, or documents that were too complex and therefore not clear enough. My opinion is that this type of positioning that tries to find an advantage in the negotiations is not a smart move, since an unfair distribution of equity or a lopsided partners’ agreement towards any of the parties will always eventually come out and destroy the startup. Really, these attitudes arise from a lack of confidence in the founder team, of wanting to overprotect oneself by assuming less risk than the rest or by thinking that they contribute more value than they really do. As when distributing among the founders, these differences must be resolved with integrity and transparency, remembering the shared future that all want to create.

How to distribute among employees

It’s a good idea to reserve part of the equity to attract talent later on and compensate them with part of the company. This piece of the equity pie is called the option pool, because normally they’re a group of options about the share of equity. This means that equity is not directly granted to the employee, but rather that the employee is going to earn it in a period of time that is normally between 1 and 3 years. If the employee stays in the company that whole time, they will start to own equity. If for any reason they abandon the startup, they’ll lose their options. This resource is quite a common way to compensate the employees’ commitment.

Nor are shares given to all employees. Normally, this type of remuneration is proposed long-term to people who it is supposed will contribute most to the startup. As time goes by, the options that are offered are fewer, because the uncertainty of the startup, and therefore the assumed risk, is also smaller. For example, you could consider this option pool plan:

  • managers (CEO, CTO, CMO, CFO, COO): 0.01-10%.
  • mentors, counselors: 0.01-2%.
  • key employees: 0.01-1%.

In the case of managers, it is understood that they do not belong to the founding team but rather that they are hired later on. That is, if the founders already occupy the jobs of CEO, CMO, and CTO, these options will not be added to their equity. The necessary managers will be hired, offering them between 0.01% and 10% of the option pool, depending on their experience, their knowledge of the business, contacts, etc.

Consequences of a poor distribution schema

As I said at the beginning of the post, when the equity is not distributed equitably according to the future value to be contributed, sooner or later this imbalance will emerge, and will become a black hole that absorbs all the energy of the developers and partners. Some examples are:

  • A partner who is not in the founder team has the majority of the shares from the first round. The problem is that investors invest in people’s talent. And the only way to guarantee a long-term commitment of the talent is to give them a significant percentage of the equity. If the founder team does not have the majority of the equity, the investors in later rounds will mistrust in their commitment and will not invest, closing the door to private capital.
  • One of the founders with a greater share disagrees with the vision of the CEO who is also a founder. The problem is that the startup ends up having two heads with two different strategies. If the problem is not solved in a prudent amount of time, the five value creation areas will need to be looked at again, to see who contributes more to the startup. Normally, this situation ends with one of the partners leaving and their part being bought out by the rest.
  • A founder has stopped believing in the project after a year and decides to stop being an employee, but continues to be a partner. The problem is that if the founder doesn’t sell their part to the rest, they leave the company without the ability to substitute them with new talent, which makes the startup less attractive.
  • There is no option pool. If the startup can’t offer equity, it dramatically reduces its ability to hire new talent.

When a startup gets to one of these situations, the solution is to redistribute the equity according to the future value to be contributed. However, to make this possible, all the partners must understand the spirit behind equity. And they must understand clearly that if the problem is not solved, the company will end up closing. The maxim that the small percentage of something highly valuable is much better than a large percentage of nothing takes on more meaning in this situation.

      

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raul

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