How To Split Equity Among Co-Founders

When starting a company, one important decision to make is how ownership in the company will be shared. Because each co-founder will likely contribute different amounts of time and money to the startup, they may question what will be a fair split. Knowing how to split equity among co-founders will help to prevent conflict when disagreements about fairness arise or assumptions about each co-founder’s future contributions turn out to be inaccurate. If you need help choosing a method for splitting equity in your startup, consider contacting the experienced Arizona legal team at Harrison Law, PLLC, by calling (480) 320-2310 to discuss your options.

What Is Equity in a Startup?

Equity in a startup equates to ownership in the company, which is usually a percentage of company shares. Each company founder has an ownership stake in the company, which represents the amount of the company the co-founder owns and the portion of future profits due to that founder. Because the percentage is something directly related to the contributions made to launch the business, equity can be used to incentivize co-founders to be more active participants in ensuring the company’s growth and success.

What Defines the Relationship Between Founders and Co-Founders?

According to the Harvard Business Review, the founder’s agreement is the legal document that defines and governs the business relationship among co-founders. Essential information to include is each person’s rights and responsibilities, how equity will be split among co-founders, and what to do with equity in the event that someone leaves the company. Drafting this document can be difficult, but dealing with uncomfortable topics early can help to prevent disputes in the future.

Should Co-Founders Have Equal Shares?

Most companies start from one person’s idea. That person takes on the initial risk of time, money, and work investments to build the business. This person is the company founder. While some companies may have multiple founders, most companies will have one founder and a number of co-founders. Co-founders join the founder in the company’s preliminary stages to help build the company. Their contributions may be highly specialized or varied; therefore, allotting equal shares to co-founders can harm the company’s potential to avoid conflict.

The company’s equity will generally be split in a way that gives the founder the largest share. Co-founders receive smaller shares than the founder. However, these often reflect each co-founder’s level of contributions to the company. In a company with several co-founders, giving each one equal shares could cause disagreements about the fairness of giving the same amount to a co-founder who has not contributed the same amount of work or investment.

Factors To Consider When Splitting Equity Among Co-Founders

When deciding how to split equity among co-founders, there are several key factors to consider:

• What skill sets does the co-founder bring? What contributions will he or she make?
• What time commitment, present and future, can the co-founder give?
• What, if any, financial investment will the co-founder make?
• Does the co-founder have business connections and credibility that are beneficial to the company?
• Will the co-founder’s past and future roles in the company be different? This factor may apply when a current role is minimal but a future role will be significant, and vice versa.
• What is the co-founder’s tolerance for risk? This factor can determine the co-founder’s ability to make key decisions for the company.
• What will the company’s vesting schedules be? How will they relate to the initial equity split?
• What are each co-founder’s exit strategy preferences? The individual’s preferences may affect the overall value that the co-founder brings to the company.
• Which co-founders will shoulder more of the legal responsibilities? Maintaining compliance and handling other legal matters are important contributions that could increase a co-founder’s share.
• What emotional and psychological qualities does the co-founder have? Creating strong relationships and building a positive work environment are important contributions.
• What are the opportunity costs? When a co-founder gives up another well-paid job or opportunity to contribute to the company, his or her shares may need to reflect those costs.

How To Split Equity Among Co-Founders

There are several possible methods that a company’s founders may use to determine how to split equity among co-founders. The right method for one company may not be right for another, as the method is dependent on the type of company, the dynamics of the co-founders, and more. According to Harvard Business School’s Founder’s Journey, the percentage of co-founders who claim to be unhappy with their equity split more than doubles as the startup matures. A skilled business law attorney from Harrison Law, PLLC, may be able to help choose the right method based on your startup’s needs.

Equal Equity Split

The equal split method, which is the easiest method to utilize, may seem like a fair solution on its surface. This method may even be the right fit for a startup with only two founders who have similar goals and ideas for the business. When using this method, co-founders may develop a stronger relationship, and they may be encouraged to contribute equally to the company.

However, co-founders often contribute unequally, which can lead to disputes over fairness as the imbalance of individual investment becomes more noticeable over time. In addition, with an even number of co-founders, decision-making problems could arise in the form of deadlocks, as the equal split in equity means an equal vote. When a company cannot make important decisions, that company cannot grow.

Weighted Contributions

The weighted contributions method accounts for each co-founder’s contributions to the company. Many of the questions listed in the previous section must be answered in detail in order to quantify a co-founder’s contributions. Time and financial contributions and overall skill set will be considered. When a fair number can be applied to each co-founder, then equity can be allocated accordingly.

This method requires a lot of consideration to place a value on a person’s total contributions. Even with the work involved in arriving at what seems like a fair split, future contributions may change and shift the perspective of what is fair.

Dynamic Equity Splits

Also known as adjustable equity, this method offers the flexibility needed to account for changes in co-founder contribution levels, market conditions, or the company’s strategic direction. Rather than splitting the equity equally without consideration of anything other than being a co-founder, or splitting the equity based on each co-founder’s present and potential contributions, the dynamic method requires the co-founders to agree on a certain set of metrics or performance indicators. These predetermined standards, which can include milestones in revenue, rates of customer acquisition, or goals in product development, will allow automatic adjustments to the equity split over time.

Performance-Based Vesting

Unlike the flexibility of dynamic equity, performance-based vesting is dependent on the accomplishment of specific objectives. Vesting is typically time-based; however, this method bases the equity split on certain measurable outcomes. Using performance-based vesting, one co-founder’s equity may vest only after certain company milestones have been reached.

Role-Based Splits

When using role-based splits, the co-founders each assume roles within the company. Those roles all have perceived values, and those values will determine the size of the co-founders’ equity stakes in the company.

Other Methods

Points-based systems may be utilized for some startups. This method assigns points to each co-founder to calculate his or her percentage of equity based on individual contributions, responsibilities, and risks.

Hybrid models may be effective for some companies. These involve using a combination of an initial method, such as weighted contributions, and a different method, such as dynamic splits, to be used in the future by including a clause in the founders agreement. Another way to make changes to the equity split is to negotiate buy/sell agreements that can allow for adjustments as needed based on future valuations and contributions.

Contact an Arizona Business Law Attorney Today

Choosing a method to split the equity in a startup is one of many essential first steps. What may be right for one company may not fit the needs of another. In addition, each method has its own complexities, and implementing the method correctly can help to avoid future conflict among the co-founders. For help deciding how to split equity among co-founders in your company, consider contacting a knowledgeable Arizona business attorney at Harrison Law, PLLC. Call (480) 320-2310 to schedule a consultation today.

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This website and article have been prepared by Harrison Law, PLLC for informational purposes only and does not, and is not intended to, constitute legal or financial advice. The information is not provided in the course of an attorney-client relationship and is not intended to substitute for legal advice from an attorney licensed in your jurisdiction.