Best Practices for Founders in Distributing Equity in a Startup

Equity serves as a powerful incentive and reward that aligns contributors to the startup's vision. Distributing equity helps to formalize relationships and commitments between co-founders, employees, advisors, and investors. Establishing a fair split from the outset is crucial to avoid conflicts down the road as the business grows. However, there is no one-size-fits-all formula for every company. The distribution must be customized based on the specific roles, contributions, and value-add of each person involved.

Key Factors to Consider

Roles and Responsibilities - The equity split should reflect the anticipated workload, skills, and expertise provided. Key responsibilities like leading technology/product development or spearheading fundraising and sales deserve greater shares.

Contributions and Commitments - Equity should reward those who contribute meaningful ideas, assets, relationships, and effort required to translate the vision into reality. Full-time commitments deserve higher proportions than part-time advisors.

Risk Tolerance - Those who take on greater career, financial, or reputational risk deserve greater equity compensation for their sacrifice. Leaving stable jobs or investing significant capital calls for higher shares.

By thoughtfully assessing these factors, founders can design a motivating structure, appoint leadership roles, and distribute equity in a manner perceived internally as fair. This facilitates trust, transparency, and harmony in the founding team. Periodic adjustments may be required as contributors add further value in subsequent stages of growth.

Distributing Startup Equity is Complex but Critical for Aligning Stakeholders

Founders must carefully evaluate roles, expected contributions, risk tolerance, and other relevant factors when assigning split percentages. This helps incentivize and reward the key people that will drive future success. A fair yet flexible approach enables unity and commitment as the company scales.

Additional Tips for Fair Equity Distribution

Start with Founders Owning 100% - The people there at the beginning should always start with a fair division of a theoretical 100%. Agreement on who does what and have it in writing. It's only a theoretical 100%, but new shares will be issued later, diluting the original 100% for options for employees and shares for investors in exchange for money. Start with a Fair Division of Equity and Responsibility - Start with a plain document that divides the initial 100% ownership areas of responsibility and authority in a way that all founders agree on. Do this first before there's money at play. Writing this up and signing it doesn't have to be a contract. It may not even have legal standing, but it's important to have these discussions first, write it down, and sign it. Understand Dilution and Authorized Shares vs. Outstanding Shares - Anybody's actual percent of ownership today is their shares divided by total shares outstanding. But normally the business has some large number of authorized shares—much more than the outstanding shares—so many will be issued later. For example, initial founders divide up one million shares in the beginning, but then 100K new shares are issued for employees, which dilutes the founders. And then 300K are issued for investors which dilutes the founders. That's how dilution normally happens. You start with 100 and dilute yourself later for good reason. Never Use Equity as Reward or Payment - Never give startup equity instead of paying for services, except in point 6 below. Never give startup equity to a relative or friend. Don't give startup equity as a reward for having had the business idea or for introductions and such. Equity is for Long-Term Work or Money Only - This is restating the point above for emphasis. This is what you tell the would-be connectors, idea claimers, and assorted hangers on. You only have 100 points to give, you'll need to give some major points to investors for their money, and you need to give the rest to people who are committed to the company for a long time or for long-term relationships. Give Small Pieces to Long-Term Allies or Providers - If you want to include a key advisor, attorney, or other service provider, give them options worth no more than a point, maybe two, to be vested over a long term, such as five years, or at exit. Do this only with people who are critical to your success. And use the vesting to demand that they continue to contribute. Use Vesting Extensively - Vesting in a nutshell means you don't keep all your equity when you quit too early. Everybody who gets equity for long-term work, even founders, should be subject to a vesting schedule so that they have to be around for years to actually earn the equity. The obvious exception is money. A check buys equity. Everybody else has to earn it. So a founder who quits or an advisor who loses interest doesn't take equity or too much equity with them.

Conclusion

By carefully considering these factors and following the additional tips provided, founders can ensure a fair and effective distribution of equity in their startup. This not only aligns incentives but also fosters a collaborative and committed team as the business grows.