By default, most startups just split their equity once and live with it. They may decide on an equal split or they may devise some reasons why the split favors one partner more than another. But when all is said and done, they make a split, and they move on.
This method is quick, simple … and usually a horrible idea!
Before we go on, once again we need to hammer home a point in excruciating detail so that the rest of this entire Phase has true context.
A quick and “fair” split avoids some of the most important considerations in splitting the equity at all. It entirely overlooks how to properly value the contributions of each member now or over the long term. If we just make a split and forget about it, we make the single biggest bet we possibly can on our stakes in the company with no recourse or consideration.
Right now we have the absolute least amount of information as to how we will each contribute over the long term. Yet we’re about to make a finite (one-time) decision with little to no data. All we know is we are both working on this. That’s it. We have a ton of options to account for these changes, so let’s agree to explore those first before we make a giant, blind, one-time bet.
Instead of explaining how to do a one-time split, let’s discuss how to avoid doing a one-time split or at the very least provide a bit more context as to how to split more fairly.
Let’s start with a little scenario that we can use to compare how equity gets split:
Imagine you and I went to dinner. I had two appetizers, a crab cake stuffed inside a filet mignon wrapped inside of a lobster set atop a bed of oysters dripping with truffles. I paired my ungodly monstrosity with a $400 bottle of wine. You had a Caesar salad and a water.
When the check comes, I suggest we split it 50/50.
My logic is that there are two of us here, we both went to the same restaurant, we both enjoyed dinner together, and it only makes sense that we split the check evenly.
Are you going to say “yes” to that? If so, let’s grab dinner sometime soon! If not, let’s talk about why splitting something far more valuable than dinner 50/50 without first considering our respective contributions is a serious issue.
To do this, let’s say we’re the only two partners in the business. We agree on a 50/50 split because we think that sounds fair. The logic goes something like this:
If that sounds familiar, it’s the basis for almost every even split. It’s a combination of not knowing how to properly value contributions with a general awkward feeling of not being able to communicate any other method. “Even” wins simply by being the path of least resistance, which is ironic considering it’s setting off the most difficult path possible for everyone involved!
As it happens, an even split is perfectly OK if it turns out that over the long run we both contribute equally to the business. But really, how likely is it that we’ll do that? Not very likely. Yet we’ll spend the rest of our business lives wondering why we didn’t take this issue much more seriously.
Splitting equity – fairly or otherwise – should come down to just 3 critical questions:
Before we just “set it and forget it” with our equity, we simply MUST ask these 3 questions because they are the only way we can ensure something remains fair. Notice we’re saying - “remains fair”. That’s because the split we decide upon today may not reflect the long-term contribution to the company. Hell, it may not even properly reflect our initial contribution to the company.
What’s important is that we set up a framework, even with our one-time split, to properly evaluate and manage the split over time.
To begin, let’s walk through each of the big questions so we have a good sense for how valuing our contribution can work in a fair and useful way.
The biggest question we will encounter is what we’re each contributing to the business at inception. There are about a dozen different types of contributions we can make, but they generally fall into two buckets – cash and non-cash contributions.
Actual cash invested into the company that is spent.
Time (sweat equity), relationships, the idea, tangible resources.
The process of valuing our contributions is about as easy as tallying up the sum total of everyone’s contributions (present and future) and weighing them appropriately. For the moment let’s just focus on the contributions people are making within Year 1. We’ll talk about how ongoing contributions will work when we move to Question #2.
All of our contributions are going to be based on real world, Fair Market Values – which means we don’t get to just “make up” our contribution based on a number that just “sounds good”. A surprising number of startups go this route.
Instead, we are going to use real world values for every contribution. An intern doesn’t get 20% of the company just because he happened to be present on the day it was founded. Each person has to be able to convert their contribution into a real-world value that can be properly accounted for.
In addition to showing an actual value for contributions, it also creates real accountability. If we just give Feargus the intern 20% of the company but have no way to tell if that 20% was ever earned or contributed, it’s a bad deal. Real world values are far easier to track because they look and feel like money – which they essentially are.
Before we begin valuing our contributions, let’s first understand how our contributions are calibrated for the type of risk a startup inherently has.
Not every contribution is created equal. Some contributions are simply worth more than others based on scarcity. For example, $1 of cash invested is more valuable than $1 of time invested for a multitude of reasons. It’s more scarce, it’s more versatile (can be used to purchase many things), and it’s harder to replace. If we’re not sure, let’s try starting our company with purely “time” to pay other people and see how far that goes!
All contributions have a risk associated with them, given the nature of our business. The risk of investing $1 of any contribution into a startup is much higher than using that same currency for investing in publicly-traded stocks or using a resource such as time to simply take a salary. Therefore, we apply something called a “Value Multiplier” so that cash and non-cash contributions can get weighted a bit differently.
We don’t need to get too complicated here. We simply apply a value multiplier of cash versus non-cash:
Don’t agree? No problem. We can adjust the modifiers to be anything we want – or use none at all. The intent here is to value the risk someone is taking by investing those assets into our business at such an early stage. This will become even more important later as we value the contributions of folks beyond ourselves, such as advisors, contractors and of course, investors.
Cash contributions are the easiest to value. We take the value of the cash invested, multiplied by the “value multiplier” and tally up the actual value.
There are a few caveats here.
In order for cash to be officially “contributed” it needs to have been transferred to the business. If I say “I’m committing $1 million to the company” but only transfer $100 into the account, I haven’t really invested $1 million. I need a mechanism to “commit” the capital, which can be as direct as transferring into the company’s checking account (which is what an investor would do) or at least having a legal agreement that either requires I put the remaining balance in or have my contribution value forfeited.
We could make an argument that cash isn’t truly committed until it’s spent (even if it’s in the bank account) but generally we may have a harder time managing that provision. What matters is that we agree on a point of transfer that everyone agrees is “committed” versus “promised”.
Sometimes the investment may come in the form of getting a bank loan or other securitized investment. In almost every case this will require someone to secure the loan by virtue of signing for it personally. In that case the question becomes, “Should the value of the loan be treated as ‘cash’ and if so, should the person who secured it get the benefit of the cash value even if the business is paying it back?”
It’s a good question and in this case there are a few answers depending on how everyone involved (particularly the person signing) feels about risk.
Each option allows us to calibrate for how all parties assess the riskiness of the loan as well as the probability of it being paid off. Since the signing party is on the hook for the loan, whether or not it came out of their bank account is irrelevant – they still have a balance to account for.
Anything that isn’t cash falls into the non-cash contribution. Most of this involves time invested, but can also include things like relationships, office space, inventory, or the idea itself. Each of these mechanisms tends to have a fair market value that we can approximate which makes our approach fairly standard.
There are some small nuances to how each asset type is treated, so let’s walk through the most popular contributions first.
The most common investment amongst startups is time. In order to value time we take the average market rate we would be paid (relative to this industry, geography, and stage of the business) divided by 2,000 hours in the year and then multiplied by the number of hours we will commit. This is most likely going to change over time, which we’ll deal with in the next section. For now, let’s focus on our initial commitment.
Remember that our value contribution of time needs to be correlated to what our startup can reasonably pay. If a CEO otherwise makes $1 million per year working at a publicly-traded company that doesn’t necessarily mean it’s a $1 million contribution to a startup because a startup may not be able to use that same skill set nor would they be in the stage of their business to offer that salary. There’s no perfect formula here, we have to use some reasonable judgement.
Sometimes providing a connection to a potential customer, investor, or employee can have a real contribution value. The trick here is that we apply a “market rate” for that contribution once it has been made, not when it’s still being considered (same as all other contributions). As such, the contribution would need to be “paid for” once it’s consummated.
If the contribution was a connection to a major customer we would offer a commission for the introduction, and perhaps more if they facilitate the full sale. That commission rate should be discussed so that an actual dollar value can be assigned. The two factors here are “what’s a market rate for this type of transition” and “what trigger confirms it has been provided?”
Some items will have a very “real” fair market value such as office space, equipment, inventory and hard goods. Offering these products can have what appears to be “cash value” however in most cases they don’t have the same versatility as cash and therefore don’t command the same value premium.
There’s a whole category of intangibles that we will often also consider based on our particular situation. The most common one is “the idea”, although this could be extended to anything that falls outside the scope of easy-to-value assets.
Note that ideas and intangibles may not require a Value Multiplier to be used since they often don’t have any “risk” associated with their contribution. The Value Multiplier is mainly targeted toward contributions that otherwise have a market value that would be rewarded without this risk.
In this case the best way to value the “idea” is to think of it like a licensing deal. “What would it be worth for us to license or buy this idea?” We can’t say “I have an idea that could become Facebook. Facebook is worth $100 billion, so my idea is worth at least $100 million.” No, it isn’t. The execution, capital invested, and time invested over the next decade is what makes the idea worth something. Right now the value of the idea or other one-off should be considered a one-time cost based on its net present value.
“I have an idea for the next Facebook. I’m willing to license it to you for $50,000.”
We can’t sell something beyond what a startup can pay for it now, and if “buying the idea for $1 million” seems like a fair price – so be it. But we should be mindful that everything has a price and it should be translated to real world dollars today, not “what it could be worth someday.”
Now that we understand how to value each contribution, all we have to do is sum them up to get a total Year 1 contribution for each member. The calculation uses the intended Year 1 contribution, multiplied by the “Value Multiplier”, to show a total contribution to the company.
Here’s an example of my contribution to the company in Year 1:
Category | Base Contribution | Value Multiplier | Total Contribution |
Time | $25,000 | 2x | $50,000 |
Cash | $10,000 | 4x | $40,000 |
Idea | $10,000 | None | $10,000 |
Total | ~ | ~ | $100,000 |
In this instance I’ve contributed cash, non-cash and “one off” contributions (the idea) which each have their own multiplier. This creates a $100,000 contribution to the company.
When we calculate everyone else’s contribution in Year 1 we will use the same formula. This will help us determine how equity splits will work relative to the contribution amount each person will make in Year 1.
Here’s an example of how our respective contributions might break out in Year 1 (with multipliers already factored):
Category | Me | You | Feargus the Intern |
Time | $50,000 | $80,000 | $20,000 |
Cash | $40,000 | $10,000 | $0 |
Idea | $10,000 | $0 | $0 |
Total | $100,000 | $90,000 | $20,000 |
% of Total ($210k) | 47.6% | 42.8% | 9.6% |
As this example indicates, your time is coming in at a higher value, either because you have a higher market rate, or you worked more hours. Feargus isn’t contributing cash so he’s simply paid based on his relatively low market rate, but still gets a multiplier based on the risk of non-cash contributions at 2x.
In order for this process to work, each year we will need to propose our intended contributions and then audit those contributions at the end of the year. This way we can compare what we intended to contribute with what we actually contributed.
We do this in two steps. We start by proposing our contribution at the start of the year, and then at the end of the year reviewing last year’s contributions while making new ones for this year.
This is where this method is most useful!
During the formative years in a startup, it’s damn near impossible to project how many resources any one person would put into the startup. So many things change so quickly, especially when we’re defining the job and the company as we show up each day. This is also why making a one-time equity split based on Day 1 is almost certainly going to fail - we have no option to refine our contribution.
Yearly proposals and audits keep everyone honest and essentially forces a conversation about commitment for the coming year. It’s a healthy dialogue all around. Also, if everyone knows they have to actually stand by their commitments (because they are audited) it provides for a much more consistent contribution.
At the start of each year, and certainly when we initially set up the cap table, we’re each going to propose our contributions. If other participants join later in the year – no problem. Just pro-rate the contributions for Year 1 and then we can get them on the same cycle as the rest of us.
The proposals give us an indication as to how much stock we will earn, but also give us a basis for comparison at the end of the year. For example:
If I commit $10,000 to the company (which would give me $40,000 with a 4x multiplier) but only ever invest $1,000 into the company, we would make the necessary adjustments at the end of Year 1.
An important part of this exercise is each of us considering our intended commitments and locking them down publicly. It’s really easy for folks to “forget” what they said they would commit early on and then later adjust their memory to their current contribution. The proposal each of us makes now should be time stamped and circulated to all participants, so we have a public record of what was said. We don’t need a scribe preparing a scroll at the town hall forum – a group email works just fine!
At the anniversary of our first full year, we’ll sit down and compare our contributions to our proposals. Sometimes this may take all of 5 minutes – we’ll both say “Yep, we both stuck it out 100% and it’s all good.” And we’re done.
After Year 1, though, it’s not uncommon for that to be a very different conversation. In many cases we may find that our intentions from the outset of Year 1 specifically are very different than where we landed. There’s a good chance that the one developer who was so excited about helping us build the mobile app got completely derailed in Month 2 and put in 20% of the effort they had committed to. Now is the time to audit that contribution and have a discussion about next year.
Within the audit we’re going to calculate each proposed contribution versus the actual contribution and true up the numbers.
This is especially important if certain members have made contributions beyond what was proposed, such as contributing more cash or working substantially more hours. Unless there is a mechanism to deliberately recognize and reward members – these contributions will feel “lost” - and that’s a problem.
After our Year 1 Audit, we may revisit our contribution table and have it look like this:
Year 1 Contributions – Post Audit
Category | Proposed | Actual | Variance |
Time | $50,000 | $20,000 | ($30,000) |
Cash | $40,000 | $60,000 | $20,000 |
Idea | $10,000 | $10,000 | $0 |
Total | $100,000 | $90,000 | ($10,000) |
Now the math starts to get a bit different because each person’s contribution will be relative to everyone else’s contribution.
When we initially proposed our contributions, the total of all of our contributions was $210,000. Yet at the end of the year each of our contributions will likely have shifted a bit. If I were to contribute 10% less than I proposed, but everyone else also contributed 10% less, our relative positions would stay the same. This keeps things very fair relative to each actual contribution.
After the Year 1 Audit our team contributions may look something like this:
Category | Me | You | Feargus the Intern |
Proposed | $100,000 | $90,000 | $20,000 |
Actual | $90,000 | $120,000 | $20,000 |
Variance | ($10,000) | $30,000 | $0 |
% of Total ($230k) | 39% | 52% | 9% |
Here, Feargus stuck with his original commitment and came out about the same. But your commitment wound up being much larger than anticipated, even though mine wasn’t far off, and relative to Year 1 you earned more of the stock. That’s fair. The more you contribute the more value the company should be getting, and the more you should be rewarded.
We’ll keep a record of the audit that we will also share amongst all the members (date stamps matter) whereby each member needs to confirm that they have seen the record and agree with it. If someone doesn’t agree, the conversation needs to open up about why.
The first year audit may be more challenging than the following year only because it’s the first time people have to come to terms with both their contributions, but also how their relative stock rewards are affected. It’s a good exercise though because it directly relates to how folks view their participation.
After our year end audit we will then submit a fresh round of proposals each year, recognizing that what we intend to propose and what we can deliver upon will probably get more accurate year over year. In some cases we will just literally copy/paste our proposal from the previous year and be done with it – that’s fine.
What matters is that we have a moment to think about it and discuss it. There’s something immensely satisfying about seeing each member on the team “re-up” for another year and knowing that everyone is as committed as we are.
Conversely there’s something incredibly useful in knowing that we have a chance to deliberately dial back our commitments if we can see that life is getting in the way of sustaining them. That’s OK! There’s nothing wrong with saying “Hey, I’m going to have to dial back my commitment 50% this year so that I can continue to work at my day job as well.” The yearly proposal should be a time of reflection and support.
This process is fairly straightforward and should continue each year until we have reached our total “Contribution Window” (typically 3 years) which leads us to our next question of how to set a contribution window length.
Oh look, whaddya know – that’s next!
The challenge with most well-intended initial contributions is that they rarely pan out.
I may say that I’m going to work full time on our startup for the next 3 years, but until I actually do, I shouldn’t be rewarded with the “promise of a contribution”. Therefore, we need to split out our contributions separately from Year 1 to account for a million things that will probably change.
We also have to consider the fact that whatever I contribute in Year 1 isn’t necessarily the same as what I will contribute in Year 2, or Year 3. If we only use a single year to account for the entire growth of the business, we may disproportionately reward members who happen to have more value in Year 1 but don’t necessarily continue to pay in that value in subsequent years.
There are a few important things that invariably change as the luster of Year 1 begins to fade and we buckle down for the long journey. Unless we account for these changes going into our split, we’re going to wind up with a really lopsided split that reflected a moment in time (Day 1, Year 1) instead of a total contribution.
This is the most common change and though we’ll deal with this when we tackle “Question 3: How do we make adjustments later?”, it’s worth at least noting because it’s so common. It’s very likely that any contribution folks make within the first year may not even make it past the first year. That means awarding someone a percentage of equity based on what we thought they would contribute in Year 2 or 3 is a real challenge.
In Year 1 we often need lots of resources to help get us started – legal, marketing, accounting, engineering, design – and many others. In Year 1 those were critical to getting launched - but their relative value will likely change once we’re up and running. Our lawyer might be the most important person when we’re in need of thousands of dollars of legal work to get started, but that doesn’t mean her relative contribution will be the same in Year 2 and beyond.
In Year 1 I may have invested $50,000 into the business as well as my time. But I didn’t invest another $50,000 in Year 2 – so wouldn’t my contribution go down in Year 2? (Answer: Yes… yes it would). We need to make sure we’re not projecting the value of my investment in Year 1 to be the same in Year 2 and beyond.
Many of our contributions will be one-time in nature, typically in Year 1. Those tend to include things like the idea, relationships, cash investments and other resources. If we simply project our Year 1 contributions as if they were being made every year thereafter, we’re going to regret it later. We’ll discuss that in a moment.
The emphasis here is to understand how important it is to split our contribution up over a few years so that we can account for some likely changes that will occur as the business evolves. If you and I both split the business 50/50, we want to make sure that our contributions remain 50/50 on an ongoing basis!
If we know all of these changes will occur, we’ll want to account for those changes deliberately by using a 3-Year Contribution Window. That means we’re going to add up our relative contributions in Year 1, 2, and 3 separately to account for potential changes over time.
Here’s an example of how my contribution in Year 1 may change relative to Year 2 and 3:
Category | Year 1 | Year 2 | Year 3 |
Time | $50,000 | $25,000 | $25,000 |
Cash | $10,000 | $0 | $0 |
Idea | $10,000 | $0 | $0 |
Total | $70,000 | $25,000 | $25,000 |
Notice how my commitment in Year 1 is almost 3x higher than my commitment in Years 2 and 3. If we were to value my entire contribution relative to just Year 1, we’d be wildly overcompensating. That’s great news for me, but not so great for the rest of the team!
What changed?
In this example, the amount of time I invested in Year 1 was higher than Years 2 and 3. Perhaps I ran out of savings in Year 1 and had to get a part time job in Years 2 and 3 which would reduce my contribution.
When we take a look at my cash contribution, I was able to rustle up some cash to kick off our launch in Year 1, but after that I wasn’t able to contribute more cash after that. I also had the initial contribution of the genius idea in Year 1, but I don’t get any value contribution in subsequent years for my genius in the first year.
Now we can see that without a mechanism to capture the actual value of the contribution over a period of time, we may disproportionately split our equity based on some wonky assumptions.
Using a Different Contribution Window
If for some reason we feel like 2 years is a better reflection of the contributions of our team – great! We can also extend it to 4 years to make it sync with our vesting windows (although not necessary). It’s also possible to do this in just one year, with the contribution windows being every 3 months.
The duration of the contribution window isn’t the most important point here. It’s having a contribution window at all! Our primary focus is giving ourselves a check valve so that if we make some horrendous miscalculation about how members will contribute, we have a way to correct for it. We also don’t disproportionately award long term equity to short term contributions.
“Hey wait – doesn’t “vesting” solve for the problem of non-contributors later?”
If we were paying close attention earlier, we’ll remember we talked about stock vesting over a period of 4 years to allow equity to be returned if someone doesn’t stick around to make their full commitment. That’s all well and good, but that doesn’t account for how much stock they earn in that time.
The 3-Year contribution window determines the value of each member’s commitment. Vesting is simply a mechanism to return whatever they haven’t earned, no matter what the value.
Up until this point we’ve found a formula to fairly value our contributions. We’ve also put a 3-year window (or whatever value we chose) in place so that we can adjust those contributions over time. Now we have to figure out how we’re actually going to make those adjustments over those 3 years.
The following years (and adjustments) work fairly similarly to the first year with one exception – the following years may see our equity swing quite a bit one way or another, and that tends to freak people out. Technically we should all support the contribution we set out to make and everyone gets what’s expected, but we’ve already established the fact that this almost certainly won’t happen.
We’re going to need to make some adjustments over time, but we’ll want to make sure we have some expectations for how to make them fairly and what to do in case we want to prevent a massive swing in equity.
Each year we will sit down and review each member’s contribution relative to the other founding members of the company. During each review we will compare the intended contribution of each member with the actual contribution and make adjustments, recognizing that in some years the adjustments may create a bigger swing in favor of one member.
Our review of my contributions after Year 1 might looks like this:
Category | Proposed | Actual | Variance |
Time | $50,000 | $20,000 | ($30,000) |
Cash | $40,000 | $60,000 | $20,000 |
Idea | $10,000 | $10,000 | $0 |
Total | $100,000 | $90,000 | ($10,000) |
% Equity Earned | 47.6% | 39% | (8.6%) |
As you can see, my contribution isn’t that much different – but it’s different. If we weren’t reviewing this closely, I would have earned almost 9 more points in the company that I didn’t actually contribute. This compounds with each year that goes by, so those little differences can create large swings.
To be fair, it’s not always easy to track and calculate contributions like time or relationships, so the review may require some honesty and accommodation if there is a real issue between proposed contributions and tracked ones.
In Phase 2 we discussed the creation of an employee “Stock Option Pool” that would be set aside to award future employees based on the ongoing contributions that they make to the company as it grows. The Founder Stock Pool can work in the same way, only it can be used to mitigate how much our contributions affect our equity stake over time.
We’d use a Founder Stock Pool if we were concerned that our individual equity stakes may be too much at risk in the future. We may recognize that there could be swings in the future, but may want to lock in a “minimum guaranteed stake” along the way.
Here’s a super simple example:
We each own 50% of the company. We agree to reduce our stakes to 40% each and contribute a total of 20% (10% from each of us) into the Founder Stock Pool. Based on our future contributions beyond Year 1, we will award the additional 20% dynamically over time based on actual contributions.
In this system we each get a minimum committed amount of stock (the 40%) but we also have an incentive to earn the rest of our contribution as we promised. If we don’t contribute what we intended, we don’t feel bad about the outcome because the system will automatically reward those that contributed more.
In this case, when we review our contributions in Year 2 and beyond, we are only talking about making adjustments to the awards in the pool – nowhere else. If you put in 90% of the contribution in Year 2 then you would earn 90% of the pool (which is 20%). Each of us would always still have our base 40% relative to each other.
We would adjust the pool amount again in Year 3. Each adjustment is essentially a “temporary” adjustment until we reach our “Cutoff Year” in Year 3 which we’re about to explain.
Note that we don’t have to have a stock pool. We can absolutely let our stock contributions change each year relative to the total contribution. There’s nothing wrong with that. The Stock Pool was mainly intended to limit the swings in our equity awards over time.
In our examples we’ve been using a 3-Year window as the target for valuing everyone’s contributions. Again, we can use 2 years, 4 years or 12 months – depending on what feels right. That said, our determination on how many years does matter. If we agree a 3-Year window is the right move, then at the end of Year 3 – that’s our “Cutoff Year”.
After that point whatever we’ve earned gets locked in. That doesn’t mean it automatically vests, or that there are no possible provisions to lose that equity, which would be driven by things like our Operating Agreement in cases of a Termination for Cause or similar issue. That simply means we’re done calculating our founding member shares dynamically.
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