Each year thousands of bright-eyed, bushy-tailed, would-be entrepreneurs enter startup accelerators, incubators and other educational programs in hopes of spawning a unicorn business, selling it and living happily ever after. In my experience, these folks have three main objectives in common: 1) change the world, 2) make lots of money, and 3) get their fair share. It’s this third objective, however, that can derail a startup team in spite of the potential for realizing the other two.
The equity splits discussion is often the first “deal” that founders do. And, in order to shed light on this seemingly complicated, highly emotionally-charged topic, they seek advice from the many educated, intelligent and well-meaning coaches, advisors and mentors that are part of the organization’s eco system.
Unfortunately, nearly all of the advice they receive will be bad advice, because the traditional approaches to this problem are just plain wrong.
When it comes to advising the founders of early-stage, bootstrapping startups, there are two primary problems with traditional advice. The first is that it encourages the founders to base the split on future, unknowable outcomes such as what the company will be worth and what individuals will contribute to that value. Founders have big dreams and their partners make big promises. This leads to equity split decisions loosely determined by dividing promises by dreams—not a reliable model. Another flavor of this advice will point to rules of thumb such as, “a CTO in X city usually gets Y%,” or, “the average CEO retains X% of the company at Series A.” This advice can be summarized in one word: guessing. There are many people and tools online that will help founders make educated guesses, but it’s still a guess.
The second problem with traditional advice is that it produces a “fixed” split in which chunks of equity are doled out to participants at the outset of the venture. The seemingly finite pie is split up according the above faulty assumptions and is set in stone more or less. The issue is that things will inevitably change. Team members join or leave, commitment levels change, strategy changes, fundraising takes more time than initially planned and a million other things will change making the split, whatever it is and no matter how carefully it was planned, to be wrong. A simple example: you and I start a company and split the equity 50/50 (90% of companies do equal splits), you do all the work and I do nothing.
To accommodate the fact that the initial split will almost certainly be wrong, well-meaning advisors recommend time-based vesting programs, buyback agreements, option programs, or special classes of stock—all of which are unnecessary wastes of time and money that could be much better used building the company.
Ugh. It’s a mess!
The solution is to rethink the fundamentals of what founders actually do in a startup company: they gamble.
Startups aren’t really companies, they are experiments and early participants usually aren’t compensated for their contributions. When people walk through the doors of an accelerator, incubator, or academic and community startup programs they are gambling with their professional lives and ability to generate an income. These same people, presumably, could offer their skills or other assets to established companies in exchange for cash compensation.
Value Creation vs. Market Rates
Established companies are willing to pay for a contribution if, and only if, the managers believe that they will yield a positive ROI on the investment. If a marketing manager is paid $50,000 per year, for example, the company would expect that manager to yield a return of much greater than $50,000 per year. Their decision to hire, in other words, is based on the candidate’s potential to create value. What they pay, on the other hand, is based on the fair market rate for the position requirements and the degree to which the candidate fulfills those requirements. If the employee is successful, the company will reap the benefits of the value she creates. The company, or rather the owners of the company, are under no obligation to share the excess value created with the employee. Of course, high-value employees tend to get bonuses and raises while low-value employees tend to get fired.
So, when that same marketing manager works for a startup doing similar work and doesn’t get paid, she is, in effect, betting on the companies’ future profits or proceeds of a sale (value created). The amount of her bet is equal to the fair market value of her contribution. In this example if the marketing manager worked a year and was not paid, she would be betting an unpaid salary of $50,000. Of course, she may also be paying their own business-related expenses (like travel) in which case her bet includes not only their salary, but also her expenses. Indeed, whatever she contributes in terms of time, money, ideas, relationships, supplies, equipment or facilities is a bet as long as she aren’t getting paid.
Base Equity on the Bets
A person’s percentage of the company’s equity, therefore, should logically be based on that person’s percentage of the bets. The bets represent the individual’s investment in to the creation of the business that ultimately creates value.
Here’s another way to think about it: if you wanted to buy a share of Apple stock as of this writing you would pay $150. Once you buy it, you own it and will reap the benefits of ownership which include profits paid as dividends and capital gains if you sell it. The fair market value of the stock reflects what people are willing to pay given their hopes of future value creation, that future value, however, is impossible to predict. In a startup, you “acquire” the company by building it at the combined fair market value of the contributions and, once it’s in place, you own it and will reap the benefits of ownership. In this case the employee who worked for no salary, participated in the “acquisition” of the company by helping to build it in the first place.
A Model Based in Reality
This approach, unlike traditional approaches, bases the split on easily observable, unambiguous facts rather than unknowable future values or rules of thumb. Moreover, it provides a formula for adjusting equity splits over time to keep it fair. If a part-time team member starts working full-time, for instance, that person’s equity share will automatically adjust to keep it fair.
Anyone who has spent any time around the entrepreneurship community is all too familiar with the extreme volatility of team changes, pivots, etc. Startup companies are just experiments in which the participants bet their own time and money. Founder disagreements are common and bad equity splits are the rule, not the exception. This model, also known as the Slicing Pie model, solves 100% of the equity problem and is already used in startup companies all over the world. It provides a clear formula to create perfectly fair equity splits regardless of how the company unfolds.
For organizations that foster entrepreneurship at the concept stage, teaching this model will allow founders to go boldly forward knowing they will always get what they deserve. Moreover, it will create a common understanding about fairness throughout the organization. When a culture of fairness exists, members will feel safe knowing that they will always get what they deserve—no more and no less.
About the Author: Mike Moyer
Moyer is a career entrepreneur who has started companies, worked for startups, and held senior management positions at established businesses. He is now the managing director of Fair and Square Ventures, LLC, a company that provides growth consulting and early-stage investments. He is an adjunct faculty member at Northwestern University and the University of Chicago’s Booth School of Business. He is the author of several business-related books including The Slicing Pie Handbook, Slicing Pie, Pitch Ninja, and Trade Show Samurai. He lives in Lake Forest, Illinois, just north of Chicago.
Moyer is the inventor of the Slicing Pie model for equity splits (allocation and recovery). The model ensures that all early participants in a bootstrapped startup get exactly the equity they deserve.
To learn more about Moyer’s formula for equity splits, join InBIA’s webinar on August 23rd at 11:30 – 12:15 EST. View more information and register here to claim your virtual seat!