So, you have a million - nay - a billion-dollar idea you’re trying to get to market, but you don’t know where to begin. For starters, building a strong foundation might begin by defining the business idea and setting out a plan for the future in writing through a Founders’ Agreement.
What is a Founders’ Agreement?
It’s probably exactly what you think it is: “A clear agreement between founders to determine their rights and obligations towards the company and each other.” This means that when you create it initially, you are using it as a baseline for your company’s operations and relationships.
One of the things this agreement includes is the equity breakdown of ownership between the founders. This determines who owns how much of the company. So, as you can imagine, this is a significant clause in the agreement. Your initial thought may be to split ownership equally between the founders but hold your horses!
There are pros and cons to the way you break down your ownership - it isn’t meant for everyone. In a lot of businesses, the roles of the founders vary, and diminish or grow as the company develops. It is because of these developments that it is imperative that you carefully consider how equity is broken down in your business. From here on, this article will discuss the types of equity splits and their uses. Hopefully, by the end, you have an idea in mind about what best suits your needs.
Equal Equity Split
An equal equity split is simply giving everyone the same amount of ownership in the company. So, if there are 4 founders, each founder gets 25%. Simple enough right?
This simplistic approach may seem like the fair thing to do because you all had a part in creating the company, but it also has its negatives. For example, the equal split allows each founder to have equal control over the business, but what if one owner does less than the others, should he still own the same amount as everyone else? Issues like this arise all the time, and because of this there are so many articles and reports that dissuade investors from doing an equal equity split just for the sake of doing an equity split.
But all is not bad with an equal equity split, since they allow the risk of the business to be equally split among all party members, and it ensures that everyone’s voice be heard when making decisions.
Varying Equity Amounts
The alternative is to split the equity in an uneven manner. There are a few methods and factors you could use to go about doing this:
- Break it down by capital contribution (amount of money each partner put into the company)
- Divide it up by responsibility (how much work and what roles each person is going to do)
- Base it on the skills and expertise that each person brings to the table
- Use the intangibles like knowledge, experience and competence
- Divide it using the commitment of each person
- Factor in additional details; like rights to the IP, business relations, understanding of the market, and other things which can make a founder valuable to the firm
- A combination of the above methods
Based on your determination of what works best, these methods could ensure that each founder only gets as much as they deserve in the firm.
So, I’ll conclude my bit about equity splits with a simple analogy. Imagine purchasing a pizza with 8 slices among 3 of your friends. When splitting the pizza, the first thought is for everyone to get 2 slices each, right? That seems fair if everyone split the bill equally - but what if you didn’t? Let’s say one friend didn’t pay as much as the rest, another friend covered the difference, and you drove the car there and back to pick up the pizza. Now, how would you divide it? Everyone is going to divide it a different way, because everyone has their own views. Your business is the exact same way, except now you are dealing with large sums of money which can have a significant impact on the lives of those involved. So, you really have to think carefully before deciding on how you divide your shares.
There is no correct answer about how you split your equity, every firm is a snowflake (yes, even yours!). It is due to each firm’s unique qualities that there can’t be a single definitive way to split equity. You can always learn more by digging into our annotated Founders’ Agreement template online and then consulting a lawyer and/or an accountant.
Take-aways
- An equal equity split might not always be the best option
- Carefully consider how you will split equity based on variety of factors