With the incorporation of your company and plans to start operations, you may be considering how to divide up the ownership of the business. There are many factors that go into who, how much, and when to allocate stock to the founder and other early team members. These all play an important role in figuring out the percentage ownership of the company.
How to distribute equity among founders and early team members?
This is a question that many founders have in their minds when starting a new business. Many factors come into play when a company decides how to split up the equity amongst its founders. Other founders may be hesitant to join the company until a concrete plan is formed for how much each founder will get of the company, and the terms involved for the vesting schedules.
Additionally it can be hard to assess the ultimate value and contribution of each team member in the beginning.
1. Consider the Roles of Early Team Members
Let us first look at the key founders of the company. Usually the individual team members have a good idea on what their roles are when the company starts. For instance, one team members would be the CEO, CTO, Operations manager, and other suitable positions for each.
Despite this, a founder might play a key role in the initial product development but might not be a great CEO in the long run. So the first step that the founders would have to take is to find out what their general stock ownership is. It is important to do this so all the roles and expectations are clear for each member. Defining these roles would also help in the growth of the company in the future.
You might consider splitting the equity based on the company roles. But before doing this, the team needs to know that there would be unintended consequences of this, and possible tense reallocations in the future when investors join the company.
Additionally, the founders who join in the beginning would feel that they need to be rewarded for the risk they take, relative to a person who joins after a milestone is achieved. That is where you will have to work everything out and have frank discussions to decide the roles of each member.
2. Advisors, Consultants, and Contractors Projecting Forward
Once you have set the roles of each founder, it is time for you to figure out the shares you will be offering to the contractors, consultants, and advisors at the early stages. And discussing the percentage you are supposed to offer them is not easy during the initial days.
This is a time where no shares have been allocated to outside investors, nor has there been any post-financing stock pool established. So, there is no meaning for you to have any conversation about the percentage of ownership here. And to make it easier for you to choose, here is an example:
Let us assume that a management team with 3 founders and an advisor are discussing and trying to work out the share allocations. They begin with a $500K convertible note round that would be converted in the next equity round without any discount (for simplicity sake). And with this, the founders come to a decision to raise a total of $2M which would include the debt conversion in the Series Seed funding after 18 months with an $8 million pre-money valuation.
Here, the founders also make an assumption that the investors would want an available equity pool with 10% of the future grants after closing. Additionally, the corporation would have already issued about 5% in the options along with it. In the end, let us say that the complete diluted share count at the time is 10 million shares. And the advisor wants 1% of the company after the financing.
Using this, here is how the cap table would look like:
|No. of Shares||Post-Financing Ownership %|
|Founder 1 (CEO)||2,500,000||25%|
|Founder 2 (CTO)||2,500,000||25%
|Founder 3 (Operations Manager)||1,400,000||14%|
|Series A Investors||2,000,000||20%|
With this, the founders now have a proper stock allocation plan right from the beginning. Although this method is not precise, it is a reasonable way of starting out. And do not forget to add a vesting schedule to be secure, in case one of the players decides to exit early from the company.
Factors to consider for how much stock should be granted to founders
With a simple example explained above, let us understand in-depth the factors to consider for determining how much stock should be granted to the founders. The equity split is normally different in every situation, but this would help you get an idea of how to do it.
Here are some factors that are taken into consideration for splitting the stock between founders in a company:
1. Who came up with the idea?
The first thing that you need to consider is, whose idea was it? The person who came up with the original idea would get a premium. Additionally, if this person is also the one who started the early development and gathered the team for the company, they would get an additional premium too. In short, based on the contributions in this area, the ownership of the company is increased by 5% to 30%. And if there is only one founder, they would get 100% equity at the idea stage.
2. Stage of the startup
The company will grow from the idea stage to the seed stage, and hopefully to Series A and then an IPO. This means that the company will get more funding in exchange for shares. In this case, one of the founders in the company would have their ownership percentage reduced. So whoever is going to be in this position has to be ready. There would be cases where the founders would have to reduce their ownership to a large extent for growing the business.
3. Salary or no salary
It is not uncommon for a startup founder to settle for a reduced salary during the starting days. And due to this, they are usually offered more ownership in the company for foregoing a salary in the beginning. But, some experts in the industry feel that this practice is not wise as you cannot estimate the correct amount of equity to give in turn of the sacrificed salary. And this practice can cause issues further with accounting, tax, and withholding. So, decide wisely.
Normally people who have an important role in the company get the most stake over others. This means that a CEO or CTO would get a higher stake as compared to an officer. So for considering the share of equity amongst the co-founders, you can think of their anticipated role in the company on the basis of their degree of skill, the company’s requirements and their capability.
Just remember that the roles and the company’s needs would change as time passes. Therefore distributions based on this entirely wouldn’t be a good idea.
5. Nature of contribution
A founder can contribute different things to the company which includes: ongoing work, business expertise, capital, patents, or the business idea. Understand the nature of the contribution and find its value to distribute the shares based on it. For a person who adds in capital to the business, you can consider giving them more shares as compared to the others. On the other hand, you can also distribute equity based on the level of work contributed by each of the founders.
6. Money or funding (External investors)
One of the commonly accepted formulae for distributing equity within the hierarchical company is:
In the case of multiple phases of investments
- Founders: 20 to 30 percent
- Investors: 50 to 70 percent
- Option pool: 10 to 20 percent
In the case of a single phase of investments
- Founders: 50 to 70 percent
- Investors: 20 to 30 percent
- Option pool: 10 to 20 percent
When founders come together to start a company, each one of them comes from a different situation. While one might be financially stable, another might be unemployed before this. Situations like these would impact the amount of equity they ask for. To keep the plan moving, you should be ready to give an attractive offer.
8. Part-time or full-time
It is obvious that a part time founder would get a smaller share of equity when compared to a full-time one. This is because this person would take on a lesser risk as compared to full-time founder. So, the part-time founder would get half the equity that the full time founder gets, or prorated for their work put in.
Factors to consider for how much stock should be granted to the team members
For you to be able to offer your first employees with equity, you will have to see that they feel the emotional attachment with your business idea, the company, and its product. When an employee feels this way, they would happily work more for the company.
In addition to this, the percentage of equity that the employee gets would depend on factors like how early they join, their domain of expertise, how important the person is to the company, whether or not this person is replaceable, the connections this person has and their experience. In case the employee is irreplaceable, an equity premium can be considered.
How dilution affects employee equity?
The percentage of equity that the company member gets would reduce by time as more investors join the company. This is called dilution. Let us take an example where an employee starts with 5% equity. When the company undergoes two funding rounds, the employee’s stock would be reduced to 2/3rd or even ½ of the original percentage with each funding round.
So, here is the truth. An early staff of a pre-funded company that eventually raises funding in the future can expect to have their ownership diluted in case the outcome is positive. And in case the outcome is negative, the employee might have to expect nothing more than what is important to keep them at the job if that is what is needed in the acquiring company.
In short, you need to carefully work on the distribution of the stock to the early team members. A lot of things are considered and nothing remains the same when the company grows. Not sure if you really need to issue shares to founders in your company? Check out the next knowledge-based article to know more!