Splitting the Pie: Looking Forward or Back
A common issue every entrepreneur faces is how to split the equity pie early-on. A recent founder discussion reminded me of my first company and the pie-splitting process -- it wasn't pretty. Our process incorporated elements of:
The result was a roughly equal split among 5 co-founders (surprise!), with some minor re-allocations as everyone's contribution became clearer in those first few months. Although it worked mathematically, the process could have been better and some of those early decisions were a sore-spot for years to come.
This topic could support multiple posts on the various trade-offs, but for now I wanted to share how investors and founders often differ in their focus. Specifically, founders place greater weight on past contribution and investors place greater weight on future contribution. Having been on both sides of the table, I understand why this happens, but it still surprises me when it comes up.
Why do entrepreneurs place so much weight on past contribution?
Because they are the ones who have invested their whole life into the business. They want to be rewarded for that investment. They see clearly that the business wouldn't be where it is -- poised to create more value -- but for their early commitment. Past contributions are also already in the record books, not some uncertain measure of future value.
Why do investors place so much weight on future contribution?
Because investors are measured/rewarded only on creating future value. As such, every decision about stock/option grants etc. is measured against whether the shareholder value created will exceed the dilution of that grant. Of course, investors have to acknowledge past contribution to maintain harmony and ongoing commitment, but that isn't the driver of their equity decisions. Investors also see a difference between number of shares and value of shares -- whereby, the growing value of shares rewards past contributions instead of the need for additional shares.
Who is right?
They both are to a degree. In fact, the entrepreneur carriers a bit of both viewpoints because they are both founder and shareholder. I can make the argument for both sides, but the important part is just understanding the different perspectives. Doing so will help with investor discussions, but could also help with early founder pie-splitting.
- who created the founding idea
- who had seed funds to invest
- who had time/effort to invest
- who had networks/relationships to invest
- what are expected ongoing roles (e.g. CEO, silent founder etc.)
The result was a roughly equal split among 5 co-founders (surprise!), with some minor re-allocations as everyone's contribution became clearer in those first few months. Although it worked mathematically, the process could have been better and some of those early decisions were a sore-spot for years to come.
This topic could support multiple posts on the various trade-offs, but for now I wanted to share how investors and founders often differ in their focus. Specifically, founders place greater weight on past contribution and investors place greater weight on future contribution. Having been on both sides of the table, I understand why this happens, but it still surprises me when it comes up.
Why do entrepreneurs place so much weight on past contribution?
Because they are the ones who have invested their whole life into the business. They want to be rewarded for that investment. They see clearly that the business wouldn't be where it is -- poised to create more value -- but for their early commitment. Past contributions are also already in the record books, not some uncertain measure of future value.
Why do investors place so much weight on future contribution?
Because investors are measured/rewarded only on creating future value. As such, every decision about stock/option grants etc. is measured against whether the shareholder value created will exceed the dilution of that grant. Of course, investors have to acknowledge past contribution to maintain harmony and ongoing commitment, but that isn't the driver of their equity decisions. Investors also see a difference between number of shares and value of shares -- whereby, the growing value of shares rewards past contributions instead of the need for additional shares.
Who is right?
They both are to a degree. In fact, the entrepreneur carriers a bit of both viewpoints because they are both founder and shareholder. I can make the argument for both sides, but the important part is just understanding the different perspectives. Doing so will help with investor discussions, but could also help with early founder pie-splitting.
Labels: entrepreneur, equity, founder, stock options
Posted by VC Dan | 4/06/2007
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Comments (7)
Founding a company and doing equity splits is such an optimistic situation. It's kind of like the first 3 months of a relationship with a new girlfriend... all smiles. Of course everyone is going to think that they all deserve an equal share. We're all going to be millionaires in a year, right? Boy does that change. I'd only suggest doing an equal split if you've worked before with that individual in an entrepreneurial setting. The founding team at Publictivity is an equal split, but that's because we've worked before. Doing an equal split with your dorm room buddies or someone you meet off the street, who hasn't done this before is a disaster. On the investor side/ future contribution, I think what the Founder's Fund has done with FF class shares is great. It let's us entrepreneurs cash out a small amount, feel somewhat comfortable,etc., but... we get more hungry. We've felt the taste of some cash, now we want to keep working onwards to get the full value. Just my two cents.
Great point about equal splits Jason. I shared my equal-split experience not as a best practice, but as one example. If there is strong support for everyone's equal contribution, consider it, but don't go equal just because it's an easier conversation to have.
Agreed. That's why it's hard to go into business with friends. It's better to go through the hard conversation (they're really hard) with the founders early on, than a year down the road with your investors and board.
In terms of distributing shares of a start up amongst the founders I think a good indicator is how much money/opportunity cost you are putting in.
Nowadays developing a beta version of a web based application can be so cheap that the effort to develop it is often not commensurable with the needed effort to make a business out of it. One way to measure commitment is with money. Are you giving up your savings to be in? are you quiting your job?
Since it is hard to extrapolate from the first two days the stand everyone is going to take when they realize they are not billionaires over a year, a good way to go about it is, I think, to establish an option-like contract between all the founders.
Dan, does that makes any sense to you?
An option-like contract is interesting because it can correct for future founder exits. However, anything with triggers for expiration/exercise require concrete roles for the participants. There are some cases where the founders' future roles aren't very clear.
Although I've never seen an entrepreneur do it, I've toyed with the pros/cons of founders creating preferred stock for themselves at the outset that carries buyback provisions and liquidation preferences. As an investor, I'm not even sure I'd accept such a structure, but I'm curious to hear if anyone had success with something similar.
I would note that your reference to money/opportunity cost is good for people of similar financial standing, but doesn't really work when a young entrepreneur/student partners with an older operations-experienced co-founder. Your model might overequitize(?) the older co-founder due to his/her higher earning potential, even though operations talent might be easier to source than a young entrepreneur's idea/vision (and I don't just mean techie skills). I think money, ideas, effort, relationships and opportunity costs all play a role.
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