Divvying up cash that comes out of a startup among those involved in building it can be a tricky business, but there are rules to follow
Building a business is not unlike baking a pie, except that the ingredients aren't sugar and flour but intangibles such as a great idea, strategy, and execution (cash helps, too). But with multiple founders showing up with different contributions at different times, it's hard to know how to split the pie, especially before it has been baked. How much should be given to the guy bringing the sugar vs. the one with the strawberries? What about the gal who came up with the idea to make dessert in the first place?
Serial entrepreneurs agree that a winning business partnership is built on compromise and fairness. But to split up equity fairly, all parties must agree on exactly what "fair" is. One option is for founders to think like investors when determining the value of their contributions, even if they have no plans to raise funds. Whether or not you agree with the approach investors use when calculating valuations, there is no denying that it produces a market-tested set of third-party benchmarks. By relying on such market-driven criteria, no party needs to prove the value of his or her particular framework.
So let's take a closer look at how professionals value founders' contributions in a Series A round, when a young company closes its first phase of financing. Typically, after such a deal, founders will be left with 30% to 50% of the total equity. That represents the product, the strategy, and other noncash contributions. The investors will get 30% to 50% of the equity in exchange for 12 months to 24 months of operating capital. Some 10% to 20% is reserved for future hires, including key managers.
Of the 30% to 50% set aside for the founders, the idea alone commands little payout. If contributing nothing more, the person who came up with the idea—no matter how brilliant—can expect to hold on to less than 5% of the company. After all, ideas are bound to evolve many times during the life of a startup. Even the principals of venture darlings such as Google (GOOG) and Facebook only began to see a premium after the Series B and C rounds, once the businesses started to gain traction.
Instead, the bulk of founders' equity is granted for developing the product, building a viable business plan, and leveraging relevant experience and contacts. Partners responsible for the product or strategy should be compensated for their sweat, with a premium paid for a proprietary, working product. Partners who join the company full-time deserve more equity than those making early, one-time contributions. Opportunity costs are a factor, too. Equity should not only compensate partners who are giving up lucrative careers but also motivate them to propel the startup over the next four to five years.
Then there's the importance of cash. Even bootstrappers need to provide some money to finance day-to-day operations until the company can support itself and its employees. This may be far less than a venture capitalist is likely to invest, but that's partially offset by the fact that the company, and any investment, is much riskier in the early stages. And these days, capital is scarce. In a tough fund-raising climate, cash commands a premium. Investors are valuing potential portfolio companies at 40% to 60% less than they did in 2007, when private equity flowed relatively freely.
A final point is that, as time passes, the company will become less risky, and those who take on less risk deserve less equity. So investors in a business that is cash flow-positive will receive far less for their capital. Similarly, a partner who joins a startup after it already has some traction should expect less equity—that pie is about to go into the oven, after all—than an early founder.
Return to the BWSmallBiz June/July 2009 Table of Contents