When forming a new company, the startup founders must make the early decision of how to split up the ownership interest of the company organization. This can be a tense and sensitive subject, as each founder has some idea of their respective worth and contribution to the company and ownership structure. Dividing equity must be a group decision, so it comes down to objectively quantifying the past, present, and future value that the founder has to the company ownership structure.
Advantages and Disadvantages of Dividing Equity Equally
Many companies will initially divide equity shares equally among co-founders. This approach has a number of advantages and disadvantages including:
- Founder Relationships – Founders are generally a team of close-knit individuals. The strength of the team’s productivity often rests with the commonality of purpose and understanding. Maintaining a positive co-founder relationship is a primary concern for the business. An equal division of equity shares may also make founders who contribute more to the business feel as if they are being cheated or under appreciated. This can cause dissension and ultimately harm the team relationships.
- Motivation – Dividing equity equally can make co-founders feel as equals in the ownership structure of the company. This often leads to a sense of equal or co-responsibility for the success or failure of the business. Be careful that the equal division does not demotivate the higher-performing members of the team.
One way of addressing the issues associated with equal division of ownership structure is to recognize the contributions of startup founders in different ways. Then, put in place a method of calculating the value of contributions going forward and reward the co-founder appropriately. This may be through higher salary, title, control rights, or increased ability to acquire ownership interest.
Uneven Distribution of Equity Shares
Some founders choose an uneven distribution of equity shares. Common reasons for the uneven distribution are as follows:
- One founder came up with the idea
- One founder contributed more assets
- One founder spends more time working
- One founder started earlier than another
- One founder has more experience
- Founders want a tiebreak in the event of indecision.
Each of these reasons show some logic, but also suffers from irrationality. The idea is really a small part of a commercial activity. There are millions of great ideas. It’s hard work that make a business a success. Contributing more assets at one point is a finite value. It is better to look at the long-term or total contribution a co-founder will make. The same argument applies in a situation that one startup founder has more experience or started earlier. Lastly, creating an artificial tiebreaker in the event of indecision does nothing to preserve the long-term relationship, which is generally more important than any single decision. In fact, it can have the opposite effect of creating hard feelings.
Below are some primary considerations for founders when distributing a company’s equity shares unevenly.
- History of Value Delivered – It is difficult to measure the value of a co-founder’s contribution to the company structure. To start with, the value of the company organization is very uncertain in these early stages. Nonetheless, it is important to consider each co-founder’s early contribution to bringing the company structure into existence and establishing operations. If a founder contributes noticeably more than another co-founder, this should affect her ownership percentage when dividing equity shares.
- Ability to Deliver Future Value – The role of the employee is not complete at the time of equity distribution. Generally, she is expected to remain a part of the company and continue contributing value. The role of founders will change as the company organization grows and proceeds through its various stages of its lifecycle. Understanding the skills, abilities, and intended role of each founder going forward is important. A cofounder who is expected to deliver greater value to the company should be awarded accordingly at the time of equity distribution. While the future contribution of value should be considered in the early stage equity distribution, the company may choose instead to identify future compensation methods that reward the founder/employee for the value contributed.
- Objectives as Owners – Lastly, the company should seek to understand the objectives of the co-founders. Early on, startup founders may not have a good vision for what they expect to achieve by founding a company. For example, one founder may seek to establish a lifestyle business that will provide employment and benefits for years to come. Another founder may want to create a company structure and later rent or license the company’s assets as a form of passive income. Yet another founder may want to grow the company rapidly in hopes of later selling the company at some valuation based upon a multiple of revenue or other performance metric. For each of these startup founders, they may have differing preferences for continuing to work in the business, how much time and resources will be devoted, and their individual roles as the company organization continues (think CEO, COO, CFO, CTO, etc.); All of these issues must be addressed when founding a company.
These are simply considerations. Each consideration may have more or less weight depending on the nature of the company and the stage of development and the ownership interest.
LawTrades Understand Equity Distribution
Organizing the ownership structure of a company is an extremely difficult process that is fraught with potential pitfalls. There are many considerations when founding a company that may not be apparent at the beginning. Don’t go at it alone. The legal professionals at LawTrades are experts in company organization and ownership structure. They can help you with the process of dividing ownership, distributing shares, and establishing control mechanisms to achieve the desired results.