How to divide equity among cofounders and employees is a perennial question in startup world. This article builds on Startup101: How Do I Divide Equity Among My Cofounders And Employees?, expanding some ideas and introducing some new ones.
1) Core Principles
i) Contributions – Give some weight to the contributions to date but the overwhelming focus should be about future contributions.
ii) Ownership ≠ Control – Economic ownership is not the same thing as authority / control – it’s very possible and in fact quite a common situation for the person in charge (CEO) to not be the biggest shareholder.
iii) Conversations – Have many conversations around equity before actually doing the paperwork. You could even incorporate the company and wait to assign shares formally until actually taking in the first money.
iv) Framework – How you assign equity among cofounders and early employees sets a strong direction but is ultimately a framework. As your company evolves you will raise money / have dilution / play with the option pool / give out grants / have people join and leave.
v) Logarithmic – From all our years we see risk / reward in startups as logarithmic. In other words, people joining at the earliest stage carry 10x more risk than the next stage. So we advocate for allocating equity accordingly, obviously factoring in role and seniority.
2) Option Pool (ESOP)
The standard is to allocate 10-15% for future employees in the series A. If you have less the lead investor will usually require it in the term sheet, which means dilution for existing employees and investors. So seed investors will often enforce the 10-15% ESOP itself in the seed in anticipation. Incoming investors can also require certain thresholds in their term sheet before their investment comes through i.e. extra dilution for existing employees and investors. Employees looking to calculate their eventual ownership should also factor they will likely get diluted 20-30% in the seed, similarly in the A, 15-20% in the B, and 10-15% in subsequent rounds.
3) ROFR, Secondary, and Buying Back
ROFR is the right of first refusal and the norm when issuing shares. Basically it means that if an employee is looking to sell their shares before an exit (M&A or IPO) the company gets first dibs. Actually selling those shares in a private transaction is what is known as a secondary. Typically there is a liquidity discount since the company hasn’t exited yet – for extremely promising companies it could be 0% but a 10-30% is much more common. Finally, a company buying back shares from an employee who has left may actually require a much more significant discount. For instance, if it was a cofounder the company may price the shares even at the issuing price rather than the current price; this is obviously a conversation / negotiation. Note this concerns vested shares since unvested ones will go back to the company automatically.
4) Recap
A recap is when a cap table gets completely wiped away and the company is rebooted. It’s a nuclear option that should be done really when the startup has value but is not well structured. The two most common issues are founders own too little and / or existing investors are dragging the company down. Doing a recap typically involves a supermajority to agree to it, say 2/3 of the voting shareholders. And given it will dilute all the existing shareholders to zero, the conversation around a recap is typically initiated by a new investor coming in. In a recap typically the management and employees are issued new shares to re-incentivize them, so the biggest loss is on existing investors. All that said, if you are contemplating a recap then seriously consider also / instead a spinout i.e., salvage the best assets into a new company and potentially sell others.
Originally published on “Data Driven Investor”. Amit is Managing Partner and Cofounder of Tau with 20 years in Silicon Valley across corporates, own startup, and VC funds. These are purposely short articles focused on practical insights (we call it gl;dr — good length; did read). See here for other such articles. If this article had useful insights for you, comment away and/or give a like on the article and on the Tau Ventures’ LinkedIn page, with due thanks for supporting our work. All opinions expressed here are from the author(s).
