One of the first significant discussions when starting a new business is how to agree on a founder equity split. Whether co-founders agree on an equal share of the business equity or opt for an equitable share of equity may determine who has the most influence in business decisions and how much value each founder may receive for their time, energy, and investment.
Setting forth the division of ownership and equity early on (and putting it in writing) may help business partners avoid lengthy and expensive legal entanglements or reduce any future challenges or disagreements over which founder is contributing the most to the business. Consulting with an experienced business attorney at Ferlito Law Group can help you and your partners protect yourselves and your respective equity.
Factors to Consider When Splitting Business Equity
Some co-founders may determine that an even equity split works best, however, complex issues can quickly surface. It is important to attempt to address these issues at the outset and resolve them to avoid contention or legal challenges later.
Expertise and Experience
The number of years that each founder has in the industry and their expertise in certain facets of running a company can factor into how much equity each one deserves. Founders may award a higher potion of business equity to an individual who has significant experience in leadership roles in their niche and can bring insight and a knowledge of industry best practices to the new venture.
Experience does not necessarily trump expertise, however. Another co-founder may have in-depth knowledge, or a particular skill set that is vital to the success of the new company, and therefore their insight and creative approach may have an equal value to the other person’s experience.
Initial and Ongoing Capital Investment
Dividing equity by the investment of each partner may seem straightforward. However, many partners may encounter challenges when valuing capital investment of cash or assets against another partner’s “sweat equity.” Generally, sweat equity refers to the labor and time invested into the company. One founder may wish to contribute financially but remain largely uninvolved with the daily operations of the business, while another founder who is not contributing capital may instead be responsible for operating the company.
When determining the business value of sweat equity, consider:
- How many hours is the founder investing weekly, monthly, and quarterly?
- Are they providing unique contributions to the company?
- What is the average salary or compensation for the job or jobs they are performing?
A quantifiable metric to track sweat equity may be assigning a salary to the partner’s work contributes to the company or a flat rate for each project. This may make calculating equity distribution easier, as the founders can compare dollars to dollars.
Intellectual Property and Original Ideas
The partner who initially developed the idea for the business may feel they deserve the largest share of equity – after all, the company would not exist if not for the idea. However, other skills and intellectual property from co-founders may help launch the endeavor and therefore be just as valuable to the company.
Any founder with ideas, procedures, product recipes, or other forms of intellectual property developed before joining the new company may wish to have their intellectual property protected and ownership of it (and the equity value) written into the business partnership agreement.
The initial idea for the business does deserve recognition, but the respective contributions of each of the co-founders need to be taken into account. If the initial idea person provides the concept for the business, but another co-founder has the ideas that make the venture practical, then perhaps both should share in the equity equitably. Putting a value on one’s thoughts may be a tough business discussion, but a necessary one.
Common Pitfalls of Founder Equity Split
While each business and founder relationships are different, there are several commonalities in co-founder equity split contentions.
- Assumptions. Each partner assumes they own a certain amount of equity. Have discussions and always make things clear.
- Failure to place decisions in writing. After discussing how equity will be shared and whether it will be static or dynamic, always draft an equity share agreement.
- Allowing personal relationships to influence business decisions. Be objective when discussing terms of business and expectations of capital or sweat equity contributions.
- Making hasty decisions. Make sure that you consider not just the current situation and contributions but also how your business and each partner’s involvement and contributions may change.
Why Is the Determination of Founder Equity Split Important for Business Success?
At the end of the day, partners enter into a business to make a profit. The amount of equity each co-founder has in the business can play a significant role in their financial situation. Some founders may intend for the business to be their main job and source of income, while others may view their involvement as a “side gig.” How each partner considers the business will likely influence their level of contribution and, therefore, their equity share.
Is There a Formula for Founder Equity Spilt?
There is a commonly known formula often used for founder equity split entitled the Founder’s Pie Calculator, created by Frank Demmler. It lists key contributions of founders, such as:
- Initial idea
- Business plan preparation
- Domain expertise
- Commitment and risk
- Responsibilities
Each component has a brief description, which is helpful for all founders to have the same understanding of the equity elements. Then, the “pie” allows founders to assign a relative weight (a percentage of 100) for each component. Finally, the founders may fill out the contribution of each one for each of the five elements.
Once that is complete, then the formula instructs founders to calculate a score for each founder, multiplying the factor’s value by the founder’s level of contribution. The score is then converted to a percent of the total, 100, and thus, each founder’s percentage of the equity.
While this is not a hard-and-fast rule for splitting equity, it may be useful for new partnerships or if there is contention about equity division.
Contact an Experienced Business Attorney To Help You With Your Co-Founder Equity Split
With so much momentum in starting a business, many co-founders may forget one of the most critical steps of starting a business: putting all important decisions regarding the company in writing. Drafting a business partnership, as well as specifically determining co-founder equity split, reduces the chances of contentious litigation should any disagreement occur in the future. Trust the experienced business attorneys at Ferlito Law Group to help you draft all the business documents necessary for your venture.