How to Allocate Initial Equity in a Startup




  • How to Allocate Initial Equity in a Startup

    An often misunderstood concept relates to how to allocate initial equity in a startup in the form of stock to early-stage partners. Doling out equity in your business is a pivotal- and often difficult – task for many founders, but it doesn’t have to be.

    Everyone is really excited at the beginning of a startup. It is super exciting because everyone sees the huge potential that a successful business will produce. It is all cool at the start when there’s no value… but after several months of effort, things begin to change.

    What inevitably happens is the business starts to hit things that feel like roadblocks or problems, such as a lack of money. These issues begin to suck the energy out of the startup, and some partners start to lose their passion for the business. On the other hand, the business may take off and the Greedy Bone effect takes root. A partner begins to question why they agreed to accept a 20% equity when the other partner is getting 80%. leading to full-on resentment between partners. Before you know it, feelings are hurt and the business folds.

    How to handle the initial equity stage is really important. The 50/50 equity splitting that is so common in small business startups is unfair, incomplete, and unstructured. Too many founders choose this option simply to avoid awkward discussions about a person’s value or contribution to the business.

    A slightly more analytic approach is to weigh three factors when it comes to allocating initial equity in a startup. They apply weight to the time a partner spends developing the business, the person that came up with the business idea, and finally, the amount of capital that each partner contributed. While this is better than just a doing a 50/50 split, it is also unfair and incomplete, since there are many other factors that should go into properly allocating to initial equity in a startup.

    When it comes to allocating initial equity, there is a more methodical and analytical way to define a proper equity split between startup partners. I recommend that the founding partners consider ten attributes when they allocate initial equity in a startup.

    I have created a simple equity allocation spreadsheet that founding partners can use to allocate initial equity in a startup. You can download my equity calculator and use each of the following descriptions to help you complete it for your startup.

    Pre-Start Cash Injected

    How much cash each partner contributes to the business so that the startup can make purchases and pay bills pre-revenue is pretty straight forward for the most part.

    However, not all partners come to a venture with the same net worth. When a partner has the financial resource to inject additional cash later in the venture, and they are willing to pledge this to the business if needed, the startup needs to factor that commitment into its allocation of initial equity in the startup.

    For example, if two partners each contribute $ 10k into a startup, and one says that if needed they can contribute another $ 10k, the startup needs to ascribe a value to the commitment. Since the partner is not committing the full $ 20k pre-start, a discount may be applied to the additional $ 10k that may or may not be needed. Perhaps as part of the calculation, the startup will allocate $ 15k to this partner vs $ 10k if there is a 50% chance that the startup may take the partner up on their commitment to inject an additional $ 10k at a later date.

    Value of Initial and Future Contracts to Business

    For many startups to be successful, they need to quickly gain traction with paying customers. Partners who already have relationships with customers that will become the startup’s early stage customers should be compensated at some level for using their relationships to help jump-start the business. Without these relationships, the business would have to find and nurture prospects, which takes valuable time. Time is the enemy of many startups who need to start generating revenue quickly to survive.

    Opportunity Cost

    Each partner has an opportunity cost if they leave where they are employed to come on board with a startup. One partner may be leaving a company where they are earning $ 100k per year in salary plus benefits, while another may have been unemployed prior to joining.

    The more a partner has to give up to take the risk and join a startup, the more equity they need to receive.

    Pre-Start Time Invested

    When I started my first company, I worked for a year writing and rewriting our business plan, as well as negotiating contracts prior to reaching out to two other partners to join me in my startup. Just as we pointed out in Raising Capital: Lesson from The Ship of Gold, early investments in terms of time and money have far more risk. With risk comes reward. Having invested a year of my time before my other partners joined my startup, there was a good chance that my time and effort would be wasted if I could not come up with a viable business model and find customers willing to pay for it. Therefore, the effort of partners who invested effort in the startup when the probability of launching a business is still very slim need to have this risk valued when it comes to allocating initial equity in a startup.

    When it comes to valuing pre-start time, you need to apply present value and cash flows to their efforts. For example, say that two partners each earn $ 50k per year as employees in another business. One partner has, let’s say $ 100k in savings, and the other has essentially no savings. The one partner with savings commits to quitting his job and uses some of his saving to live on for six months while they work full-time on the business. The other partner keeps their job and earns an extra $ 25k in salary. You cannot simply allocate $ 25k to the partner that quit and worked unpaid for six months. When allocating initial equity in the startup, it likely took the first partner many years of saving up the money they used to live on for six months, while they worked full time on the business.

    For example, using the rule of 72, and considering that you could earn a 10% return on your money, it would take 7.2 years to earn that money back. So, when it comes to allocation equity to six months of work with no pay, you might allocate $ 180k ($ 25k x 7.2) toward equity value and not $ 25k to more fairly account for the present value and cash flow.

    Value of Idea or Intellectual Property Provided

    Most founders go straight to the fact that ideas and IP play the most significant role when it comes to the allocation of equity in a startup. In my opinion, too many businesses place way too high a value on the idea or the invention. As I have learned, a great idea is not enough.

    In many cases, a startup thinks that the idea on which the startup is based upon is unique… only to discover much later after time and money have already been expended that someone already has a patent on it. You might even end up in court after you launch for infringing on another company’s patent, creating a liability for the business rather than an asset that should be rewarded with equity.

    At the risk of getting ahead of myself, most businesses should value partners that have business acumen and the ability to get stuff done, over the partner that has the idea or was the inventor. Don’t believe me- consider Nikola Tesla, one of the world’s greatest inventors of all time who died penniless.

    Value of Personal Brand, Contacts, & Relationship to Business

    Some partners have spent an entire career cultivating a positive reputation in an industry. If they join your startup, their personal brand can give the startup instant credibility, which needs to be valued when you allocate initial equity in a startup.

    For example, a partner may be what Malcolm Gladwell calls a Connector, and may have thousands of relevant industry contacts that the business can use when prospecting for new customers. Or a partner might be a trusted influencer on Facebook with a million followers and based on a simple recommendation, could take a business from complete obscurity to worldwide fame with a few reviews or posts.

    Another often ignored factor when allocating initial equity in a startup is a partner’s personal relationships or health problems. Let’s say that after you launch, a partner gets divorced. The partner may be forced to sell their interest, or perhaps some or all of the partner’s equity is allocated to their former spouse. Do you want the partner’s former spouse as your new business partner? Or let’s say that a partner has heart issues or has been diagnosed with cancer and they become incapacitated or die. What happens to their ownership and contribution? What a nightmare for a business to untangle! Therefore, some weight needs to be placed on these factors when you allocate initial equity in a startup.

    Public Officer Risk Adjustment

    Not all partners may be decision-makers. Decision-makers can often be held personally accountable for their decisions, while other non-decisions-making partners may not. As I shared in the video Limits of Limited Liability, there is a gross misunderstanding when it comes to the protection afforded to business owners. If one partner has personal financial exposure beyond what they may lose if the business fails, or the business is sued and another has no personal financial liability, it is totally unfair to treat them the same. Therefore, being the public officer of the startup needs to be accounted for when you allocate initial equity in a startup.

    Value of Loan Guarantees

    Because startups have few if any assets the partners in startups will often have to sign a personal guarantee for any obligations to a creditor. It may be a guarantee on a lease or on some form of debt financing. As a guarantor, the creditor can bring a suit against the guarantors separately or jointly. Given that not all partners will have the same net worth if the startup gets sued by a creditor, the high net-worth partner has much more to lose than a partner that is all in with the business but has no other non-incumbered liabilities at risk. So, when allocating initial equity in a startup the value of loan guarantees needs to be a weighting factor.

    Value of Personal Resource Contributed

    Many startups leverage the personal resources owned or controlled by the partners. Founders will frequently donate used furniture, tools, and equipment to a startup to avoid using capital to buy new stuff. Maybe they will contribute a portion of their home to house supplies, or provide early-stage office space for the venture.

    Some partners may have a spouse or family member with a skillset that the business requires that they may commit to the startup. For example, a partner may have a spouse who is a web designer, and they agree to contribute their partner’s labor to develop and maintain the company’s website. When a partner contributes personal resources to a venture, the allocation of initial equity needs to take these contributions into account.

    Value of Expertise Provided to Business

    Finally, there is the value of a person’s expertise. Of the ten attributes that a startup needs to ascribe value to, when it comes to allocation initial equity to partners, applying a value to a person’s expertise it one of the most important and one of the hardest to value. If a partner has a skill that the business desperately needs, yet is hard to acquire elsewhere, a startup may have to heavily weigh a person’s expertise to get them on board.

    “Ideas are a commodity. Execution of them is not.”

    Michael Dell

    “To me, ideas are worth nothing unless executed. They are just a multiplier. Execution is worth millions.”

    Steve Jobs

    As stated earlier, having a partner that can get stuff done will be the difference between success and failure. As such, the expertise that a partner brings to the business so that the startup can execute their plan should be highly sought after, and rewarded with a greater share of the equity of the new venture.

    Example

    When I started my second company in 1994, I didn’t really understand all the nuances of allocating equity to my partners as well as I do today. That said, I did get pretty close to considering many of them. The following is my story to provide some context to understand how to allocate equity for a startup.

    It was 1992, and I knew that it was only a matter of time before my department and job would be eliminated. I decided that I would start my own company and leverage my industry knowledge and network connections. Keeping my day job, I worked nights and weekends for over a year writing and rewriting my business plan. Since there was no guarantee that anything would ever come of this effort, I factored my pre-start time invested into my equity allocation.

    I also negotiated with my first customer to close their local operations and outsource the work to my new company, so I factored in the value of initial and future contacts into my equity allocation.

    When the market was finally right to launch the business, I had to quit a good-paying job as a manager with benefits and received no severance package. Here, I factored my opportunity costs into my equity allocation, since I could have just waited and received a severance package.

    My two partners were employed by my first customer. They were both pivotal to the operational success of my business and possessed complementary skills to my own. Known that I needed them, I recognized their personal brand and the expertise they provided in my equity allocation.

    They each received a lucrative severance package from their employer when their employer shut down their local operations and outsourced their work to my new business. Since their severance package was an unexpected windfall, I factored that into my equity allocation as well.

    Since I was the President and CEO of the C-Corp I created, I had additional risk and essentially no liability protection, which I also factored into my equity allocation.

    As the personal guarantor on our office lease and on an SBA loan, I factored that into my equity allocation.

    In the end, I needed to raise $ 100k to launch my business. I had only $ 50k in cash at the time, so after taking into account many of the factors described here, I accepted $ 25k from each of my two partners (essentially a portion of their severance package) in exchange for a 10% equity stake in my company. After all my calculations, my two partners paid 2.5 times as much as I did for the same share of stock to account for all factors associated with my formula to allocate the initial equity in my startup. In the end, each partner was fairly and handsomely rewarded when we sold the company and cashed out several years later.

    Do you know how to allocate initial equity in a startup?

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    Author: Steven Imke

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