How to Fairly Divide Equity Between a Co-Founder and Investor
Q: How do you divide the equity if two partners have money to invest, and the third has the idea and will put in the work?
A: This is a huge foundational issue that can make or break your company, as it will affect every aspect of the business and will have consequences for the entire life span of the venture. Therefore, it is important that you set yourself up for success.
The person who has the idea and is going to do the work should be the majority owner of the business with the money partners getting a small minor share. Too many founders make the mistake of giving away too much ownership, control, influence and power to the money partners.
While they should be super grateful for the offer of an investment, it is important to remember that the blood, sweat and tears, the long hours, the stress and the grind is for the founder to carry, for the most part, alone.
That said, the money partners are super important and are major reason why your business will succeed if you don’t have access to your own money. Just make sure that the terms and conditions are in the startup’s best interest. The money partners will not be running the business and they will have other careers and businesses to focus on besides yours. When the going gets tough, most investors will not be arm in arm with you solving and fixing the problems. Those that do are golden so try to seek them out.
The founder should be adequately taken care of with majority equity ownership percentage, stock options and a parachute should his/her employment be terminated down the road.
It is also very important that the investor is adequately compensated for their trust and belief in you. In many cases you can get a convertible loan or straight debt financing instead of giving away too much equity, as these are usually more attractive from a tax perspective to the investor.
The question of valuation and percentage ownership for the business partners is always a thorny and uncomfortable subject. Get a valuation formula or mechanism agreed to and in place up front before you take their check in order to avoid downstream problems.
Many businesses fail because the partners cannot agree on the value of the business and the ownership percentages. Most of the time this is because the founder thinks that their idea is the next billion dollar unicorn, blinding them to the reality that almost every business fails.
If your business is pre-revenue and pre-profitability it can easily be argued that the business is worth zero. So don’t kill a potential financing opportunity because the investor wants to value your "idea" at $ 500,000 or $ 2 Million. Be grateful that you are one of the few that actually get financed as most start-ups never do.
Do not make the mistake of trying to own a large piece of a small pie when owning a smaller chunk of a bigger more viable business would be better for you, your partners and the company.
Try to avoid investors who are looking to control you through the legal documents. Beware of agreements that force you to give up board seats, veto rights, anti-dilution rights and approval rights. Instead you want partners that believe in you, who trust you and most importantly who empower you and support you. We call this ‘friendly money’.
You want partners who add significant value by rolling up their sleeves, working in the trenches, providing mentorship, expertise, and/or connections. These folks are called "smart money."
If you can get both friendly and smart money then accept the investment with gratitude and run hand in hand with your new money partner towards success.