Dividing Equity Between Founders and Investors
Free Book Preview Money-Smart Solopreneur
Q: I founded a company with two partners, and we're currently looking for a venture capital firm to invest in us. How will the equity be divided among us and the VCs?
A: One of the most common questions I get is about how equity should be distributed. I'll warn you in advance: There are no hard and fast rules. Equity is negotiated on a case-by-case basis, which makes it hard to give any generalizations. I'll try to give some thoughts on what to consider when you give out equity.
Dividing Equity Among
Founders receive equity for what they bring to the table. How much of the company they own as a result of their contribution is purely up to the group to decide. There are several factors that need to be considered, however.
- Timing, size and duration of contribution: The earlier, bigger or longer the contribution to the company, the more equity a founder should receive.
- Power: Equity conveys voting power and control over the business. Generally, founders who intend to stay with the business long-term should retain the most control. I have heard it recommended that one individual own at least a 51 percent of the company, to provide consistent decision-making when resolution is needed. Equal partners, while great in theory, can destroy a company when the partners don't agree and have no way to resolve fundamental disagreements.
- Money: Early money is a contribution for equity. Money has the side effect of valuing the company. If you give 10 percent of the company for someone contributing $50,000, it implies a company value of $500,000. If you try to raise money immediately thereafter, that valuation could hurt your negotiating ability. But if substantial infrastructure has been built in the meantime--if customers have been acquired or if more of a team has been built--then a higher angel/VC valuation is justified.
- Kind of contribution: A founder may contribute in many ways. Some bring patents or product ideas. Some bring business expertise and ongoing work to build the business. Some bring capital. Some bring connections. Some may bring big names or reputations which convey credibility with VCs and/or clients. One big name that provides instant credibility may, in fact, be worth more to the company than a founder who actually puts in the work to build the business. Make sure to understand what each founder's contribution is and value it appropriately.
We Have Five Founders--What Do
Negotiate, big-time. Too many founders can be a big problem. As the company reaches for outside funding, you make many decisions about equity, contribution and dilution. The more equity-holders, the more negotiation has to enter into each of these decisions.
Having several founders makes it hard to keep everyone adequately compensated. By the time of harvest (IPO or acquisition), the founding group can expect to own about 20 to 30 percent of the company. With one founder, that can mean riches. With several founders, that may mean splitting the pie into so many pieces that no one is happy with the value of his or her piece.
In short, fewer major equity holders are better. If you've already got several, make sure to tie each founder's vesting to the contribution you're expecting from him or her.
How Much Will Investors Expect
The basic formula is simple: If you need to raise $5 million, and an investor believes the company is worth $15 million, you will have to give them 33 percent of the company for his money.
Different investors value companies in different ways. Some look at the quality of the idea, assets, market size and management team. Some rely on financial projections. Some simply look for "big ideas" and determine their percentage ownership purely through negotiation.
I asked a couple VCs, some entrepreneurs who recently received funding and an angel investor how much of a company is typically given up in the first round. While one VC had seen investments as low as 5 percent, the majority thought that first-round investors usually take between 25 and 45 percent of the equity.
One entrepreneur remarked: "The better thing to ask is, how much should management and founders try to hold onto before the IPO? Answer: as much as possible, but no less than 25 percent."
The entrepreneur has an important point. If it comes down to the money (as it often seems to, these days), what matters is percentage ownership at harvest multiplied by the valuation at harvest. Owning 1 percent of a company with a billion-dollar valuation is still more interesting than owning 10 percent of a company with a $50 million-dollar valuation.
What Equity Should Part-Time
Not very much. The reality of the situation is that start-ups usually require 150 percent commitment by everyone involved. Venture capitalists insist equity be given in return for ongoing commitment. Even founders who stay with the company have a multiyear vesting schedule. Many VCs will not allow equity to be given to part-time employees or contractors.
There is a one-time contribution for stock that is routinely made: giving capital itself. A cash investment for stock lets the investor own the stock free and clear, with no further contribution required. Having part-time contributors purchase stock outright may be the best way to include them in the deal.
What Does Ownership Look Like
After the First Round?
According to Ann Bilyew of Advent International, a typical first round is:
- Founders: 20 to 30 percent
- Angel investors: 20 to 30 percent
- Option pool: 20 percent
- Venture capitalists: 30 to 40 percent
Stever Robbins is the founder and President of LeadershipDecisionworks Inc., a national training and consulting firm that helps companies develop the leadership and organizational strategies to sustain growth and productivity over time. His web site is http://LeadershipDecisionworks.com.