Ask a Startup Lawyer: How Should You Manage Co-Founder Equity? One lawyer explains when and how to formalize equity splits between founders.
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Harvard Business School professor Noam Wasserman famously determined that 65% of startups fail as a result of founder conflict. Startups have neither the time nor resources to litigate the dissolution of partnerships, or to divvy up ownership as circumstances change. Preventing and managing founder disputes is crucial. Let's take a look at equity and some potential related issues that can arise.
"When and how should equity splits between co-founders be formalized?"
Short answer? You should formalize equity splits as part of incorporating, and you should incorporate as early as possible.
Many co-founders work together for months (or more) without formalizing an equity split. They might discuss equity over email, verbally in person, or not at all, and this is an almost sure path to disputes and disappointment. Without a formalized equity split, there is too much room for misunderstandings. Those misunderstandings might come up in the context of eventually formalizing the equity split. Or there may be a fallout over some other issue related to the startup. Either way, the co-founders are often left with nothing more than vague promises about equity that would be too expensive and time-consuming to litigate.
Of course, you can formalize equity splits before incorporating. Pre-incorporation agreements can exist, but usually are not worth the time and expense. If you are willing to spend money on something as costly as a pre-incorporation agreement, you should move directly to the incorporation stage instead. One of the nice things about incorporating is that it comes with an overlay of corporate law built in with everything being out-of-the-box. Most lawyers in this space have templates to give you the basic things you need with standard incorporation. A pre-agreement would be bespoke, meaning that everything would need to be created entirely from scratch. So, you can easily incur costs greater than simply incorporating with a pre-incorporation agreement. And, of course, you will still bear the cost of incorporating later when you decide to move to that stage.
In the startup world time is always of the essence, which is why you should incorporate as soon as you can afford to do so. Potential disputes around equity splits may become evident quickly in the incorporation process, so the sooner you incorporate, the sooner you can address those issues.
When you're deciding how to split equity, one thing to keep in mind is that while a 50/50 split may sound fair, it is generally not advisable. This is something first-time founders may not realize. The reason? 50/50 splits can create deadlock in decision making.
If one co-founder is a holdout, this could threaten the viability of the business. Under corporate law, generally, unless something is varied by agreement, decisions are made by majority. A 50/50 split would make major corporate actions very difficult, if not impossible. In those cases, the only solution would be to dissolve the company.
How do you decide who will be the majority shareholder? It varies. The important thing is to be realistic about each founder's role. If you accept minority ownership, be aware that it means you could be pushed out at any time. Anything the minority holder needs must be documented in writing at incorporation because the minority holder will technically be at the whim of their majority co-founder. Any stock not vested could be repurchased at any time or ownership could be diluted without much recourse. At an exit, minority owners' profits will, of course, be less than that of the majority owner.
That said, being the majority co-founder isn't always better. In many cases it's simply not realistic to assume that two or more founders are all equally suited to be majority owners. Maybe your co-founder is a luminary with the unique potential to make the business succeed such that it's worth it for you to take the risk of a minority position. Maybe you are involved in other projects or ventures that require your attention in a way that makes it hard for you to spend the same amount of time focused on this company as your co-founder. In some cases, one co-founder is simply better suited to the majority.
It might sound scary to be the minority holder, but my team and I work with companies with multiple founders all the time. The vast majority of co-founders with minority stakes do well, are not mistreated or kicked out despite having no special protections. There are plenty of good reasons to accept the role of minority shareholder, as long as one has clear and proper expectations.
As your company grows, there may be changes in equity splits. Document those changes as soon as possible to minimize the tax implications of equity changes. Once you've incorporated, equity splits should be formalized through stock purchase agreements. Offer letters, or exhibits to employment agreements or consulting agreements, are insufficient as they don't actually formally grant equity.
In summary, it's best to incorporate as soon as you can afford to do so, document equity splits as they occur and formalize splits through stock purchase agreements. In addition, carefully consider which co-founder is best suited for a majority role, and make sure that the minority shareholder is prepared for the risks associated with that position.
The information contained in this article is provided for informational purposes only, and should not be construed as legal advice on any subject matter. You should not act or refrain from acting on the basis of any content included in this article without seeking legal or other professional advice.