Saturday, March 31, 2012

Splitting up the Equity

People often ask me about splitting equity up in a start-up.  People commonly ask how they should split the equity within a company.  For example, if there are 3 partners, do they each need to be at 1/3 of the equity?  If you have 2 partners, should you split the company 50/50?  What happens when you disagree?  What happens if one partner leaves the other hanging?  How can you run the business without that partner?

Well...I've seen all of the above things happen.  When there are 2 partners in a business and they each own 50% and they have a "majority rules" rule - they really have unanimous ruling - i.e. everyone (both parties) must agree for anything to "pass."  That sometimes works out just fine.  But, what happens if one partner gets upset and decides he effectively doesn't want to be part of the business anymore?  I saw this exact case study recently.  So the "active" partner was left to run the business.  How could he legally make any decisions for the business?  I'm not sure he really could...but decisions had to be made, so he made them.  This could easily have become a very ugly legal battle.

To answer the question above, does the equity need to be split up equally, absolutely not.  Equity should be split based on contribution to the business.  This is easy enough to say, but often tough to define.  What you don't want is for anyone of the founding partners to feel slighted by the equity they received.

In one business that I was a founder in, my partner and I decided to split the equity 60/40.  60% to him and 40% to me.  We originally did a capital call (i.e. we needed money and it had to come from us) for $20,000.  That meant that I had to come up with $8,000 and my partner had to come up with $12,000.  The reason we split the company as we did was that I had a day job and this was his day job.  Neither of us were going to get paid until the company made money, but he was going to be available for every meeting and I couldn't guarantee i'd be available to fly all over the country on a moment's notice.  

As time rolled forward after the sale of another business, as a part of my earn out, I was asked to not spending any more time on that venture.  This left my partner holding the ball...yet I still owned the equity I owned.  He was still working on the business full time (and getting paid by that point) and I wasn't working on it at all.  For the 3 years prior to this, I felt like I was working 100 hours a week on the business and I didn't feel like he needed to do the same.  I was building out the technology, managing the tech team, etc.  At times I felt like I should have had the 60% and he should have had the 40%...but it all worked out to be the exact right percentages in the end.

As we raised money and took our valuation from $20,000 to millions of dollars, the capital calls turned into a lot of money!  When you own 40% of a business and if the company is valued at $10M and you do a capital call for $1M, that's $400k that you would need to come up with.  This is where the VC firms often "get you."  They will do a capital call for a large sum of money - let's say it's $5M in this case and they will either dilute you heavily or they will do what's known as a cram down.  A cram down is when the valuation is reduce and money is put into the firm.  So let's say the new valuation of the company is $1M instead of $10M..then they put in $5M, so the new post money valuation would be $6M.  At this point instead of owning 40% of the company, the existing shareholders would own 1/6 or 16.7%.  So if I owned 40% at this point, I would now own 6.7%.  That might feel like it was crammed down your throat!

You can split up equity by any number of formulas, but it has to feel right to everyone...and you have to think about the long term effects too.  In another business I started, I had 2 other partners.  We each owned 33% of the business the day we started and other than employee options, at the end we still each owned an equal portion of the company.  This always felt right to me over the years as we were equal contributors.  None of us put money into the business to open it.  We often self funded the company (by not cashing paychecks), but we did this equally.  So it worked.

In other businesses one person puts in all of the capital required to start the business and someone else puts in their time.  Spend the proper time determining the right way to divide up equity.  Remember that the most expensive thing that you'll ever give away is equity.  If you turn your business into $100M business, each and every percent of the business is $1M.

So think about equity carefully.  Give it the proper time and energy.  You don't have to determine this before you get going.  In fact in several businesses that I've worked on, we didn't determine the official equity split until we were pretty far down the path.  At that point we had a much better feel for how the equity should be split.  We knew who contributed what by then.  I've only had one instance where this didn't work out well for anyone but the CEO (he wanted to keep the lion-share of the equity, which didn't feel right to all of the contributors).

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