How to distribute equity shares in a start-up business?

by Osama Natto, January 15, 2013

An Easy Way to Distribute Shares Among Partners and Employees At Start-Up

Entrepreneurs get excited when a great idea comes to mind, but once the dust settles, they realize that structuring any new business can raise a lot of difficult questions. In a rush to bring their idea to life, some start-up partners forget to talk about how they’re going to divide company’s ownership, assuming that the equity distribution is understood and it will work itself out later.

There is a lot of scattered information on the Internet and in books about how to hand out equity shares at start-up. There are also costly consultants around town who can do the math for start-up partners. Learning how to share control of a company is easy to understand, and most start-up founders can do it themselves once they become familiar with the basics of an equity sharing model.

The model described below brings the subject of equity sharing to light, which comes from my personal experience after co-founding six successful businesses and working with start-ups over that last seven years. The recommendations described in this piece gives new start-up founders some general guidance in dividing ownership, saving them time from making unnecessary equity calculations.

Partners

In the beginning, a start-up company launches from a simple idea. This idea usually comes from two or more people collaborating. Once the group decides to put their ideas into action, they become founders or partners of a new business.

A start-up should have at least two founding members, but it should not exceed five partners because experience tells us that less than two is a hobby and more than five is a party.

For this model, let’s assume that there are four partners seeking to distribute start-up ownership:

Partner #1: Innovator – The person who came up with the idea.

Partner #2: Scientist – The person who has the skills to bring the idea to life.

Partner #3: Program Manager – The person who will put everything together or bring the idea to the market.

Partner #4: Financier – The person who will use his or her funds to start the business.

Equal Partnership When Founding Members Work Without a Salary

It’s recommended to set up an equal partnership if none of the members work for salary. This is because experience has shown that dividing up equity among founders can get complicated, and it may become a deal breaker at some point during the start-up process. If none of the four partners in the new business described above accept a salary, each one should own 25% of the company before financing.

Variable Equity Distribution For Founders Who Accept a Salary

Equal partnership would not apply if one or more of the start-up partners accept a salary, since a founder without a salary takes on more risk. In some cases, one of the founders may become the financier of the start-up, as in the example above. Equity distribution will vary when this happens. The Seed Funding section below outlines the general rule in dividing variable equity shares.

Funding

Start-ups go through a series of funding phases. Each funding stage determines the amount of equity shares (ownership) that a business will distribute among its players.

Seed Funding

To bring an idea to life, start-up founders need cash to get them through to the next level of financing. Seed funds usually come from the founders themselves. Sometimes, the partners will ask their friends or their family to join the business to get their idea off the ground.

During seed funding, it’s a general rule that distribution of equity among partners and employees fall between 0.1% and 5% of equity shares. The founders and the seed investors then decide who gets what and how much.

In this model, the seed funding comes from partner #4. Since this partner will carry most of the risk, his or her ownership in the company will rise. The other three partners will receive a market salary in exchange for their work and a percentage of equity shares. The four founders in this start-up model may distribute ownership as follows:

Partner #1 (Innovator): Market salary + 0.1% – 5% equity shares

Partner #2 (Scientist): Market salary + 0.1% – 5% equity shares

Partner #3 (Program Manager): Market salary + 0.1% – 5% equity shares

Partner #4 (Financier): 99.7% – 85% in equity shares

Employees

Employees are separate from the founders. They consist of the support group that will help the partners bring their idea to reality. Employees of a start-up usually receive a salary. They also take on risk of start-up failure, although the amount of risk they carry is much less than the founders’ risk. The 0.1% and 5% in equity share distribution rule also applies to any new employees taken on during seed funding.

Offering stock options to an employee is justified because on top of the salary the worker receives, he or she takes on risk that things may not work out for the start-up. Company ownership also gives the employee an incentive to do well, which contributes to the start-up reaching its next level of funding.

First Round Funding (Series A)

If a start-up does well, their seed funds will push it to the next round of financing. In this round, the founders will dilute their equity shares by taking on some new investors. Venture capitalists usually take part in first round financing, offering the start-up partners and their employees a lot of money for a piece of the company. The first round financing will fund the start-up for the next 1-2 years and hopefully push it into the second round of financing and beyond.

Partners should distribute between 0.01% and 1% in equity shares to any new employee who comes on board during first round financing. The smaller distribution percentage is a result of the lower risk involved in joining a company that already is semi-established and that has found financing for the next couple of years.

Series B and Other Funding Levels

There are other stages of funding that follow a successful start-up. Ownership dilutes among founders and employees, as the company grows and acquires new investors. However, the number of owned shares among original players will always stay the same, and the value of those shares will hopefully increase substantially.

As a start-up realizes future funding stages, the distribution percentage of equity shares decreases for new employees. The employee and the partners negotiate the actual equity percentage.

Recap: Distribution of Equity Shares in a Start-Up (General)

Before Financing = Equal partnership among start-up founders

During Seed Financing = 0.1% and 5.0% of equity shares among partners and employees

During First Round Financing = 0.01% and 1.0% of equity shares among partners and employees

During Second Round Financing and Other = To be negotiated between partners and employees

Disclaimer: This article was originally published on OsamaNatto.wordpress.com (link)

 
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Samer Helmy , Tue 08.10.2013
As a serial entrepreneur, investor, and financier, I would go further than disagree, and outright state that what you are advising here is fundamentally flawed.

A model where the founders who contribute the idea, the vision, the science, and management holding less than 1% of equity while their financier holds 99% is outright slavery in any context. It is ridiculous and I have never heard of such a thing across 12 years of investment analysis, entrepreneurship, and being coached by dozens of coaches and advisers. If innovation and scientific work is involved as you suggest, they almost always retain more than 50%, and that is if financing was badly needed and it was close to millions.

Additionally, I would like to point out:

1- No such thing as founders paid equally regardless of type of contribution. Innovating visionary almost always gains the major shareholding, matched by the one with the irreplaceable scientific contributions. The rest can be outsourced or hired as salaried employees and so gain lesser equity.

2- Salary does not affect equity much, almost none at all. If founders are not drawing a salary, it should be because they are bootstrapping in the beginning, and most founders should start drawing a salary as soon as the business can afford it. Sometimes it is accounted for as a drawdown from their profits, sometimes it is an extra agreed upon. Many investors even ask for it because it creates emotional stability for the entrepreneur.

This is not opinion, this is factual case by case review across a whole career. Anyone can check on the history of the Top 50 companies born after 1980 to see how they were founded to validate.
 
 
Khurram Zafar , Fri 18.01.2013
As a fellow entrepreneur, adviser to several US based VCs, and an investor, I will have to disagree with your proposition. I have rarely, even in the worst of capital crunch, seen founders part with 85%+ equity in seed stage unless of course one is raising 10s of millions of dollars, which defeats the purpose of a seed stage. Similarly, typical post Series A cap table is rarely like the one you suggest. Less than 1% equity holding of founders post series A is a bit out of the ball park also. Having investors on board that demand this kind of dilution from founders is a bad idea to begin with. It kills the motivation of the founders and can't be good for the start-up as well as the investor's money.