The decisions made by a founder regarding equity allocation early on in a startup’s lifecycle will impact the company’s financial well-being over time. Decisions made now can put your company in the best possible position when it comes time to attract talent, garner investment capital, and add to your teams.
Getting started with equity allocation
First, consider the purposes, such as incentivizing contributions to company growth or promoting long-term commitment. Start by asking this question: What will a co-founding team member contribute to the growth of the business over time?
Equity allocation to co-founding team members should reflect a reward for the value they’re expected to contribute. If the expected contributions are fairly equal, then the initial equity should be allocated relatively equally (for example, 51% and 49%). Suppose you anticipate the co-founders’ contributions to be unequal. In that case, a greater portion of the initial equity granted should be distributed to the founder(s) who will be contributing more value to the company.
In addition, the team can adjust the proposed equity allocation to account for disproportionate past contributions to the business (such as seed money contributed by co-founding team members, code, or ideas.) by increasing the number of shares allocated to those early contributors.
Upon incorporation, most of the shares should be allocated to the founders, and a smaller portion should go to the option pool. The ability to offer equity in your company will continue to be a valuable tool, so avoid giving away any large amounts of company stock (e.g., greater than 10%) without consideration.
Impose time-based vesting
Each co-founder should be subject to time-based vesting on their shares. With time-based vesting, if a co-founder leaves the company, they will be entitled to keep only the shares they have vested to that point.
Time-based vesting protects the company and the other co-founders if the founding team’s initial assessment of someone’s future contributions is inaccurate. Co-founders may choose to part ways for various reasons. Without vesting, a co-founder could walk away at any time with a large chunk of the company’s shares.
The time to impose vesting is at the time of incorporation, when everyone is excited to build a company together, and not later on when disagreements are more likely to arise. A typical vesting schedule provides for the monthly vesting of shares in equal increments over four years, with a one-year cliff before any shares vest.
How to split equity among co-founders
Equity—non-cash compensation that represents partial ownership in a company—allows you to attract talent to an early-stage startup. Founding team equity is typically distributed among those who join the startup in its earliest stages, i.e., founders, financial backers, and employees.
Here are four factors to consider for an optimal startup equity distribution for founders:
1. Salary replacement
In some cases, co-founders and/or employees will agree to work for lower salaries in exchange for ownership in the company. Be sure that wages satisfy laws governing their payment. Paying employees through stock or stock options can violate state and federal wage and hour laws if unaccompanied by sufficient pay.
2. Idea generation
Whoever proposed the chief value proposition of a company typically receives the largest percentage of equity ownership. However, dividing equity's sum may not be that simple. Concrete, measurable contributions in capital and sweat equity might matter more to the success of your startup than a single idea. Therefore, a fair equity split will usually follow a careful analysis of the relative amount of early development work contributed by each co-founder. That requires a balance in which the goal is to fairly reward the early contributors while also leaving enough equity to incentivize others to contribute and to move the idea forward.
3. Development stage
Those who join a company in its earliest stages, such as before the seed or Series A round, often receive a larger grant of equity in recognition of the time they invested and the risk they assumed in working for such a young company.
4. Seed capital
If one co-founder provided more seed capital into the business than the other(s), equity would often be a way to reward them.
Tips for managing your cap table
A capitalization table (or cap table for short) records the pro-rata stock ownership of the company’s founders and shareholders. Maintain your cap table well to ensure that stock is distributed with care. Follow the tips below to keep your cap table organized and accurate.
Setting the option pool
When you’ve determined how you plan to split equity among co-founders, focus on setting the size of your option pool. Typically, an option pool will range from 10-20% of the total equity among startups. The optimal size of the pool will depend on how much hiring you intend to do before the company’s first round of equity financing, such as a Series A raise, for example.
Authorizing shares of common stock
When incorporating a new Delaware corporation, a good starting point for founding teams is to authorize 15,000,000 shares of common stock. Of the authorized shares, the co-founders should allocate 10,000,000 shares among themselves and the option pool. If the co-founders anticipate greater hiring needs, they can increase the pool size and reduce the allocations to themselves. Typically stock allocated to a CEO, COO or other C-level executives ranges from 2%-10%. Stock allocated to other employees ranges from 0.2% to 1%.
Purchasing founder shares
Once the co-founders have decided on their share allocations, an attorney can help them document and make their share purchases and any recommended tax filings, such as their 83(b) elections. When the purchases are complete, the co-founders hold issued and outstanding shares. The shares in the option pool do not become issued and outstanding until the company grants options as approved by the board of directors and those options are vested and exercised by the recipient of the option grant.
Centralize the data
Centralize and share your company’s cap table with your company’s accountant and lawyer. A tool like LTSE Equity can help you keep accurate records and plan financing rounds.
Review your cap table regularly
Review your cap table whenever you make a change, hire a new employee, or issue a round of funding. In such instances, you may need to review the equity plan and to update the cap table. Just as you would check in with your accountant quarterly, you’ll also want to review your cap table on the same schedule at a minimum. As a business owner, it’s important to know how much of the company everyone who’s invested in it owns.
When getting started with equity allocation, think back to the purpose of splitting equity: to incentivize future contributions and instill long-term commitment. The goal is to balance allocating equity among co-founders while leaving enough available to sustain growth and hiring. Be strategic. Don’t make concessions now that you can’t live with in the future.
Disclaimer: LTSE is neither a law firm nor provides legal advice. Before making decisions on matters covered by this post, readers should consult their legal adviser.