What is Founders Equity and Why Should You Give Up Some
I didn’t know what founders equity really meant with my first company, and I did everything myself.
Lots of long hours. Nobody to talk to. Making all the decisions by myself; often not knowing if I was doing everything correctly.
Tons of anxiety. Self-doubt.
Back then, I was quite alone with my venture. Going solo wasn’t easy.
In my second venture, after all my business studies and work experience, things were different.
I was dead set on not doing it alone.
And I didn’t. I ended up running a team just shy of a dozen with maybe a little too many investors.
I went overboard.
Today, I’m looking at founders equity as an essential instrument that we, as entrepreneurs, need to understand well. You are making important decisions even if you are not issuing any stock.
If you want to be smart, fast and prosperous, this article is for you. At a minimum, these are the basics that you need to know!
What is Founders’ Equity, and How Is It Created?
Founders’ equity, or founders stock, means the stocks that a founder or a co-founder gets when they found or join a startup, e.g. a stock company. Equity is created when the company issues the stock.
If you become one of the startup’s founders or co-founders, you’ll then hold stock, typically common stock, which means that you own a percentage of the company in question.
Let’s take a few examples in founder stock equity splits:
- Case A. You are a single entrepreneur and hold 100% of the 10 000 common stocks of the company. You’re the boss.
- Case B. You have the majority of the stock, say 80%, and you have given 20% out to 5 co-founders against their “sweat equity”, meaning they work for you without salary (you equity finance their work), and they get a 4% ownership each in return. With these equity allocations, the number of stocks for each comes at 8 000, 400, 400, 400, and 400, respectively, in a 10 000 total common stocks case. You’re still the boss, but you have taken others to join your ride.
- Case C. You are two founders with 25% each, and you have sold 50% common stock to angel investors. That is 2 500 stocks for each founder and 5 000 for investors. If the investors have paid 20 USD per stock, your company POST-money valuation, meaning the valuation after the investment is paid, is 20 USD*10 000 = 200 000 USD. You are a captain and still have control. Yet, if you fail, you might not continue as the leader.
You have founders, co-founders, and investors. They all have stock, depending on how they have agreed to split it. Those who don’t have stock are either paid employees or pro-bobo volunteers.
No need to make this more complex.
In general, equity partners are all those who carry stock. Founder’s equity split refers to how the founders and co-founders have split the stock among themselves.
To be clear on the equity basics, stock options are basically a stock purchase agreement. It is another thing completely. Options refer to an arrangement in which employee stock options are given, and if the company succeeds (stock price goes up), the employees use the options to buy the stock with a lower before-agreed price. The rationale behind this is to incentivise employees to work so that the company stock price is valued higher.
Example 1: If you are running your own side hustle and you don’t need external capital to start your business, you might want to keep all the stocks to yourself. Having a simple setup might serve you well. No time wasted in negotiations with others. After all, they might not understand what you are doing. So, if you have everything that it takes to succeed, go for it!
What is Startup Pizza Theory?
Startup Pizza theory means, in general, that a slice from a large pizza is bigger than a small pizza just for yourself.
Ok, what do you mean?
Let’s take an example. If you own 100% of a startup, the chances are that you are a solo entrepreneur. It is just you, your skills and your capital — nobody else. I would say that is a small pizza.
In the other case, you might have a 20% founders stock slice of a company that has raised 500 000 USD capital, against 50% of shares, in addition to 400 000 USD in R&D loans, which with a 1 000 000 POST-Money valuation would give you a slice of 200 000 USD share in value. In addition, you would be probably sitting at the company leadership table, managing the daily activities, and you would see 900 000 USD in your company bank account, with an exciting 18-month business plan execution waiting on you. To that with a fair monthly salary and think that is called a quite tasty pizza slice.
See the difference?
Getting others onboard and getting investors can dramatically speed you up!
How many years do you want to be in your garage?
Don’t get me wrong. I am all in for bootstrapping, but I hate wasting time. So if getting investors and co-founders straight from the start means that I can jump 3 to 5 years ahead in time while taking a smaller slice, it is all wonderful by me.
I don’t need the whole pizza.
You should know that this is the decision you are making; you need to understand how radically different the two scenarios are.
Example 2: You have three founders, each with equal splits, and you have sold 40% of the company ownership to two investors with 20% each. Thus, you would have 40 000 USD, 100 000 USD post-money valuation, and five owners at the general stockholders’ meeting, all with 20% of stocks.
How Much Equity Should the Founder(s) Get?
Y Combinator partner Michael Siebel advises splitting the equity equally.
This is simple and clear advice, and I would advocate it as well.
However, I would first recommend getting a crystal clear view of what you want to do. How quickly you want to do it and how you are going to do it. This should define your equity split strategy.
If you are all equally valuable and have equally high motivation and commitment, an equal split makes sense. Which for the very first founders should be at least 50%, according to Corporate Finance Institute.
“More equity = more motivation”. Michael Siebel, Y Combinator Partner.
In many cases bringing on others shares the load, and you can get tremendous help and competitive advantage from complementary skillsets. But, face it, rarely are we masters in everything.
This means that you would need to motivate others to join your thing. You do this by giving them founders stock.
Example 3: You have deep industry experience and some business skills. You think you can rock the business solo, but you want to leverage the top industry minds and get additional capital, say 40 000 USD. So, you write your investor pitch deck and present that to the top four professionals in your field. You value your business at 200 000 USD post-money and sell 20% shares to four angel investors, each with 5%/10 000 USD. They all loved you! Now you bring talent into the company in advice and money (=smart money).
Vesting Unlocked; How Do You Protect Founders Equity?
You protect the founders’ equity with a proper vesting schedule.
“The standard vesting schedule among companies in the tech industry is 4-year vesting; 1-year cliff.” Patrick McKenzie at Stripe.
Huh? You lost me.
A vesting period means that the shares are given to the founder or co-founders across time. Cliff means that there is a year before any stocks are given.
The 4+1 vesting scheme is the standard in Silicon Valley.
First, this means that if the founder/co-founder quits or is fired during the first year, he walks with nothing. After one year cliff, the co-founder would get 1/4 of the stocks and thereafter every month 1/48 of the total stocks.
Say he has 10 000 stocks on the paper. Then, on 1st day of year two, he gets 2 500 stocks and then 208 stocks each month afterwards until he has got them all (which would be last month year four).
This protects against free riders and allows to replace team members if they are found out to be not suitable for one or another reason.
Time-based vesting is often a suitable instrument since it will create the commitment and helps to allocate the founders equity to those doing the job.
Like Michael Siebel Says, “Startups are about execution, not about ideas”.
Example 4: You were a team of five, and you had early investors. You had two founders with 20% shares and three co-founders, each with 5%. Investors had 45% at the time. You got the co-founders at the beginning of the second year to boost your skillsets. You needed them. You already had revenue coming in, and the seed investment round valued your company at 2 MUSD post-money. Thus each co-founder 5% slice was 100 000 USD in value, which was good motivation at that time. It was great that you understood the risks of one or two quitting before they had delivered, so you choose to set up a four year vesting with one year cliff. As it happened, one of them was not suitable. He looked good on paper, but working with him was a disaster. Not only he did not deliver, but he made the whole team performance and spirit go down. At 8 months in, you choose to replace him. In retrospect, that was an awesome decision since the replacement was instrumental to the next business phase, where you jumped 3x in annual revenues in just 6 months period of time. The 5% today is valued at 600 000 USD, and the three co-founders are working like a fine-tuned Swiss clock.
Running Stock Company as a Form of Art
I hope you’re starting to get the point.
And the value this thinking brings you.
You can look at a startup as an instrument with which you move people and phenomena across time. It is like a virtual reality brush; you paint time and space.
“What we do in life, echoes in eternity” Banksy
Once you have really embodied this understanding, there are really no limits to what you can do business-wise.
Conclusion; Founders Stock Done Right!
It doesn’t matter who came up with the original idea. What matters is the work ethic. Thomas Edison famously said that “Genius is one per cent inspiration and ninety-nine per cent perspiration.”.
It is essential to have everybody 100% motivated.
You do this by splitting founders equity. If you give, give enough to motivate and make sure everybody understands the value of the equity.
While Y Combinator recommends equal equity stake among the founders, for everybody that doesn’t work, you are the equity allocation judge — you decide.
Remember time-based vesting when you are doing your startup equity plan. If you are already few years in the business, perhaps, the typical vesting schedule (4-year vesting) is too rigid for you. Again, you decide and negotiate. After the one year cliff, have a monthly vesting trigger and reserve a small pool of founders equity if you need still additional hands-on board.
Equity allocation conversation is, often, the most important discussion you will go through in your venture. So please be smart about it.
Be generous and equal. Be fast and prosperous.