Deciding how to split equity among co-founders is often the most common and earliest point of contention when starting a company. In today’s episode of The Small Business Show, George Deeb, managing partner at Red Rocket Ventures, outlines key factors that should drive equity division decisions to avoid future conflict.
Deeb stresses that there is no “one right way” to make these decisions. Each situation is unique and must be examined and negotiated to ensure equality. He offers four considerations co-founders should consider when deciding how to allocate equity.
The fundamentals of equity allocation
There is no concrete correct way to allocate equity, as every situation is unique and complex. However, all parties must come to the conversation with clearly defined points to facilitate the negotiation process and reach a mutually beneficial agreement. While there is no right or wrong way to structure these negotiations, Deeb suggests that the following questions be explored at the negotiation table.
Whose idea was it?
Deeb suggests that the founder who originated the business idea should receive a premium, approximately 20%, over other founders. So, instead of a 50/50 split, a 60/40 split may be more equitable. However, this shouldn’t be the only factor considered, especially when another founder is contributing significant capital backing rather than innovative ideas.
How much capital was invested by each party?
When discussing equity, it’s critical to consider how much each party is investing in the business. If a business is valued at $1 million, and one founder invests $500,000, it’s similar to investing a 50% stake in the company. This could shift a default 50/50 split to something along the lines of 75/25.
The terms and conditions when investing in a company are all up to negotiation. However, typically investments are either equity investments or loans. With equity investments, the investor gets an ownership stake in the company. However, if the investment is structured as an actual loan, the investor doesn’t get an equity stake but will instead be repaid (potentially with interest).
What is the importance of their role?
How mission-critical is that co-founder’s role in the organization? Will they be the driving force behind the company as the CEO, or will they be heading the marketing department? While both roles are essential, they carry distinctly different weights, risks and skills.
How much salary are they forgoing or deferring?
A founder can opt to forgo or defer a salary to help the company conserve cash. This decision carries a significant risk burden and, as such, should be considered equivalent to a cash investment.
What other financial risks are they taking on?
When seeking financing from a lending institution, the institution often requires a personal guarantee (PG) on the loan. If a co-owner pledges their assets, such as their home or vehicle, as collateral for a loan, it must be factored into the equity discussion. Not only are they assuming significant risk, but it also carries heavy financial consequences that can impact their families.
The most common pitfalls
Once a contract has been signed and equity has been delivered, the deal is done. That’s why it’s critical to go into these discussions prepared to avoid some of the most common pitfalls that can cause imbalances, tension and potential legal ramifications.
Rushed acceptance of terms
First-time founders may accept inequitable deals due to a lack of experience, excitement or desperation for funding.
Oftentimes, this leads to them being too readily accepting and flexible, making them easier to exploit. Seasoned investors may recognize this naivety and attempt to exploit the imbalance to obtain a more favorable deal. Deeb advises first-time or inexperienced founders to seek counsel from more seasoned peers or consult a lawyer.
Informal or casual agreements
Deeb strongly advises founders to refrain from conducting equity discussions casually and informally. This can often breed misunderstandings, leading to broken trust and potential disputes.
Failure to legalize the agreement
Once a decision has been reached, co-founders must record the details in a legally binding agreement. Deeb acknowledges that some owners may not have the money required to foot the legal bill; however, they should—at the very least—thoroughly discuss the terms and iron out any potential misunderstandings before proceeding.
Failing to involve significant others
Equity decisions extend beyond the individual negotiating the deal and can impact the entire household. Deeb suggests that founders align with their families, particularly regarding financial risk or long-term ownership implications. Estate planning should also be taken into consideration to ensure ownership transfers appropriately in unexpected circumstances.
How to identify a good deal
One of the best ways to identify a good deal is if both parties are happy, yet very slightly disappointed at the same time. Deeb describes this as the perfect “middle ground” where both parties didn’t get everything they wanted but got most of what they wanted. It’s a good indicator that neither side has the advantage over the other.
Revisiting settled terms
Deeb advises parties to move forward without revisiting settled terms unless there is a significant change. If original expectations aren’t being met, it may be appropriate to amend the equity split.
Navigating equity discussions
Every situation is different, and the discussion should revolve around the value each founder contributes. Contributions can range from ideas, money, time and risk. The most critical aspect of successful negotiations is to be transparent, thoughtful and document the terms to build a fruitful partnership and avoid disputes.
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