The Only Wrong Answer is 50/50: Calculating The Co-Founder Equity Split
The spirit of entrepreneurship is alive and well in America, with some states making it easier to establish a commercial enterprise than others. In Maryland, for example, community support for new business, higher than average income potential, and proximity to Washington D. C. and government contract work all prove strong lures for commercial start-ups.
Unfortunately, Maryland’s high taxes and labor costs leverage a heavy burden against solo-ventures. To offset risk and establish a more stable footprint, taking on co-founders to share the load is increasingly common.
Maryland business attorneys work successfully with small and large businesses to navigate corporate co-ownership and equity splits, which, when left unaddressed, have often proved the undoing of many a start-up.
And, while there are various ways to calculate the co-founder equity split, the only wrong answer is a hasty 50/50 split.
When to Determine Founder Equity Splits
The first hurdle in determining equity splits is when to approach the subject: now or later?
Many founders assign equal equity splits before any measurable investment of time, energy, or money into the start-up. Often, early and equal equity splits presume to avoid later tensions and future disagreements among founders while creating a clear path for moving onto other operational decisions.
However, teams taking a more delayed approach observe and evaluate co-founder contributions over time, assigning ownership percentages later. This approach is more apt to result in unequal, though fair, equity splits based on each founders’ actual, realized contributions vs. expected contributions.
In either scenario, it is worth noting that Harvard Business Review reports that founder unhappiness worsens with hindsight, with the percentage of founders unhappy with their equity split increasing by 2.5x as their start-ups mature.
To protect your business, deciding when to define equity splits is vital and demands outside counsel by an unbiased, experienced business lawyer. They will guide you regarding the best timing for your unique situation and also about important factors to impacting equity ownership.
4 Factors Impacting Equity Ownership
Whether deciding equity splits up-front or later, several key factors impact the division of equity. Awareness of these four factors provides a foundation to assess whether shares will be divided based on expectation or execution.
The Idea
Intellectual property is valuable. The founder who brings the original idea for the product, skill, or service has contributed the very foundation to the business.
No concept, no business.
Financial Investment
Every venture needs money to launch. A founder contributing working capital or procuring independent investors provides a valuable asset to the start-up.
Sweat Equity
An idea without execution is just an idea, not a business. Founders investing their skills and labor provide the framework for marketable products and services.
Time Contributions
Founders investing their time are often the driving force behind motivating and advancing business development. Founders devoting themselves full-time to the operations and development of the business are invaluable, particularly when compared against those with divided priorities and attention.
As a business transitions from the exchange of ideas to performance-based results, founders often note the continued contributions or lack thereof of their partners. This leads to speculation about each co-founder’s merits and whether equity splits should be equal or equitable.
The Equal or Equitable Split: How to Calculate Equity Among Founders
There are two general types of equity splits: equal and equitable. Equal division of equity means that each founder receives an equal ownership share of the business, regardless of their attributes and contributions. In contrast, an equitable split determines ownership percentages, based on each founder’s contribution to the company. Let’s examine the two more closely.
Equal Ownership
Equal ownership equity splits are determined by dividing 100% of the equity shares by the number of co-founders involved in the start-up. If there are five co-founders, each co-founder receives 20% equity in the company.
The caveat surrounding an equal division of equity is that rarely is the contribution of each founder the same in scope to one another or to the growth of a successful business.
As an example, the idea generator. While it is true that without the initial intellectual contribution of the idea, there would be no concept around which to build the product or service, the execution behind an idea is the underpinning to the success of a business. The idea generator should benefit for their initial contribution, but to the same extent of the founders that work to launch the businesses?
Similarly, if two founders contribute sweat equity, but one only partially and in no other measurable way, should both be rewarded equally? Likely not.
Equitable Ownership
Every founder will make a contribution, but to varying degrees. Each input may be essential, but not necessarily equal in value. Founders that invest more time, risk, and effort should be rewarded with more equity shares than other less contributory founders.
Dividing equity based on the long-term value of a founder’s contribution is wise, though tricky. No one can see the future, which means that deferring equity splits might be wise when basing calculations in terms of execution vs expectation.
Talking with a skilled business attorney to help value the business and the contributions of each founder is essential.
Equity Splits and Your Maryland Business Attorney
While the endeavor of launching a new business is exciting and fun, the process of dividing equity isn’t going to be either. Discussions about money and valuing one’s contributions can cause hurt feelings and create inter-relational stress among founders who each want their efforts to be recognized and rewarded.
Consulting a Maryland business attorney is a wise strategy when navigating co-founder equity splits. Clear communication, early planning, and counsel from a skilled business attorney will help avoid painful missteps.
Contact Thienel Law today to speak with a qualified business attorney about negotiating business founder equity splits and ownership agreements.
Related
