Why Startups Shouldn’t Skip the Equity Conversation
Equity is a conversation that many founders shy away from. When you’re scoping out an idea or doing research into the market you’re considering, it seems premature to ask, “who owns what of the business?” Because in the early stages, there is no business, so what is there to own in the first place? But equity is one of those things that is not an issue until it is. And once equity becomes an issue, it can be a costly and unwieldy one.
As Noam Wasserman states in The Founder’s Dilemmas, “entrepreneurs usually find it much harder and more costly to undo an early founding mistake than to make the right decision, to begin with.”
The Importance of Equity
According to Investopedia, “equity represents the shareholders’ stake in the company, identified on a company’s balance sheet.” Typically every founder is a shareholder in the company. And whether they’ve invested time, money or blood, sweat and tears, they own some of the business. When there are multiple co-founders or multiple owners, ownership determines the weight of a founder’s influence on the company’s vision.
Until founders get revenue or external investment, there’s no cash, so founders often use equity as a tool to incentivise the founding team and early employees. However, if you give someone too much equity and they don’t pull their weight, this can cause a lot of tension within the team. Similarly, if someone doesn’t have enough equity, they may not feel respected, hurting morale. The other time equity matters is when it scares off investors. Or too much equity has been given away, leaving the founding team with little control over their own business.
Different ownership models have emerged over the last decade. There are broadly three approaches for splitting equity within the founding team:
The Old Faithful: Equal Division of Equity
For a long time, founders opted for equally fixed equity splits. Ownership is split between two founders 50/50 or three founders 33/33/33. It implies that founders are taking on the same level of risk and working the same hours.
- It starts founders off equal footing. Fixed splits mean that founders agree to take on the same level of risk or responsibility.
- It allows founders to start building their startup immediately rather than on the nuances of equity and where the business might take them.
- It forces teams to renegotiate every time circumstances change (a member leaves, takes on more responsibility or joins the team).
- It does not take into consideration the nuances and volatility of early-stage startup life.
The Transaction Approach: Assigning Weighted Value
Co-founders assign a weighted value to assets or contributions. For example, founder one could get equity based on coming up with the idea once it has been successfully executed. Founder two invested £20K into the business and so got equity as a bonus for that. Founder three is working on the startup full-time while the others balance a full-time job, so they get rewarded with equity accordingly. There are many “equity calculators” or spreadsheets that can be found online to allow your team to work out to assign value to contributions.
- A good way to manage expectations and agree on the value of different contributions
- Ensures co-founders discuss roles, risks and responsibilities in the early stages of founding
- Have to speculate with very little context on your company’s current and future value
- Often founders place more value on contributions made in the early days, but the value isn’t static, and things can change quickly.
The New Way: Dynamic Equity
An increasing number of founders are opting for a new approach: dynamic equity, whereby equity evolves as the startup grows. Each participant is assigned a market rate; they log their hours (either using an app or spreadsheet), and the more they work, the more they own. At the start of a new business or project, no one can know what each contributors participant will be. Founders often overvalue their future contributions without knowing that circumstances, direction and team dynamics could change at any point.
- Less room for conflict forces founders to adopt a transparent culture where all contributions are out in the open.
- Much more flexible than the other two approaches and takes into consideration the volatility of early-stage startup life.
- Early contributions tend to outweigh those of new joiners, leading to resentments for later stage co-founders who also take on significant risk.
- Forces co-founders to have difficult conversations about what they deem to be worthwhile contributions early on.
One of the most pressing challenges founders must overcome is employee compensation and equity distribution. How a startup team responds or does not respond to this will say a lot about the company’s future culture. Unfortunately, it can be easy to underestimate the costs and complications added by new co-founders and founders overestimate the value that prospective founders will add before any work has been done.
If you do want to opt for Dynamic Equity, Here’s Some Best Practice
Anyone that joins your startup in the early stages will have a huge impact on the culture, whether good or bad, so it’s crucial to have a period where both parties are testing the water. For example, the initial founding team are much more likely to be overly optimistic or certain about the future of their company. Similarly, new co-founders can overestimate the value they will bring. A trial period can help to offset some of these challenges.
Clear and actionable objectives need to be in place that new contributors can meet to get their ownership. Objectives attached to key results seem to work best with one overarching objective and numerical values linked to key outcomes so that it’s pretty clear whether a goal has been reached or not. For example, “Objective: Lead customer outreach after the launch of the app. Key Results: On-board 50 users onto our app. Get five positive customer reviews.”
Minimum Time Commitment
It is precisely as it sounds. In many roles in the early days of startups, specific hours need to be reached so that the team gets the true value out of the collaboration or partnership. Before welcoming a new joiner or founder, it’s essential to have a conversation about hours and expectations. Not everyone can quit their day job, yet a startup is fragile and needs dedication to survive. Founders need to be happy to have these uncomfortable conversations.
The equity conversation is not one to be ignored. It has long-term, and far-reaching consequences on a startup’s culture, agility and poorly thought out equity split can lead to fraught team dynamics. Resentments build when a team member is not pulling their weight or when a new co-founder completely transforms a company for the better but is not rewarded accordingly. The equity conversation can highlight a company’s priorities and what they deem to be valuable. It is about so much more than ownership.
About the Author
Naïma Camara is CEO & Founder of Ownership, an app for simple shared ownership. It allows anyone working on a project to log their hours, and our app creates fair ownership based on the hours worked and money invested. The team has spoken to hundreds of early-stage founders and creatives to build all the features they need to get started on a brand new project with a great team.
Naïma has an MA in US History & Politics from UCL and believes her grounding in history and knowledge of the systems of power that govern society allows her to thrive within teams working towards a social good to deploy tech that can achieve real positive change.
Naïma also likes to blog at https://www.naimaella.com