Allocating Equity to New Team Members

For a startup, equity is the most important asset it has. Equity is distributed by the founders to raise investment and even to hire great talent.

Giving equity to new team members has some benefits

- The startup may not be able to afford a talented person it wants to recruit. Giving equity helps in attracting that person to join in despite offering a comparatively lower salary.

- Giving equity to new team members is a great way to align their interests with the interests of the startup as a whole.

On the flip side, giving equity means that you are giving a piece of the company and are assuming that the new hire and the startup will find each other to be a good fit for each other. To reduce the uncertainty in this assumption, a lot of startups offer equity options, which get converted into common equity after a particular period of time, during which the fit and understanding of the new hire and existing team can be studied and assessed.

So having decided that equity can prove to be a great tool to get new talent to join, how do we decide what percentage is fair. This is an analysis which the entrepreneur must do.

Value the amount of money, time and effort which has already gone into the business. Now add to it the value of time, money and effort which will be put into the startup going forward. Let’s call this sum A. Now value the money, time and effort which the new team member will put in going forward. Let’s call this B. Dividing B/A will be a good proportion of equity to offer to the new team member. You can probably add to it a little growth premium to account for any additional growth the startup may see because of the hiring.

Splitting Equity Models Between Co-Founders

This is one discussion which does happen at the onset of any startup, but is not given enough attention. How should the equity be split between the different co-founders? If the split is not agreeable, the co-founders working harder get demotivated and the ones who do not deserve as much equity as they get tend to be at an advantage ('free rider problem').

I read this article about the different ways to splitting equity on Plantostart. It's a must read, especially for first time entrepreneurs.

The Fixed Equity Split Model

Most start-up companies use a fixed model to allocate equity to founders and early employees. In this model equity is doled out to members of the team based on what the founders think the other team members will produce based loosely on past performance and promises of future commitment. This method is widely used, yet fraught with danger when founders are forced to renegotiate equity splits when changes occur as they inevitably do in a start-up company.

For example, three founders with similar backgrounds and abilities decide to start a company and split the equity 1/3 each. One founder works hard, the next founder works really hard, and the third founder slacks off (our friend the free rider). The first two founders will eventually get tired of the behavior and attempt to renegotiate the equity split with the third. To make matters worse, there is an imbalance of effort between the first two founders creating a very awkward negotiation to say the least.

The Dynamic Equity Split Model

The solution to the free rider problem in start-up companies is the dynamic equity split model. A dynamic model allows for changes that occur during the early stages of a company’s life and allocates equity based on the contributions of each participant. Using this model, for example, the person who makes 25% of the contribution will ultimately receive 25% of the reward when it comes.

To use a dynamic equity split managers track the various contributions from participants. Contributions include not only a value for time, small investment, intellectual property, equipment and supplies, but also a premium for risk given the likelihood individuals may not get paid. A Grunt Fund is one such model. It applies a theoretical value to the various ingredients. Because start-up equity has virtually no value, a theoretical value allows managers to make meaningful calculations with regard to the contributions of the team.

Although a dynamic equity model is intrinsically fairer to participants, fixed equity splits will continue to be the norm because

1) dynamic models are a relatively new concept and

2) fixed models allow experienced entrepreneurs to take advantage of less experienced entrepreneurs.