Back in 2004, in a far, far galaxy, when I was obsessed with the idea of Targetprocess, I started assembling a founding team. Obviously, there was no money in the game, so everyone had to work evenings and weekends for free—well, for a share in a successful product in an unlikely future.
The founding team consisted of five people at first. One person made off real quick without doing anything. And so there were four of us in the founding team. Since there was no money, only a share, we needed a mechanism for an equity split.
It was clear that static equity allocation won’t work. The thing is, we had a pure and beautiful idea elaborated to a certain degree—and not a single line of code. In such a situation, if the founding team agrees to divide the startup equally, there’s a possibility that John won’t do a %*ck, and Mary and Jake would need to grub as if damned—for an equal founder equity share. Not fair.
Seriously though, fairness is the best foundation for the castle of your future company, regardless of how you’re going to split the equity.
In the case of our startup, the only resource we’ve invested in the product was our precious time. This was the reason I thought we needed to tie founder shares to the time spent. Almost all of us were working for outsourcing companies back then, and time tracking became a habit; it seemed very natural. And so we measured our equity depending on time spent for the new company.
The general point here, however, is that the founder shares in a company are dynamic and change over time. Here’s a simple example:
- Michael spends 40 hours on the startup in April;
- Mary spends 30 hours;
- Jake spends 30 hours;
- John spends 0 hours.
At the end of April, Michael has 40% of the founder shares, and John has 0% equity compensation. We rated an hour of work of each startup founder the same, and our calculations were real simple.
For a very long time, this deal for equity split was merely our verbal agreement based on mutual trust. The mechanism of splitting equity wasn’t cast in stone (or paper for that matter), so it all had zero legal force.
Mutual trust is the second cornerstone of your future company after fairness. Trust is very, very important for a good equity conversation.
The dynamic share model is the only correct way for a startup to split the equity pie. I must admit, in our startup team, it was overly simplified. Ideally, when a CEO or an employee is not paid a fixed salary, we need to take into account all the benefits they bring to a startup—and translate it into their share. Now, even in an early stage startup, a person can benefit a company in many ways: by investing their time, money, ideas, and connections. Time and money are the easiest to estimate. With ideas and connections, valuation gets more sophisticated.
Another tricky part with dynamic equity ownership is this: When the hell do they become static for every co founder? In our case, there was a rather complex mechanism. After working on the project for a year and a half, it turned out I had somewhere around 45%, the rest had 10–20% each. Our chickens looked like they would hatch anytime now, and so we wanted to count them asap.
We decided that, since everyone performs an almost full-time job at the company, over several years, the shares will level out and become more or less the same for each co-founder. Now I do think this is an unnecessary complication. We could as well just leave the time tracking and live like this for another two years. This would have balanced the shares, too, but by a much fairer mechanism.
So what’s the point of this whole story? It turns out there’s a book describing how to split startup equity in a much more systematic and in-depth way. Check it out on Goodreads.
The book isn’t particularly well-written, but it provides a genuinely good equity model split. If you are too lazy to read the whole thing, you can check out this keynote. I truly believe every company founder should know this model. In the book, the dynamic shares are thought through much better than we did at Targetprocess, considering individual skills, money investments, founders leaving midway, and much more. For instance, Slicing pie very clearly spells out when the shares must stop being dynamic—when the virtual value of the company has reached $ 1M. So if there are five founders and each has a virtual salary of $ 50K a year, it’s in four years. Depending on where you work, you can stop the dynamic model at $ 0.5M or whatever is realistic.
What’s more? It’s great to keep in mind that for a very long time, your startup equity pie is worth almost nothing. And that’s why fairness is better than greed.