A critical input into the pre-investment due diligence process for a startup is the capitalization table. Also known as the cap table, it shows how the startup’s equity is distributed among its owners. These owners include the founders of the company, team members with equity grants, investors, and in rarer cases advisors. The cap table is an important source of information because it shows how the founders allocated equity among themselves and to other parties in the past. It reflects the thoughts of the founders regarding the contributions of each owner to the business. The main contribution of founders and team members is in the form of time and effort. This is also called sweat equity. Investors contribute their capital, network, and strategic guidance, while advisors act in a similar capacity to investors without providing capital.
In the post Don’t give away more than 30% of your startup in a single funding round, I provided guidance on the allocation of equity to investors. As the title of the post suggests, I recommend that startups not concede more than 30% of their equity to investors in a single round. This will ensure that the founders have sufficient equity and hence financial incentives to continue working to grow their startup even after the 2 to 3 rounds that are often necessary to scale a VC-funded business. This post will address a different but equally important equity allocation decision: that among founders.
I’ve discovered that many startups allocate equity rather arbitrarily among founders. The most common allocation is an equal split according to the number of founders. So if a startup has two founders, each gets 50%. If it has 3, each gets 33%. This approach is particularly common when the founders have been friends for quite some time. While this is an easy way to get started without stepping on each other’s toes, it often leads to problems down the road when there is a clear divergence between the relative contributions of each founder to the business. This is why I recommend that equity allocations among founders be based on fairness, not equality. In particular, a fair allocation is one where each founder is compensated according to their contribution to the startup. Although, as stated earlier, this mainly takes the form of sweat equity, it can also include capital, especially at the seed stage, as well as a relevant network or other inputs. The specifics will depend on the responsibilities which must be carried out in order for the startup to succeed. However, by applying the principle of fairness to equity allocations among founders, a startup can avoid many of the problems which would otherwise emerge in the event that there is much greater value at stake in the future.
As a founder, a good test to see if you’ve allocated equity fairly among your team is to try to justify the allocation. I request this from all of the founders with whom I enter later stage discussions, and the results range from incredibly premeditated to downright amusing. At one end of the spectrum are those founders who have clearly thought about each founder’s contribution to the startup, including such intangible but important inputs as a founder’s ability to motivate the team. At the other end are founders who have clearly placed the question on the back burner with the hope that it will somehow miraculously take care of itself. Unfortunately, in some of these cases the issue has been left simmering for so long that it becomes an obstacle to investing. If the founders agree that the current allocation isn’t fair but cannot agree on what a fair allocation should look like, it makes little sense for an investor to back a dysfunctional team.
My recommendation to founders reading this post is simple. Set aside half an hour this week to meet among yourselves and voice your thoughts about the fairness of your equity allocations. In most cases, there shouldn’t be a major problem, so thirty minutes is all you will need. If you find yourself taking much longer than this, you may have identified an important obstacle to your future success. Address it now. Your team and investors will thank you for it.