This is just one of many methods. Different businesses suit different models. This presentation is to help you clear blind-spots, seed ideas & inspire. It also serves to break what is often a back of the napkin approach by entrepreneurs at the critical start point. If you prefer watch the University of Sydney lecture I did on this topic.
What’s the experience of equity splitting?
How to handle initial equity stage. This is really important and everyone gets themselves into problems. If you saw the Facebook movie you saw the drama it caused, not getting initial equity locked down properly
We have thousands of startups on our product and I’ve met lots of the young startups because as part of working with educators and startups. Equity splitting is a really common need. They often haven’t got the equity split right at the start. You get what’s called the greedy bone effect.
The greedy bone effect is when it’s all cool and cosy at the start. This is when there’s no value, so greed hasn’t kicked in yet. However, when you get six months down the track, and the business is starting to get some traction and some success, all of a sudden one or more founders are saying “Hang on, why did I say 20%? My partner got 80% and I’m doing all the work!”.
Thus founder heads off into full-blown resentment and before you know it the startup has busted up and it’s all over.
Obviously you want to try to avoid that if you can. I’m going to give you a way to do that. This is one way, I’m sure someone from Harvard will give you another way, and a someone from Sydney Uni will give you another way, but this is my way.
Here’s what equity splitting usually manifests as:
- Legal paperwork
- Changed contributions
- Unaccounted contributions
This is the common experience of equity splitting. It’s unfair, it’s incomplete, it’s unstructured, there’s legal paperwork, there’s changed contributions over time. People put in different levels of work into the venture, and also unaccounted for contributions. You might leave your job and work in the business, but you don’t change the amount of equity you got in the business with your partner and that’s unfair. As a result you will see resentment and all kinds of emotions appear.
Default elements of equity splitting
IDEA ~ CASH ~ TIME
The conversations goes something like this…
I’ll put in X and you put in Y. As it’s my idea and I’ve already been working on it, I get more equity for that.
People new to business often come to the conclusion that this is how equity splitting is in business. It’s basically worked out by looking at who’s putting the ideas, the time and the cash into the venture initially.
You will absolutely get the wrong answer if you use this method, but circa 95% of people use this method. That’s why most equity splits are incorrect or aren’t as accurate as that could be. It’s impossible to get it completely accurate to be honest, but you can get it close. You can get it to a reasonable level where reasonable people will stay in partnership, an investor group, or a syndicate, or even if it’s just two founders without getting in a whole lot of fights, legal or otherwise.
Business equity is often split on a napkin
This is the typical initial approach that some think is a kind of right of passage to call yourself a “startup”. As though you need some cool back story for later on how your amazing success started on a napkin.
In reality people do tend to do it on the back of a napkin, a piece of paper or similar. The classic one is Cafe napkins with domain names, how much money each person’s putting in. They start working out a few things some people are putting the business idea – “Oh, it’s my idea so I should get more for that”. This kind of emotional analytics gets used. You might get an answer, but it’s pretty much a hack job in toward getting an answer as to how you split your equity.
Even if you’re going to do this by yourself, this is really important. Mostly startups end up getting an investor unless you’re planning to do a completely organic approach, owning one hundred percent. Including never giving any equity to your staff, never invite any other investors, all the way to the end and exit. In my experience it rarely happens.
You might end up with a big business that doesn’t list. There are people who have done that and often they are very successful and never sold their businesses. So I can’t say that it doesn’t happen, there’s definitely situations. Actually, if you want a stress-free lifestyle, that might be a better way.
Do some stuff on the napkin first to get the thought process going, but you’ve really got to switch into logic and maths.
Where do we start? A: Logic, then some maths
Lose the Napkin approach. Don’t do 50/50. It will come back and bite you later. The greedy bone kicks in for some people as the money shows up. e.g. Facebooks history.
The only way to do that is to start dissecting what it is that makes up the equity value of a business and having a spock-like approach to it. I use this analogy because I like the logic of Spok the character in Star Trek. He’s a very logical person, an engineer, strategist etc. He’s the equivalent of a product person. The sales guy is Captain Kirk and that combo is a common and classic startup. Two founders, one product, one sales. So startups often end up in that sort of scenario.
Value execution and focus skills
Don’t over value ideas. People who get stuff done are super valuable.
There’s probably ten plus things to think about that makeup equity value at the start and also down the track too. The people you bring in and what you should give them is critical. Say you meet someone who’s really good, had lots of success with startups you’re sitting there with your other founder saying “What do we need to give this person in equity? What are they worth?”. That’s a really hard question to answer, but there’s actually an easy way to work it out.
Value, execution, and focus skills are much more valuable than ideas. That’s the first thing to consider. Everyone goes straight to “the ideas are worth the money” but I guarantee someone else’s thought it up or come up with some variation of that idea and it’s not as valuable as people think. Actually the idea you can get you in a lot of trouble. If you claim the ideas worth all the money and someone already has a patent on it and you go and build out that idea, it’s actually a liability to the business. You built something someone else has already owned and all of a sudden, the guy that owns all the equity has got the idea that you’re in court about. So you can’t really look at ideas as the core value in an outright sense. It’s okay to attribute value to it, but I just think about execution. It’s way more important. Winning at the game of startup is much more about getting stuff done.
The officer at risk
Don’t underestimate the risk and thus equity value of being Public Officer, Director etc. When the shit hits the fan you’re the person everyone goes for.
The way we have our society set up is that there is someone who is a risk taker, whether it’s legal, tax, privacy etc. Someone’s taking that risk, and you can have all the founders be directors and share the risk equally, or you might have a senior founder or who owns 80% – 90% of the company and you agree that that person is going to be the director and the public officer. You’ve got to attribute some value to that, and they should get significant equity for taking that risk because it’s hard dollars if you think about it.
There’s no way I would go and be the public officer of a company (i.e. the person the ATO or ASIC comes after) without knowing I’m not getting some reward back for that. That would be insane. Plenty of small startups do this thopugh. There’s one person taking all the risk, a director, public officer, company secretary, you name it. They’ve got 50/50 shares while the other person is so much safer legally. It’s a crazy situation.
Present value your future time and cash flows
- Future cash flows need to be present valued.
- If you plan to work for free for 3 years and your partner only 6 months. Allow for this.
- Free loans need to allow for interest to be paid in the future or equity provided for in lieu.
You’ve also got to present value your future time and cash flows. What this means is, one founder might have committed to two years of working for nothing because they had been in a job, they’ve got some savings and they paid off their house. The other founder might be a younger person who hasn’t done any of that and can only afford to really do this for six months and then the startup has to start paying that person. The person that’s giving up the two years has to be given some valuation for that in the equity split.
Foregone salary, as an opportunity cost
What you give up in pay is real money but it’s harder to save $100k than earn $100k. It is definitely not the same thing for your calculations. Allow for differences like this in the model. People often make this mistake.
People will say “I’m not going to earn my $50k a year for the next two years, so I’m putting a $100k in the business”. No this is not correct. To put that $100k in the business and thus have saved $100k. In reality you’ve probably got to earn $500k+ in a normal job to get $100k saved even if you are an excellent saver. You’ve got to allow for that. That’s the foregone salary opportunity cost in essence.
Benchmark your ideas to competitors IP value
Don’t over value ideas. IP is essentially “Creations of Mind”
Flipside: IP can be a cost if someone else beat you to it.
Check your IP value against competitors in similar situations.
The thing to do at the start of the process is to benchmark your ideas versus competitor’s IP values.That’s about being realistic about what your IP is worth. Everyone new to business seems to think it’s worth more than it really is because their mind will find ways to say why it’s special or different because they’re in a state of excitement around the idea. Which is fair enough, that’s human nature, but you’ve got to be realistic about it. You might see it like this. “Okay, my competitors product idea is not as good, mine is up here.” The reality is for them to get from where they are to where you are is with the advanatage of a running business (versus a riskier startup) can make it easier. The sales and operational machines are going, it’s probably not a lot of extra capital for them. The difference between the product levels is really the IP value. The difference for that competitor to get from where they are to your products level is really the practical IP value. You can’t just look at it this in its outright sense. That is one lens but not the only one.
Another good example and a classic mistake people make around IP value and how that relates to the stock market or business for private sale markets. When you benchmark the value of your business against another business, its R&D, assets and so on, the opportunity cost of starting a business from scratch and investing the dollars to get it running has at a minimum to be at parity to the business that’s listed and trading. That’s why in high inflation environments stock markets often rally (go up). The cost of starting the business goes up and thus the listed businesses or businesses for sale go up in value (as that is the alternative, buy an existing business). You have to look at them in a similar way. The IP is the same. If I go and create that IP in a high inflation environment and it’s expensive to do (IT people might cost $200k for a really good person, not $100k) the business that’s listed has gone up in value by those costings. That’s because to redo that is now cost $200k. Inflation is your friend in IP.
Relationship and health pre-conditions
Great businesses are often destroyed by bad marriages, debt or health issues.
This one is nearly always forgotten about. Say a marriage in a dangerous situation can be just a problem waiting to explode if you’re with two founders or group of investors. All of a sudden people split up and they’ve got to sell their shares. That means it gets a bit public you’re getting out of the company, stuff can happen and it gets a bit messy.
Someone could die due to poor health. Maybe they’ve had heart problems and all of a sudden you’re a partner with their partner who you may not want to be in partnership with.
You’ve got to think ahead and look at each person and question “Are we all healthy? Is there a good chance we’re going to be okay? Has anyone got a divorce they haven’t mentioned coming up?”. All those uncomfortable conversations need to be had.
You would be amazed how many people go into big financial decisions without having talked about these issue.
You also have to consider if the partners are happy with their husbands/wives not working for a year or two and being involved in a start-up and the lifestyle change around that. There’s often resentment there and that hasn’t been talked about in the group.
Personal brand wash applied to the business
Personal brands act like Gravity. They attract Sales, PR and Results
You have a personal brand. The cheap and nasty way people describe it is how many Instagram/Facebook friends you have. This is wrong, they overvalue those connections. It’s your presence in an industry or in a social or a networking sense. It’s just your contact network in general, with influence as a multiplier. This is what creates a personal brand at a basic level, however, it is much more complex than this.
Some people can bring a massive personal brand into a business and that’s worth money and they should get equity for that. It’s often the case that one founder gets a bit of resentment towards the other founder around that issue, but you’ve got to recognise it. People build up personal brand through effort, it just doesn’t happen accidentally unless you’re a movie star. It’s real and worth money.
Agree probability of cashflows
Business owners will often promise to invest funds in the future. Do you have your trust dial set to 100%?Do you believe them?
You should risk adjust promises made of future cash flows. If a partner promises funds in 2018 but is fully leveraged on a million dollar house then that cash-flow is far riskier and thus less valuable in a present day sense than that of a wealthy investor who has a long track record and reputation to uphold.
You should agree a probability of cash flows on things. A good example here is when you two founders. One founder is wealthy and the other one isn’t. The wealthy founder says “look, if things are going bad in a years time I’m going to put an extra $50k or $100k into the business and we’ll keep it going and we’ll be okay”. That’s a promise. That person’s promise is probably pretty good if they’ve got 100 million bucks in the bank and have a whole lot of property and they’re trustworthy. That’s not so great if that person’s got a million-dollar mortgage and the markets about to collapse, that’s not worth the same amount of money as $100k dollars. You need to look at it from a risk perspective.
Promises made about money coming in the business down the track or people bringing in investors when we get to a certain size etc. All those promises need to be discounted a bit. Applying some probability of those things happening when you’re working out the equity split is really important. If you’re wondering what is the rough calculation for that, don’t worry about it I’ll show you in a second.
Note: This is credit assessment, not something we can teach here as there are sim ply to many approaches and it’s extremely academic. This is guidance around the concept only.
Value experience and youth
Experience flip-side is some baggage. Old methods and ways less relevant now.
Youth flip side is lack of failure/win learning.
Experience is excellent, obviously. You’ve learned from a lot of failure, you’ve probably worked out how to be pretty efficient in terms of getting stuff done, but you may or may not be willing to work 18 hours a day. There’s pros and cons of each. It’s the same thing for Youth. Youth don’t have rituals and habits in place that are bad habits. They think outside the box and there are benefits around that.
There’s always a flip side though, a youthful person might be more of an explorer and less of an action orientated person. I’m just making generalizations, but what I’m saying is, don’t just bucket people into young versus old, good and bad, because it doesn’t work that way. I’ve found in hiring people over the years that I get really shocked at both ends of the spectrum. I’ve learned not to even think about that for a second.
IDEAS ~ BRAND ~ RISKS ~ COSTS ~ CAPITAL
We can collate a lot of these concepts discussed in some rough buckets.
Think at the bucket level for your business model and industry.
The real starting point for the equity split part of a start-up, in terms of modelling it, is to actually look at it a bit more detail. Ideas and IP have value, we’ve talked about execution as being really important as part of that. There’s capital going into the business, the physical capital or cash capital. There’s costs that have already happened, like people forget about that one someone could have been working on a project for a while and might have been paying web-hosting bills, they might have been buying wood to make their chairs that they’re going to sell online or whatever it is they’re doing. There’s risk taking that’s worth money in the split, and there’s the brand that you bring into the business.
You might bring brand in a personal brand sense, but you might also bring in brand in your concepts and ideas and I saw that with one startup.
A customer of ours who was head of digital marketing at Saatchi. He was a really smart guy in terms of understanding data and branding. He created an amazing brand and just came into the business with another founder. That was very high value, I thought, because he had nailed it straight away from his background. That’s worth money. That company didn’t have to go off and spend $200k with Saatchi to get it. You kind of got to view the value of that as well.
Step 1: Break each component down
Then we can start to detail the buckets using spreadsheet tools.
Disclaimer: This is just one way you can do this. Don’t treat it as gospel, but I think it works well to get a more accurate method than the napkin, but there’s other models you can use.
The thing is to look at the initial capital breakdown first. This is a spreadsheet with lots of columns for the different initial investors and founders. It shows what money has been spent in different areas to start off with. There’s the cash that might have been put into the bank account to start the company, someone might have spent some money on website development already with a friend or something and got some business cards printed, the other founder came in a bit later so hadn’t done any of that.
List everything that’s been spent to date and you’ll get a number. This person has spent circa $39k to date in the savings account for the business. Founder 2 has put in $11k so far. He’s put some money in but he’s come into the business late. They’ve got $1000 of miscellaneous stuff that relates to getting this happening. Maybe some legal fees for a shareholders agreement between these two, for example. From this, you’re starting to get the first number you need in terms of the initial investment split, but it’s only the first bit.
Step 2: Total of all the components
Then create a summary worksheet adding up all these elements. You could do one big spreadsheet, or a worksheet for each.
In a proper model for splitting startup equity and you really believe you’re going to do this with lots of money, you want to go through this process. You can do it in one spreadsheet, but that’s one part of initial capital. I’ve transposed those numbers up into there – $38k and $11k. Then you start going through different areas like contracted future capital. That one is, for example – one founder says “I’m putting $150k in in a year’s time” and the other founder says “okay, in a year’s time we’ll put another $100k in” and they agree that upfront.
So one founder has left a job for two years at $75k a year the other ones left a job for two years at a $50k a year, so there’s $150k and $100k split there. Obviously I’m not discounting this, or present valuing it, but if you want to be really accurate, you’d start doing that. That cash flow is in the future, so if you’re a finance background you know what I’m talking about. Money in the future is worth less today, so $100k in the future is probably you know roughly $90k today if it’s five percent interest rate. (just roughing the numbers here in)
You start working through this and you’ll start to see some stuff that I’ve talked about earlier. Being the public officer facing the ATO, $50k risk there. A founder might take that on, happy to do that job but want some value for it, because if they’re to go out and do that as a CFO in a company they’re going to get a $150k because they’re taking that risk on. $50k of that $150k salary is probably for taking that risk on, so it’s real. Company secretary role, debt provision, things like that guarantees – one director might write the guarantee on the lease for the property for example, that’s a $40,000 investment that’s just capital sitting aside. NB: I haven’t got that right because you get that money back in the future, so it should be the difference between, it should be the interest value.
Taking on the director role, that’s risky too, that’s the ASIC facing risk you take. Non-financial resources, perhaps if one person putting computers and desks and stuff like that. Or maybe one founder got his wife to agree to help for a year and she’s a sales exec and she’s coming in the business and she’s just going to help out for a year because they’ve got some savings behind them. It could be something like that. So while she’s not getting paid, it’s worth money so it should go in here.
Eventually you get through this list and you look at things like pre-existing IP and key relationships – for example if someone had a relationship with say Richard Branson and could really call on him to do something for you. That’s got to be worth some money. It’s hard to put a value on this, but you notionally can do that. To be honest, this one’s really tough to put numbers on. It is a guess, there’s no right or wrong about that one.
Business and strategic planning – someone might be financially savvy and the other person might be sales and marketing orientated but if that person is financially savvy and has a banking or finance background, it saves you going to accounting firm for as many activities. That might be $15k bill you save each year. So it’s worth some money.
Step 3: Split the equity
The totals gives you the split ratio for simple ordinary stock situations. For more complicated options, convertibles and the like you’ll need advisors to assist.
Optionality is disguised as convertibles, bridges, equity based on performance and more.
Get a day one intrinsic value and then you can work out your equity split pretty well from that. This is a good way to do it and you can do it across multiple founders. It’s one model, there are other models.
Disclaimer: Work through a list that suits your industry, strategy and business model with your advisors. Don’t just use the above list. It’s an example only intended for educational purposes.
Companies doing bigger startup projects that are putting millions of dollars of capital in right from the word dot will have a project spreadsheet, modeling systems, and the like that looks at present valuing all these cash flows and putting risks against them. Also looking at IP in a more valued sense by getting accountants to work out what IP is worth and/or goodwill or anything that’s coming into the business before they split it. That’s for really big startups backed by players looking to move companies from initial values of millions to hundreds of millions or billions of dollars.
Equity Splitting Infographic
This info graphic is a bit of a guide and cheat sheet we’ll be giving you.
It may not have everything but is a great framework to start your thinking for your specific business model. Go through headline items and see what sub components might apply in your business.
Photo by Hugo Aitken