How to Divide the Pie

Sam Martin sent in an email asking about determining founder equity. "What amount/percentage of equity is usually reserved for the founder, CEO, and management team.  Is there a rule of thumb for how you determine who should receive equity and who shouldn’t?  What is a common vesting schedule–if there is such a thing?"

Great questions and ones that we have to address with every deal. I have a couple of thoughts on the above:
1) Alignment of interests is critical…all the way down to the entry level Java programmer. Equity is the great connector. I am a fan of making certain that all employees have equity, even if only token shares. This means making certain that you have an option program in place and all employees are participants.

2) Setting equity levels is more art than science though there are ranges. At the start-up level, equity allocations will be larger since they will be diluted down with financings. As you start to near break-even, some ranges…CEO 5-10%, VP-Sales or Marketing 1-2%, CFO 1%, next level down .25-.5%.

3) Most of our companies have fairly consistent option plans that a lawyer who is familiar with VC deals can help set up. These usually have a one year cliff vest (e.g. no equity before 12 months) and then monthly vesting for the next 3 years…a four year vesting in total. Strike price is usually a fraction of the preferred and with the new 409A accounting rules, you’ll need an appraiser to CYA. The employee has two months to exercise options upon leaving. The company has the right to buy back those shares at fair market value.

4) Dividing the pie up should be split into two parts. The first is to divide the equity amongst the founding team. This is a matter of determining who deserves what and who has what leverage. Some founders go with an equal split mentality (four founders, each with 20% and another 20% set aside for future hires). Others go with a layered approach and different ownership levels. The second is to determine how much capital is coming in and what pre-$ valuation. If $1m is coming in at a $2m valuation, then the new money gets 33% of the business and all existing shareholders are all diluted down by 33% (e.g. the 20% above is now 13.6%).

The trick to all of this is to break these allocations into multiple steps, lock %’s down and then go to the next step. It is also key to have good counsel to make certain the appropriate provisions are in place such as a drag-along provision (if the majority agree to sell, everyone else has to also…avoids small, disgruntled investors from holding the company hostage) and a legal structure.

In short, though, share the wealth as it is a lot easier to row the boat together when incentives are aligned.

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