In Part II of my Founder Series, it is time to structure the organization and issue ownership interests to your founder. I have worked with companies who think that this is an easy step. It isnt'. And it can be very uncomfortable. Embrace that. The first thing you should do is resist the urge to just check the box on this by splitting the equity equally among the owners and moving on. It may seem like a purely academic exercise because you are just "dividing up zeros" of a company with almost no value (which, in fact, you pretty much are). But your decisions here will have significant ramifications for the company - and your relationships with your co-founders - in the future. Treat it as the beginning of a negotiation, not an endgame. Future investors may also look skeptically on a hasty resolution for a major decision. It may be that you ultimately decide to do a straight equal split, but that decision should not be made without going through this analysis.
Separate the Roles: Managers and Owners are Different
Remember that there are two sides to equity ownership: economic rights and management rights. You can consider each separately. An equal split between co-founders may sound fair on the economic side, but the management of the company may be stymied by impasse. A Founders Agreement or Voting Agreement can then give you additional flexibility by reallocating some of the responsibility on the management side.
Valuing Contributions: a Co-Founder's Value is Not Necessarily Static
Don't overvalue pre-formation contributions. Many founders look at what they have on day one and issue equity based on the perceived value of that contribution means to the company at that moment. But each is contributing some asset to the company, whether it is cash or time and opportunity cost. Cash is easy to quantify, but what about technology, or future services? Start by determining how much the company would pay for that contribution and use that as a baseline. Then any differences would add or subtract from that total for each co-founder.
Also, future value can be just as important as past contributions. You may want to give a founder's share to someone who will be doing development work for the company in the future, which could mean just as much as the $10,000 cash contribution. But again, make sure you look at the bigger picture when doing this. Here is an example of how this can cause trouble:
There was a company that had two co-founders, but they split the equity of their company into three equal interests - the third interest going to one co-founder's mother for use of her basement to start the company. On day one, this may make sense because the value of the space is just as important as the contributions of the other owners. But a few years later - long after the company had moved out of that space into a new location - investors questioned the credibility of the co-founders. Aside from the logistical hassle of getting the mom to sign some of the documents, it made little sense. While the co-founders continued to build value for the business, a third of the company was tied up with someone who now had nothing to do with it.
This same scenario could play out when a founder leaves a company early, particularly where there are three or more founders. The goal is to put together an equity arrangement that makes sense at formation, but also is relevant as the company evolves.
In Part III of this series, I will talk about Founder Agreements and some ways to structure equity splits that can help with some of these issues.