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Balderton Essential Guide to Employee Equity 2017

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Founders often ask how they should split equity with their co-founders.
When I search the web on this topic I often see horrible advice, typically advocating for significant inequality among different founding team members. We see this trend reflected in the thousands of applications we review at Y Combinator every year.

Here are some of the most often cited reasons for unequal equity splits:

I came up with the idea for the company

I started working n months before my co-founder

This is what we agreed to

My co-founder took a salary for n months and I didn't

I started working full time n months before my co-founder

I am older/more experienced than my co-founder

I brought on my co-founder after raising n thousands of dollars

I brought on my co-founder after launching my MVP

We need someone to tie-break in the case of founder arguments

All of these lines of reasoning screw up in four fundamental ways:

It takes 7 to 10 years to build a company of great value. Small variations in year one do not justify massively different founder equity splits in year 2-10.

More equity = more motivation. Almost all startups fail. The more motivated the founders, the higher the chance of success. Getting a larger piece of the equity pie is worth nothing if the lack of motivation on your founding team leads to failure.

If you don't value your co-founders, neither will anyone else. Investors look at founder equity split as a cue on how the CEO values his/her co-founders. If you only give a co-founder 10% or 1%, others will either think they aren't very good or aren't going to be very impactful in your business. The quality of the team is often one of the top reasons why an investor will or won't invest. Why communicate to investors that you have a team that you don't highly value?

Startups are about execution, not about ideas. Dramatically unequal founder equity splits often give undue preference to the co-founder who initially came up with the idea for the startup, as opposed to the small group founders who got the product to market and generated the initial traction.

My advice for splitting equity is probably controversial, but it's what we have done for all of my startups, and what we almost always recommend at YC: equal equity splits among co-founders. [1] These are the people you are going to war with. You will spend more time with these people than you will with most family members. These are the people who will help you decide the most important questions in your company. Finally, these are the people you will celebrate with when you succeed.

I believe equal or close to equal equity splits among founding teams should become standard. If you aren't willing to give your partner an equal share, then perhaps you are choosing the wrong partner.

Thank you to Justin Kan, Qasar Younis, and Colleen Taylor for reading drafts of this essay

Notes:

[1] If you fear what will happen if you have to break up with a co-founder, make sure you have a proper vesting schedule. In the Valley, a typical setup is to have four years of vesting with a one year "cliff." In other words, while you might own 50% of the company on paper, if you leave or get fired within a year you walk away with nothing. After the one year point you get 25% of your stock. Every month after that you get an additional 1/48th of your total stock. You only earn all of your stock at the end of four years. This ensures that founders are a good fit for the long haul - and if there is a problem you can fix it without harm in year one. Another good contingency measure is for only the CEO to hold a board seat before a significant equity fundraise. That will prevent board disputes during tough decisions, such as in the unlikely event that the CEO has to fire a co-founder.

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Founders often ask how they should split equity with their co-founders. When I search the web on this topic I often see horrible advice, typically advocating for significant inequality among different founding team members. We see this trend reflected in the thousands of applications we review at Y

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Getting together with a friend or two and creating a new business is an exciting time in any entrepreneur's life. However, Co-Founders are often so busy building and running their new business that they skip a hugely important step, the Co-founder Agreement. A Co-founder Agreement is a contract between Co-Founders setting out the ownership, initial investments and responsibilities of each Co-Founder. This agreement also safeguards you in the case of a dispute, as it can provide protection to show what the co-founder agreed to.

Use this Co-Founder Agreement if:

You are a co-founder and would like to clearly set out the equity participation in your new business.

What does the Co-Founder Agreement cover?

Co-Founder details;

Project description;

Equity breakdown and initial capital contributions;

Roles and responsibilities of each Co-Founder;

Management and approval rights;

Non-compete, confidentiality and intellectual property; and

Resignation, dissolution and removal of directors.

Other names for Co-Founder Agreement include:

Founders Agreement; and

Hackathon Collaboration Agreement.

What are the best ways to split equity?

Splitting equity can be a difficult task if you have not done so before. However, it is important to note there is no right or wrong way to divide equity. Some startups would split the equity Equally, others would negotiate, and few would decide on launching a successful product. Before coming to a decision, it is essential to fully understand both sides of the agreement to ensure the best outcome.

Key considerations include:

Ideas and contributions of co-founder(s)

It is important to consider what each founder brings to the business. If one of the co-founder's brought the original concept to the table, they might deserve a higher percentage of shares in the company. Long-term contributions, such as time and quality of work may also be determining factors in the distribution of equity.

Reputation and experience

Being experienced versus a beginner entrepreneur may affect the amount of equity you get. An experienced founder with an extensive network in the field can be of great benefit to the company (i.e. securing more funding) and deserves more equity.

What are their priorities?

Are the founders fully invested in the business or are they using this as a stepping stone for their next project? You would want to make sure your co-founder is focused on your project and not looking elsewhere before determining the division of equity. Transparency between the partners is essential for the success of the business.

Besides equity, what else do I need to discuss with my co-founder?

Division of equity is one of many items included in a Co-Founder Agreement. Other issues you should discuss would your co-founder include:

Ownership percentage;

Roles and responsibilities;

Salary;

division of work and commitments;

business vision and goals;

dispute resolution policies;

What happens when one founder leaves;

Sale of the business.

After completing a Co-Founder Agreement, what are the next legal steps?

For a startup to legally operate as a business in Australia, it must be registered as an Australian business (i.e. ABN, TFN, ACN, GST) and follow the legal requirements in its relevant field. It is advised you consult a legal professional to ensure the protection your business and comply with the laws.

Key legal considerations for every startup business include:

Business structure

This is one of the most important decision a new business will make. Choosing between the partnership, sole trader, trust, company or co-operative would have a significant impact on key areas including tax and legal liability. This is a decision you should be making with a business lawyer to obtain expert advice on the legal structure which will best suit your business.

Employer responsibility

If your business intends to hire employees, it is important to familiarise yourself with the legal requirements and standards to ensure compliance and avoiding liability. Key requirements include sick leave, annual leave and superannuation.

Intellectual property

Many startups are created by inventing a product, piece of technology or service. It is important you consider the intellectual property rights your business wishes to protect. Depending the nature of your service, patents, copyrights and trademarks are available to protect your intellectual property.

Business terms and conditions

This would act as the legal contract between your business and your customers. It sets out what your business is providing, how it is provided and how the customers will pay for it. These terms and conditions must comply with Australian Consumer Laws and contain key terms which cover refunds, repairs and returns.

Other documents you may need:

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Getting together with a friend or two and creating a new business is an exciting time in any entrepreneur's life. However, Co-Founders are often so busy building and running their new business that they skip a hugely important step, the Co-founder Agreement.

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If you have a partner, you are bound to have fights. 62% percent of all startups fail due to co-founder conflict. Look at the most common types of conflicts in a startups. Do You Recommend Any Of These Solutions?:

When you throw together two ambitious people from different backgrounds and have them live and work in close quarters under the pressure of having little money and the constant fear of their startup failing - conflicts are bound to happen. Married couples argue 321 times a year. Although there is no statistics about co-founder fighting - the number is probably not too far off.

The first step to avoiding these conflicts is avoiding faux-cofounders. Who are they? There are a couple types.

Types of Faux Cofounders

First of all, choose the right person. Just like in dating, take your time to find the right one. There are plenty of wrong choices out there. Here are the steriotypical profiles you need to avoid.

The Lawyer. This type of co-founder tries to define every expectation you can define. He will try to put everything into an agreement. The downside of this type of co-founder is that he will worry about dividing things up before actually creating anything. What is the point of having all the equity split agreements if there is really nothing to divide in the beginning.
The Friend. This type of co-founder is probably someone you knew before working on your startup together. They are probably a really nice person who got excited about the startup. They said they loved your idea. 6 months later, after the honeymoon period of the statup was over, they lost steam and stopped working as hard. At the same time they are still thinking they have 50% of the equity.
The Genius. This type of co-founder is probably really smart. Much smarter than you even. They work hard. You probably first fell in love with that combination. But they are so brilliant they don't even need you. They just cannot collaborate with anyone. In effect you are not working together - what is the point of having this co-founder then?
The "Marketeer". This type co-founder hustles day and night getting clients and marketing away. That's great, except they have no understing of the product that the other co-founder is building. When the technical co-founder tries to explain to them why the javascript is slowing down the load time they draw a black. Run the other way.
The Thinker.This type of cofounder is going to want to strategize with you a lot. They are going to have grandiose plans of revolutionizing the industry. But they got no real clue of how to get the initial 1000 users. It's all just talk, no action. Send them back to the academia.
The Lurker. This type of co-founder always has the Job Monster website open in a tab. They have multiple Facebook accounts, that they use to market their many side projects. Their official Facebook account doesn't say anything about them doing a startup. At any moment, and without warning, they will up and go work on something else.

Types of Conflicts

Ok, now that you found the right person - you are still going to have conflicts. Whether those conflicts are going to destroy your startup depends on how you deal with them. Now let's look at the most common conflicts and what to do with them:

My idea is better!
Ideas are worthless. Execution is everything. Stop fighting about this. Now. Try executing a bad idea - you will see that you got a lot farther than you'd think.

Who gets to decide what? Devide up the responsibilities. Let you co-founder decide on half of everything - it's healthy for you to delegate responsibility. Otherwise you are going to burn out before you know it.

I work harder than you. Unless there is a pattern of your co-founder working less than you - calm down. Doing exactly 50% at all times is pretty hard - and it's hard to measure. Maybe they failed to make a sale this week, but next week they are going to bring in the biggest customer.

Leave, or I leave!
This one is the worst. The worst thing is not even that one of you is going to leave but that you have probably been fighting for a while before the situation got this ugly. If you care about whether this startup survives at all, solve this asap.

OMG, We are gonna fail...
Almost every day in a startup can be the death day. Failure is always in the back of everyone mind anyway. So why even talk about it? If they are talking about it - stop them. Your enthusiam is your biggest asset. Don't let you co-founder chisel it away.

Who gets what
Equity vesting agreements will solve a lot of the fighting about dividing up equity. If you are just starting out, divide the equity 50/50. There is no reason to give more to the person who had the idea first. What's the worth of an idea?

Who cleans up the pizza?
This is petty. It really should never happen. But it does. All the time. Over time it builds up. Get a cleaning person. Whatever it takes to focus. Or just clean the pizza.

We need to strategize more
"Nine times out of ten strategizing is just a form of procastination."Paul Graham.. Better to do the wrong thing, than do nothing.

I'm out at 5 pm
If they have a life outside the startup, let them know that you need 100% of their time. Make sure you sleep in the office, too.

Adioma Founder and Information Designer

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Startup Dirty Laundry: Conflicts That Kill Partnerships [Infographic] - Adioma

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If you have a partner, you are bound to have fights. 62% percent of all startups fail due to co-founder conflict. Look at the most common types of conflicts in a startups. Do You Recommend Any Of These Solutions?: When you throw together two ambitious people from different backgrounds and ...

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Information about startup documents, including the safe (simple agreement for future equity).

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Editor's note: Understanding how to divide founder equity at a startup can be tricky, even to the point of reaching emotional riffs between founders. Below, Lee Hower offers advice for approaching these equity discussions objectively and properly. In addition to being a co-founder of NextView Ventures, Lee was an early member of PayPal and a founding team member at LinkedIn, so he speaks as both a former entrepreneur and a VC.
I like to say that "there are only co-founders" - it's extraordinarily rare for a successful business to have just a sole founder. But not all co-founders are equal in terms of title, ownership, responsibilities, and so forth. As a result, one of the trickier things co-founders tackle is determining the equity split amongst the founding group of individuals.

There's no magic to this, and there's no hard and fast rule. Across both the startups I've personally been involved in (PayPal and LinkedIn) and the startups in which I've been an investor, I've seen a broad range of co-founder equity splits.

Sometimes co-founders put off the equity split question for some time. This is often the case where there was a close personal relationship between some or all of the co-founders, as former co-workers, friends, or college roommates. If we're all friends, we can just be comfortable with the notion that we'll "figure it out later," right? But delaying or avoiding the conversation often results in it being more awkward than it needs to be. Once you're working on a project in earnest, even if it's still at the nights-and-weekends phase, co-founders should go ahead and discuss this topic.

Additionally, you should put whatever agreement you reach to paper, even if you have not yet incorporated or had your legal counsel draw up the founder stock paperwork. For example, you can type out a simple letter saying something like, "We the founders of XYZ agree to the following schedule of founders equity ownership: John Doe - 20%; Jane Doe - 40%; Mike Doe - 40%." Then have each co-founder sign it, with each co-founder keeping a copy. You can then work with your law firm to formally draw up founder common stock paperwork either then or subsequently.

It's also worth keeping in mind that regardless of how the founders' common stock is divided, there will be future issuance of stock that will dilute the founders over the lifecycle of the company. You don't really need to worry about how much common stock will be set aside for an employee option pool or how much preferred stock might be issued from raising future VC rounds in order to determine an equitable founder stock division. But all the co-founders should keep in mind if they own X% today, their share will likely be smaller (though still usually quite substantial) down the road.
The most successful approaches to splitting founders equity typically involve establishing a framework that all the co-founders buy into at the outset.
This needn't be some terribly complex formula that tries to do a cost accounting of everyone's contribution to the decimal point. But they frequently capture some of the following dimensions:

1. Experience/Seniority/Role

Every founding team is different in terms of whether co-founders are peers or near peers or if there are broad disparities in terms of seniority and experience. Founding splits typically acknowledge that more senior folks or folks in C-level positions will have a larger founders' equity percentage than more junior or staff-level co-founders.

2. Capital Investment & Sweat Equity

Sometimes some of the co-founders provide personal startup capital (hard cash) at a company's inception, and often they will receive a larger portion of founders' common equity as a result, rather than structuring their capital as a separate investment via preferred equity or convertible note. In other cases, some co-founders might forgo salary early on (if their personal circumstances permit) to earn an additional share of "sweat" equity. Both of these are typically reflected in the founder equity split.

For example, when we started LinkedIn at the end of 2002, each member of the founding team essentially had a couple chunks of founders' common stock. One chunk was based on the experience level and role of the co-founder. Next, those that were forgoing some or all salary prior to Series A got an additional chunk for that. And lastly, a chunk of our CEO Reid Hoffman's equity was attributed to the fact that he provided the initial ~$750K in seed capital for the company.

3. Prior & Ongoing Involvement

A co-founder's equity should also be reflective of their on-going involvement in the company. For example, it's not uncommon for there to be a couple co-founders at the inception of a company. But sometimes, for a variety of reasons, one or more of the co-founders won't be involved on a full-time basis going forward. Those co-founders that are there for the long haul and working full-time should have a larger chunk of equity (typically multiple times that of co-founders not working full-time on the venture). Co-founder equity should have vesting periods (or lapsing repurchase rights) so if a co-founder departs substantially earlier than others, their stake in the business is accordingly smaller.

4. Ideation/IP

Sometimes a portion of founders' equity splits are attributed to "who came up with the idea" or to actual IP that's brought into the business at inception. For most software and internet startups, the hard IP coming in isn't usually an issued patent, which is obviously different for biotech or other kinds of startups. Sometimes, however, there's an existing code base that one co-founder brings. In general, successful startups are based on execution and not an idea, so I personally attribute a pretty small portion of the co-founder equity split to this factor, though entrepreneurs sometimes use it in their frameworks.
Once you have the framework, it's simply a matter of having the conversation and reaching an agreement.
Yes, sometimes these conversations take a few sessions, and at times the conversations can be contentious. But this is one of the very few times in a startup's life where the co-founders are playing a zero-sum game. And ultimately, no matter what split you work out, building a successful business and growing the pie of the whole company's value is what will really matter for all the co-founders.
Questions about founder equity splits? Leave a comment below or tweet NextView Ventures @NextViewVC

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How to Divide Founder Equity: 4 Criteria to Discuss

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Editor's note: Understanding how to divide founder equity at a startup can be tricky, even to the point of reaching emotional riffs between founders. Below, Lee Hower offers advice for approaching these equity discussions objectively and properly.

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When you start a company, it's you and your co-founder against the world. You will sacrifice everything to build your vision. Sleepless nights, forgoing a social life, letting your health go to crap, and even neglecting your own family are all on the table to achieve your dreams, but it's going to be OK, because you are in it together. Together forever.

But what if it's not forever? What if you sacrifice everything, and after two years your co-founder needs to find himself? What if his ego gets bruised, because you are the CEO and as the company grows he becomes less important? What if she develops a serious drug problem? What if she turns out to be not quite as talented as you thought? What if he likes partying more than working? What if "shit happens"?

Well, it can be OK, or it can destroy your company. It all depends on how realistic you are when you set things up.

Yes, breaking up is hard to do - whether in love or in business. But, at least in business, there are some things founders can do proactively to lessen the pain. Think of it as a common sense prenup to protect your company.

So, what can you do to help ensure that founder breakups don't end your startup dreams? Here are some things to consider:

Founders understandably want to get full credit toward vesting of their founder shares from when they first conceived let alone began working on the new startup idea. As a result, by the time founders raise their first institutional financing round, they may be as much as 50% vested. However, with companies staying private demonstrably longer these days (11 years for the 2014 tech IPO cohort), the work required to build the business into a successful venture has only just begun.

We have seen many instances where a co-founder leaves - whether voluntarily or otherwise - once he or she has fully vested, leaving the other co-founder to bear the brunt of managing the business and building long-term shareholder value for many years to come. And, although the remaining co-founder may receive incremental refresher equity grants from the board over time for her continued service, the likely financial value of her new equity pales in comparison to the value of the fully-vested equity the former co-founder has realized.

The difficult conversation with the remaining co-founder is the same each time: 'I'm here every day busting my back to try to build long-term equity value for my employees and investors while John is enjoying the celebrity party scene.'

So, what are your options?

Think about whether four-year vesting is still appropriate

This at least applies to founders - given the much longer runway most private companies will have before they get to their public market debut. Equity is intended to provide long-term incentives, so the question is whether the definition of "long-term" needs to change. The goal is to make sure that founder equity serves its purpose - to create long-term incentives - and that the economic rewards of success accrue to those (both remaining co-founders and key employees) who are disproportionately creating long-term shareholder value.

Consider the circumstances in which a founder can be removed

In most cases, founders have common board seats and, in many cases, the founders/common directors control the board. In those cases, the decision to remove a co-founder from the company can only be done with the agreement of the other co-founder. Those worried about VCs arbitrarily kicking founders out (or trying to screw founders out of equity) can use a structure like this while preserving the ability for only another co-founder to remove a co-founder that is no longer right for the business. (In fact, it is most often the co-founder, not the VCs, who has the ultimate decision.)

Avoid a situation where a co-founder is 'ruling from the grave'

If you do make the decision to remove your co-founder from his executive role in the company, you don't want him staying on the board and potentially interfering with the company's ability to move forward. To deal with this situation, make sure that board seats are conditioned upon continued service to the company as an employee - not simply granted to someone as a function of them having been a co-founder.

Now, I know what you're thinking - isn't this just a veiled attempt by the VCs to screw founders out of their equity? That's not what we are suggesting, nor consistent with what our experience has been as investors. These are co-founder splits, which as we noted above, generally can only happen cleanly with the consent of the other co-founder.

Transfer restrictions

Let's say your co-founder has left but is now sitting on hundreds of millions of dollars in vested stock and wants to sell the stock privately, in the secondary markets. Meanwhile, you are trying to raise primary capital for your business, so your co-founder's secondary stock is competing for that demand.

The best move here is to have instituted blanket transfer restrictions on stock sales from the founding of the company. A blanket transfer restriction means that shareholders cannot sell without some form of company consent, most often from the board. Your co-founder can't sell under the above scenario unless given permission. But very few companies have such restrictions in place. What most of them do have is a right-of-first-refusal (ROFR) agreement, which essentially means that if someone is trying to sell, the company has a right to match any offers received. But this alone does not prevent co-founders from selling stock. Plus, in nearly all cases, the company does not want to use its cash for stock re-purchases vs. investing in growth opportunities.

This one is tricky, because you can't just implement transfer restrictions at a later date and impose it on all existing shareholders. To implement transfer restrictions post-hoc requires consent of the shareholder, and you're unlikely to get that because you're asking them to give up a valuable right that they already have!

This is why you do it at the beginning. That is the time to get perfect alignment between you and your VCs for the journey ahead. Everyone is making the same covenant - we are all committed to creating long-term shareholder value, and we'll all share in it (or not) once the company goes public, or the board agrees to provide some structured liquidity programs to former/existing employees. The keys here are "structured" and "orderly" - something only a blanket transfer restriction can provide.

Acceleration of vesting

In most cases founder stock vesting is tied to continued employment with the company. That's the whole idea behind vesting: You contribute to the success of the company by helping to grow the business, and are rewarded - over a period of time - with an ownership position in the equity you helped create.

But, what happens when co-founders leave - should they continue to vest their stock or get their vesting accelerated? What if you sell the company while your co-founder is still there, but refuses to join the acquirer: should vesting accelerate?

No. There's no need to provide for accelerated vesting on termination of employment, as long as you and your co-founder have agreed on the circumstances under which either can be removed (and you're both comfortable that the decision to do so was governed by a fair and deliberate process). The sitting co-founder is better off having unvested equity return to the pool to reward those employees who are actively contributing to the long-term success of the business.

In the acquisition scenario, founders will often have single trigger or double trigger acceleration provisions. In a single trigger provision, the founder's stock is accelerated upon the closing of an M&A event; in double trigger, both the closing of the deal and the acquirer's decision not to retain the founder in the new entity are required for acceleration.

A single trigger is sub-optimal for the same reasons that accelerating vesting post-employment without an M&A event is - you are consuming equity for an individual who is no longer actively contributing to the success of the company. With a double trigger, the acquirer has removed that option for the co-founder, so it's only fair that there not be a penalty of losing unvested equity.

From the perspective of the acquirer, single triggers can be costly if they want to retain the co-founder (ultimately impacting the total purchase price that the rest of the team receives in the deal). If the co-founder has the option to accelerate on a single trigger, the acquirer will need to offer additional cash/equity incentives to retain them. But there are no free lunches - that additional consideration must come from somewhere when the price pot for the purchase is fixed.

* * *

There is nothing we want more than to see companies be built by their founders, and for the long haul. But it doesn't always go that way.

Startups are passionate, exciting endeavors - but they are still businesses. And when things go wrong between co-founders, as with most things in life, a little planning up front can mean the difference between a catastrophic vs. a merely painful outcome.
This article originally appeared in Fortune.

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When you start a company, it's you and your co-founder against the world. You will sacrifice everything to build your vision. Sleepless nights, forgoing a social life, letting your health go to crap, and even neglecting your own family are all on the table to achieve your dreams, but it's going to be OK, because you are in it together.