How should equity be split among founders? What about employees or external partners? Entrepreneurs struggle with such questions in their quest to bring in people who can bring credibility, experience, and knowledge to the table. We have seen cap tables done both right and wrong. Here’s what we consider to be the first principle: Startup equity is a function of risk.
First, let’s roll back a bit to define what is the risk that someone takes in a startup. A startup is the product of two scarce resources: time & money. Capital contributions are more straightforward to calculate. Investors are putting in money, which is finite and comes with a probability of success. As long as a valuation and an investment amount are defined, the exercise is done.
Time-related contributions may seem more complex at first. Founders and employees are contributing their labor, which is usually accompanied by lower compensation. More importantly, it also comes with a high opportunity cost, since they could make much more money with less uncertainty if they were working at an established corporation. What’s the best way to account for the above?
This is where the first principle comes into play. Taking risk up front demonstrates your determination and tenacity. These are perhaps the more important success factors for a startup. Quitting your job to build a company has a monetary value that should be reflected in the cap table.
Other members who, for example, may have a contribution in the form of connections, expertise or other abstract ways and may or may not take the leap to join full time later, while taking no significant risk in the meanwhile, should be rewarded disproportionately. We do not advocate for not rewarding such contributors at all, yet you should limit such a reward to a lower single digit or even decimal percentage.
After all, the question should be clear: What will a potential partner lose if the company fails? If life continues, as usual, equity is not for them. People who are risking careers, savings and sanity should be the ones to rip the benefits of a successful startup. Equity is a startup’s most sacred asset; be stingy with it, reserve it for those who truly join you onboard.
TL;DR f(Risk) = Equity