In this article, Swapnil Singh, pursuing Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata discusses on the process followed when founders decide to split up.
The growth of the business field has marked the development of several forms of business organizations such as Companies (including One Person Companies), Limited Liability Partnerships, Co-operative societies, Partnerships etc., apart from the traditional sole proprietorship and family owned businesses. The advantages of these various forms of organizations over the traditional business forms is their better financial standing and stability, due to increased number of contributors.
Something interesting happens between the time an idea is developed and it becomes extremely profitable. Typically, everyone who had a role in the process — no matter how small or large — begins to jockey for position and to fight for a piece of the company. In other words, everyone wants some equity, regardless of the amount of work they’ve put in. As a member of the founding team, you should take responsibility for splitting equity in a way that’s fair to all contributing parties, while simultaneously positioning your startup for long-term success.
The problem with splitting equity, however, is that there’s never a “clean cut.” Any time you have more than a couple of people involved, disagreements will erupt over what value people bring to the table, which parties were there from the beginning, etc., etc. But by keeping several guidelines in mind, you can ensure the process is grounded in fairness.
However, at the same time, when two or more persons come together and decide to operate a business from their ideas and resources, the determination of the control and profit sharing ratio becomes a fundamental question.
Founders Decide To Split Up – What should be kept in mind?
Splitting equity is difficult if you haven’t done it before. The tricky part being, there’s no right or wrong way to divide equity. Some startups split equity equally, others wait to get to know each other; some go through a negotiation process, and few save the decision for later just so they can launch a successful product first.
Before you settle on splitting equity 50/50, there are a few key concepts you should understand. Once you grasp the following pieces of information, you can rest assured you will have enough knowledge to keep everyone involved motivated and financially rewarded throughout your startup journey.
Solving the equity equation is typically the most challenging and time-consuming aspects of structuring your startup correctly. I recommend taking the information from this article and discussing your situation with industry experts: investors, successful founders, or startup advisors. These professionals will be able to leverage their experience to provide you with the unbiased insight needed to make important decisions. One thing that should be kept in mind before splitting is – split the shares without giving away the company. You never know what your co-founder will do in a span of months whether he decides to walk away from the company and still retains the large portion of the company. It will be like giving the value of your hard work to a person who doesn’t contribute.
Issues that might arise when Founders decide to split up
One of the most pressing and significant issue that might arise is with respect to the discomfort that might arise due to the split, would necessarily be the change in working environment, if either of the founders are discontent with their share of equity in the company. Therefore, if such a decision is taken without due discussion and deliberation, it might lead to counterintuitive effects in the working of the firm in future.
The second issue that might arise is with respect to analyzing and monetizing the net contribution in terms of money, skill, management or any other form that the co-founder(s) will be able to provide in future. Such a form of estimation is based on future expectations the co-founder(s) has/have from each other and therefore, needs to be done with utmost care and caution.
Hence, it is sufficiently explicit that any incorrect decision at this first instance might prove to be detrimental for the interests of co-founder(s) and eventually the company.
Splitting the Equity: Key aspects to be considered
Understanding the significance of this step, several experts have provided with their own tips and guidelines as to how should the ‘pie’ that represents the company be divided amongst its founders. The famous ‘Founders’ Pie Calculator’ is a widely accepted test in determining the elements that need to be necessarily considered in the event of splitting the equity.
Coming up with the idea
The first aspect that needs to be taken into account is that who actually came up with the idea of the start-up. The founder who is the mind behind the instrumentality of the business should under all circumstances, be accorded a special status as compared to other founders. Now this does not compulsorily imply that the individual who proposed the idea should get a greater share, but instead it provides that the significance of the brain behind the corporate should not be undermined.
Contribution towards the preparation of the business plan
The second feature that needs to be considered is that which founder contributed to what extent toward the preparation of the business plan. It is pertinent to note that the mere existence of an idea is not enough for a successful business to be set up, a considerable amount of importance should be attached to its translation into a commercial viability i.e. done through the business plan preparation.
Expertise in the proposed business
The next component that is imperative to be thought of while distributing the equity is whether the co-founder possesses any degree of expertise or skill, specifically with respect to the proposed business. Therefore, if there are two founders, out of which one of them is highly skilled and owns a certain amount of expertise in the field, the equity split should consider this aspect also along with the other components. This is desirable because knowledge of the working or management of the business is an essential pre-requisite for the success of any form of business and thus, the founder should feel that he is being significantly rewarded for his contribution to it.
Amount of risk/commitment offered
The fourth aspect that requires due consideration is the amount of risk and commitment the founder is willing to offer. In order to explain this better, the concept of sleeping partner can be appreciated. A sleeping partner is essentially a partner that primarily contributes money in the business, but is not involved in its day to day functioning, as opposed to a working partner. Thus, it makes more sense if the founder who is actively involved in the affairs of the business is provided a greater share than his inactive counterpart, as he is serving more valuable to the organization. Similarly, the risk-taking founders would be like to portray more loyalty and hard work towards the business.
Distribution of responsibilities
The fifth aspect is based on the distribution of responsibilities and is closely linked to the commitment towards the business mentioned above. Nevertheless, it is better to consider the responsibilities that each person is willing to take up and ascertain his future interest in the business through that.
Therefore, majorly these are the five things that need to be taken into account while assessing the split of equity between the members. It is pertinent to note that the weight attached to each of these aspects may vary from organization to organization and on that basis decisions can be made. However, it would be a grave sin if, as is the usual practice among close friends, the equity is split into equal parts, in complete disregard of the aforementioned conditions.
It is pertinent to note that if in order to avoid discussions on this issue, a middle ground is adopted wherein every founder is accorded equal share, it would lead to a plethora of problems.
Firstly, it would prove as disincentive to the more deserving founder and may lead to his dissatisfaction and discontentment in the long run.
Secondly, if at a later point in time, any of the founders wish to alter this ratio, it would lead to clashes and may not also be possible.
Hence, in order to avoid such a situation in future, it is better to deliberate upon these issues in a sophisticated and professional manner, considering the Founders’ Pie Calculator test.
Apart from this, there is another thumb rule that needs to be established while deciding upon equity split. This thumb rule states that whatever be the situation, no co-founder should be provided lesser than ten percent of the total equity in the company. If it is less than that, the founder would constitute the category of first employee and should be then, entitled to remuneration.
Thus, it can be said that this is the manner in which the co-founders should proceed.