Equity distribution in an early stage

Do the math.

This is a great question, and one of the most important issues facing early stage companies. When it comes to ownership, try to quantify everything. This helps to eliminate subjectivity and protect each party involved.

1. Simply coming up with the IP, the business plan, and early stage work to get to the point that you are currently - this is worth something. I think its worth about 25%. If you did this yourself, you should start with 25%. If multiple people worked on it, they should split it fairly.

2. If you put money into the project, this is also worth something. Figure out what the valuation of the company was when you put that $8000 into it. I recommend using the expected future earnings valuation - Here's a calculator. Use your expected earnings for each year, and a discount rate of about 45% since its such an early stage product. After you use this method and get a valuation, you can figure out how much ownership $8,000 actually buys. For example, if you get a present value of $200,000 you will do $8,000 / $200,000 = .04 or 4% ownership.

3. The size of your stock option pool is going to depend on how quickly you can afford to start paying employees. You mentioned that you think you'll add 1 or 2 more people - how much are you going to be able to pay them when you hire them? Will stock options just be a bonus in addition to a competitive salary? Will stock be a compensation for a reduced salary? Or will stock be the only thing you're paying them with, because you can't pay them salary? If your current team can get this company to the point that its generating enough revenue to hire more people, then your stock option pool shouldn't be more than 5-15%. But if you're going to need another full time partner who's going to be working for equity rather than a paycheck, to help you get to the point that you can start paying people, then you may need to have more stock available.

4. Free labor is the most valuable thing at this point in the game. If you have 3 people who are all working full-time, then they each deserve about 33% ownership. In your case, if these other guys cannot work full-time until you can pay them salary, then they deserve to have much lower equity in the company than you have. If you're not being paid a salary, you deserve to be paid in equity. If you are being paid in salary, you only deserve as much equity as the difference between the salary you deserve and the salary you're being paid. In your situation, let's say that you're working 60 hours a week on this thing, while Co-founder 2 is only working 12 hours a week on it. In this case, you deserve to have much more ownership than he does for the labor component. If he comes on as a full-time only when you can pay him, that makes his labor contribution closer to that of an employee, not a founder.

So, you take these factors all together, and you come up with a formula something like this to determine how much ownership each category is worth:

100% Ownership = IP Creation and Initial Work + Capital Invested + Existing Equity Commitments + Stock Option Pool + Future Labor Commitments by Founders (that are not being reimbursed in salary)

Company Ownership by Category:

• IP Creation and Initial Work = 25%
  If Co-founder 1 was responsible for 60% of the IP, then he gets .6 x .25 = 15% ownership
  If Co-founder 2 was responsible for 40% of the IP, then he gets .4 x .25 = 10% ownership

• Capital Invested = 4%
  If Co-founder 1 invested $8,000 when the company was valued at $200,000 = 4% ownership

• Existing Ownership Commitments - 3%
  You mentioned that you're paying Co-founder 3 with 3% equity.

• Stock Option Pool = 15%
  (Since we think we can start generating sufficient revenue to support future hires with our current team.)

• Future Labor Commitments = 53%
  This leaves 53% ownership left over to be distributed by time commitment.
  If Co-founder 1 puts in 60 hours a week and Co-founder 2 puts in 12 hours a week, we have a total of 72 hours per week.
  
  Co-founder 1 gets 60/72 x .53 = 44.17% ownership
  Co-founder 2 gets 12/72 x .53 = 8.83% ownership

Company Ownership by Individual:

• Co-founder 1 - 15% + 4% + 44.17% = 63.17%

• Co-founder 2 - 10% + 8.83% = 18.83%

• Co-founder 3 - 3%

• Stock Option Pool - 15%

Now, this may not be agreeable to Co-founder 2, so you'll probably want to be tactful about how you interact with him. But if he doesn't agree with this distribution, he needs to justify his position with objective, mathematical reasoning, not subjective opinions.

If you need to decrease the size of the stock option pool to give Co-founder 2 more equity, you can do that. In my opinion, equity is what you pay people before you can afford to give them a paycheck. After you can afford to give them a paycheck, I think that you need to very careful about how much equity you give to your employees, because you're going to need that equity to give to investors to get money so that you can grow your company. That isn't to say that you can't pay your later employees in equity, just that you have to be careful how you spend it, because the way you spend your equity in the early days has a massive impact on your options down the road - forgive my bad pun. ;-)

And lastly, I would encourage you personally, as the CEO, to try to stay above 50% ownership for as long as possible. If you go below 50% ownership simply in your negotiations with your 2nd Co-founder, you've already lost control of your company before you took a single investor or reached 3 full-time employees! This is a dangerous way to start your entrepreneurial adventure, because you've lost control from the very beginning. This means that you may have difficulty growing your company and remaining the CEO.

Hope this helps!

You need a simple approach that acknowledges and respects everyone’s contributions to date. Suggest that you break this into two parts Pre-Beta and Beta:

Part 1: Compensation-To-Date (or through Beta). Everyone estimates the number of equivalent 40-hour weeks that they spent. Determine a reasonable (perhaps generous) dollar value of compensation/week of work. The results determine the compensation that everyone will get for their work-to-date (or through beta). This payout occurs at some future point dependent upon some profitability criteria that you’ll need to establish, e.g., payouts of 10% of annual profit until the full amount is paid out.

Part 2: Future (or Beta) Compensation & Equity. Sounds like CF3 is not seeking an equity stake, so he may or may not be part of this calculation. You each decide upon your time commitment going forward. Those percentages determine the equity split. The fact that CF2 is not willing to give up his current job give him a significantly lower percentage share, which is appropriate. You may need to give up some of your equity share to CF2 to keep him happy, which might be good for both of you.

You can vary the above approach based upon what you think would work; this is just a framework. For example, perhaps you three agree that everyone that worked on pre-beta should have an equity stake. Maybe you allocate 20% of the equity to the pre-beta work and split that based upon the calculations for Part 1. Then the remaining 80% is allocated by Part 2 calculations.

thanks for your sarcastic feedback! Of course the situation is a bit more complexe and fortunatelly more promising that what you suggested. I understand that what you mean with your statement is that commitments and vesting time are crucial and without them the project will not go anywhere. So here are some elements you might have misunderstood or were missing in my question:

1) I actually did more than having the idea and paying someone. What I meant with the external communication is that I’ll be the only one in the team doing this job which includes (external comunication, finding investors, finding partners etc). I worked on the whole concept of the project from initialization till the IA, did the business plan, marketing plan etc.

2) Co-founder 2 brought an innovative technical solution for the project, created the whole back-end structure and coordinate the work of the developer we pay.

Most important, we aim to work together to make the project profitable, and I rely on him to do the job (and he on me too). There is a big part of „human parameters“, and therefore it is difficult to purely consider the shares under the work done/to be done aspect. I am fine to bring my expectancies down so that it doesn’t sound like he is working for me, but we do the job together. Only thing is to know what is fair enough? BTW during our last conversation we came to an unformal agreement of 46%-33%. What’s your thought about it?

As the resident expert on founder equity split, let me try to answer this one...

1) You seem biased in favor of yourself. That's natural of course, but I'd take anything you describe with some suspicion. Because if we listen to you, you did everything. Except really, in terms of role, you are only in charge of "external communication", and no matter how important that sounds to you, the product would still do just fine without it. So really, you paid $8K for someone else to do the work

2) But then, co-founder 2, the only other person who seems to claim having significant equity in this story, also isn't really doing much. The typical part-timer who promises to do some work once he gets paid. Not taking any risk.

So now I'm left with no one actually doing any serious work, except some cheap contractor possibly. So I'd be as extreme as saying this is your baby, you paid for everything, you should own most of it (75%?). But don't fool yourself. None of these descriptions sound like co-founders.

I'll conclude with my usual question: if any of those team members completely stopped working on the project, would it matter?

Don't lose your company.

Keep majority control of the shares under the first scheme (you get 55%). Consider offering the creative person cash for the work instead of shares. If their involvement isn't ongoing, why offer them shares?

One thing I did (under the advice of a lawyer) with my start-up was to split the first $12X in profits evenly. So, each founder gets $4X in profits, then the distributions after that fall according to the percentages.

That way, everyone is happy, and you retain control over the company.

I think you have the general right idea on how to figure this out, but perhaps a few more suggested nuances to how I would go about this:

1) Quitting a job and taking a "risk" is really just a personal risk/reward trade-off. It is not inherently adding value to the company in and of itself. Therefore, there should not be a separate premium in equity for taking this "risk". The way to put a value there is to put a price tag on the contributions being made whether it's the core idea/plan, the actual dollars or unpaid labor. ie: How much would have been given to somebody else, if that work would have been for hire.

2) Once you know the dollar amounts of each contribution the other step is to break down these contributions into key milestones for the business. These are the places where money actually went into the business or where key objectives were met where one might have raised money instead of having the sweat equity into the business. These are the milestones that can then constitute a virtual round of funding where a specific value can be assigned to the overall business at each of those stages.

3) Given now that you have virtual founding rounds, value of the business at each stage and also contributions being made to make each stage happen, you can then price shares at each stage and have the contributions "buy" shares by issuing more shares in the company at each step with the associated dilutions occurring. After you let all of these virtual rounds playout, you'll see a good approximation to fair percentages of the company shake out from the math.

Note: Your question about the option pool should be handled in a similar manner going forward. The key thing to do is to determine a fair valuation of the business and decide what chunk of that value makes sense for the planned future contributions to the company being recognized via the options.

For more details on all the mechanics of this, check out this answer I wrote to another similar kind of question asked by someone else.