One of the first conversations co-founders have in a newly-formed partnership is about equity splits. In most cases, this is an emotionally-charged, awkward and uncomfortable experience where participants must negotiate their “worth” as contributors towards the startup’s vision. Coming to an agreement is extremely difficult, especially in the face of extreme uncertainty and ambiguity. Many founders either try to avoid the discussion or they compromise and do an even split between them.
Some founders seek the advice of more experienced entrepreneurs. These well-meaning advisors draw on their own experience, which is often riddled with disappointment and resentment in the wake of their own past partnerships gone bad. They warn of the importance of maintaining control, preserving equity for future rounds and subjecting new contributors to time-based vesting. Next, they advise founders to consider rules of thumb, the impact of future rounds of funding, financial projections and negotiation skills. In spite of best efforts, even this type of careful planning does little to ease the pain or even solve the problem of equity splits.
The problem is that the traditional approach to negotiating equity splits is fundamentally flawed. No matter how careful or thoughtful you are, it’s going to be wrong.
There are two primary flaws. The first is that most equity discussions are based largely on predictions about the future. Founders have big dreams and potential co-founders make big promises. So, equity splits use promises and dreams as the primary components of the calculation. The second flaw is that equity allocations are usually expressed as fixed percentages of equity. So, in order for a traditional equity split to work, the future must unfold as predicted. This is highly unlikely because the future is unknowable. When something doesn’t go according to the plan, founders must re-enter painful renegotiations or deal with the—often dire—consequences of an unfair split.
A much better approach, called the Slicing Pie model, bases equity allocation on the actual contributions of participants.
Think of a startup like a gamble (because it is). People place “bets” on the future financial rewards which may come in the form of profits or a sale of the company. A bet is anything a person contributes to the startup without compensation. This can include time, money, ideas, relationships, facilities, supplies, equipment or anything else. The value of each person’s bet is equal to the fair market value of his or her contributions. Each day, participants place more bets as they each spend more time, money, etc. on the startup. Betting will continue until the company reaches breakeven or Series A. At either of these times, contributors begin to get compensated for their contributions.
So, while the future is unknowable, the fair market value of each person’s contributions is easy to observe. A person’s share of the equity, therefore, should be based on that person’s share of the bets. The Slicing Pie model provides a logical, unambiguous and perfectly fair split regardless of how the company unfolds.
In Slicing Pie, the person who bets the most gets the most. Those who bet less, get less. The model fosters collaboration, provides ongoing motivation and allows the managers to make smart business decisions. Traditional models pit founders against one other, encourage self-interests and breeds resentment.
Source: Arctic Startup