Ask HN: How to split equity? | Hacker News Reader

Ask HN: How to split equity?

84 pointsespitia50 comments

I am about to ship my second app and I'd like to bring in a good friend of mine who I believe can contribute a lot in many areas that need to be covered in order to build a succesful app company. How do I go about forming a mutual agreement as to how to split equity?

To explain what I've done so far:

- Developed and shipped first app.

- first app has a few thousand downloads and growing.

- put up investment for the development of second app (validated market with customers, great potential).

- invested my time for 3 months almost full time (taking care of metrics, marketing, managing developer/designer etc.)

Any more info that is needed please ask. All comments or helpful links are appreciated.

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People who are doing this for the first time care a lot about the numerical split but people who do this professionally care a heck of a lot more about vesting. Whatever you choose, your outcome will be a lot better with a defined vesting schedule. The standard one in the Valley is (for both of you!) "four year vesting with a one year cliff", which means that 25% of the eventual grant is durably yours on the 366th day and then 75% gets parceled out in equal increments every month for the next 36 months after that.

I'd be inclined to have the company write you an IOU for your cash contributions so far, and split it 50/50, perhaps with one of you getting a tie-breaking share. The company can dispose of your IOU like any other short-term debt of the company at some point in the future when it has the financial wherewithal to do so. [See below about IOUs.] Your vesting clock starts 3 months ago, your partner's starts as of the day when he becomes full-time.

I cannot emphasize enough that your equity split is not nearly as important as "Does bringing this guy on uniquely make this business successful and do I have confidence that we will both be happy with this arrangement 5 years from now?"

Edit to add: As I get older and wiser, I am coming to appreciate the discipline of separating one's personal and business finances and explicitly receiving written acknowledgment for transfers of money into one's company. These feel like moving money from one pocket to another in the early days, but they are not, and explicit written confirmation of that fact will make your life easier in a lot of futures.

For example, I know one entrepreneur who, like many, tightened his belt, ran up substantial personal debt, and put blood sweat and tears into building a company. Professional money came into the company. Without documentation that he had loaned the company money, the best resolution would have been asking the other stakeholders to approve increasing his salary so that he could cover his "personal" debts. Had that documentation existed, he would have had ample authority to extinguish that debt in the ordinary course of business, and it would have likely had favorable personal tax consequences.

Are you sure that 1-year cliff is a good idea for founders? A lot can happen in a year, and founder disputes are A Thing; and it sucks for the person with 49.9% to be in a position where any unresolvable disagreement in the first year means he walks away with nothing.

I agree with you that a lot of founders have catastrophic breakups in the first six months. In most cases, this kills the company, and good riddance. In the cases where it doesn't kill the company, the cliff minimizes years of painful conversations of the general flavor "Hello, 10th engineer. We are happy to offer you 0.2% of the company, which you'll earn over four years with us. This grant represents 1/250th of what someone who worked with us for two months once earned." or "Hello, potential acquirer. That certainly sounds like a very fair offer. Unfortunately, I'll need to run it by someone who I haven't spoken with in 5 years who you'll be writing a check for several tens of millions to."

Cliffs are, of course, negotiable. If someone suggested one to me with regards to my business, I'd accept it contingent on the clock starting at either launch or incorporation, either of which would result in the cliff being moot.

It keeps your cap table clean, which you will really only appreciate later on.

This also depends somewhat on what it means for someone to leave the company. This is actually not a simple issue - e.g. as the CEO of the company, you may be entitled to fire someone, even a founder, and that stops the vesting. But usually you'll have a board of directors, and the board is allowed to overrule the CEO, and guess who else sits on the board? The co-founder.

This gets very complicated very quickly. That's why you should consult lawyers (or legal documents available online, but unless you're a lawyers you should consult one anyway).

I'm actually not sure how this gets resolved in most startups. Oftentimes there are clauses like Shotgun clauses that try to solve this in a catch-all manner, providing a way of forcing people to sell their shares.

Usually for someone to lose their future vesting, they have to walk away, or be removed "for cause." A disagreement between founders is insufficient. Forming a company with partners is like a marriage. You can't dabble in it.

>"I'd be inclined to have the company write you an IOU for your cash contributions so far, and split it 50/50, perhaps with one of you getting a tie-breaking share. The company can dispose of your IOU like any other short-term debt of the company at some point in the future when it has the financial wherewithal to do so. [See below about IOUs.] Your vesting clock starts 3 months ago, your partner's starts as of the day when he becomes full-time"

This is something I tried to suggest to my former cofounder. His contribution was merely financial, and he wanted an exorbitant share of equity plus the title of CEO. I tried negotiating with him, but somewhere in the course of it I realized he was not the right person for any startup, and the venture was bound to fail with him onboard. I resigned and now have a startup that is quickly growing with loads of customers.

I'm probably missing something obvious but if all the founders have vesting schedules who actually owns the company initially? Surely there must be a legal entity that technically owns the shares even if they are contractually obliged to distribute them on the vesting schedule.

With regards to documentation of loans to company and things like that is having it recorded as a company liability (to the named entrepreneur) in the accounts sufficient or was it more formal than that?

Technically, it actually works the other way around from vesting. Instead of you having 0% of your shares and working your way up to 100%, you start with 100% of your shares but the company has a Repurchase Right to buy back shares from you for (effectively) nothing. They incrementally lose this right until they have the right to repurchase 0% of your shares, which is when you are "fully vested".

Ask your lawyer if you need clarification, but my understanding is that vesting is typically actually instantiated as a contractual term which describes the company as having a right to repurchase shares at par value or either repurchase or cancel options.

For example, my LLCs have 10 million shares issued at par value 1/100th of a cent each. I own them outright. If for some reason I wanted to do a vesting agreement, I'd agree to the company having the option to purchase up to XYZ shares from me at par, with XYZ being any number up to and including the number defined by $VESTING_FORMULA_GOES_HERE.

I figure as long as you're going to write it in the books of the company you might as well write a piece of paper saying

"$COMPANY agrees to, at a date of its choosing within 10 years of the inception of this agreement, repay to $FOUNDER the sum of $SUM plus 5.0% annualized interest." Sign twice (once in personal capacity, once as authorized representative of company), date, file for later.

I am not experienced in these matters, but my intuition is that an IOU as you described isn't really fair in all situations. As an extreme example, if you invented and quickly prototyped a genuinely new technology that no one else knew about, then I would say your contribution is much more than whatever it cost you to make the prototype.

It's commonly asserted that ideas are worth next to nothing, the difficulty is all in the execution, etc. I don't think that's entirely true. If your idea is just a vague one-liner like "facebook for pets", then sure, it's not worth much. But as you start building out a prototype, you're forced to be more specific and refine the idea, and it becomes more valuable. If you've got a handful of users and you've gotten some feedback, that's yet a bit more value. And if you've thought about the problem for a long time, you will probably have a good sense of what are the main challenges and what approaches won't work. That's valuable too.

I don't think there is a well-defined line between refining your idea and "executing" on it. Obviously there is a limit to how much you can accomplish in the planning and prototyping stage. However, I suspect it is a lot higher than is commonly believed. Working for 3 months may sound like not very much on the scale of a startup's lifetime (let's say 2-5 years before it either fails or grows big), but consider this: maybe the OP did 4 or 5 failed 3-month projects before he or she got to this one, which seems somewhat promising. Suddenly that looks a lot more significant than 3 months.

For this specific case, we don't have enough details to assess whether the OP has really hit on something big, or if there is still a lot of uncertainty about whether the idea will pan out. So unfortunately, after all that discussion, I don't really have an answer to the original question. I think what I would do in your situation is to make my best guess as to the "fair split" based on what I've contributed and the expected future value (let's say I decide it's 70/30), offer the friend that split, and if he/she accepts, I would immediately change it to 65/35. That way, they should be happy, but things are still close to fair from my perspective.

IANAL, but in that case I'd write an IOU for the monetary value (i.e. your hours), but arrange it so that the technology / patents / copyright / idea is legally your own, and that your company licenses the technology from you personally; that way, later on, you could make an arrangement that the company buys up the full rights to your technology instead of licensing it. Something like that.

> It's commonly asserted that ideas are worth next to nothing, the difficulty is all in the execution, etc. I don't think that's entirely true. If your idea is just a vague one-liner like "facebook for pets", then sure, it's not worth much. But as you start building out a prototype, you're forced to be more specific and refine the idea, and it becomes more valuable.

This is a very important point you make. I guess the exact dividing line between an idea that's worth something and an idea that's worth nothing is whether time or money has been invested into the idea or other forms of personal risk by the time it was just an idea. It is the investment and commitment that makes an idea valuable, not the idea itself.

Thank you Patio for that reply, it really helped. As for writting IOUs for cash alone, why not my time spent working as well? I am guessing since my vesting schedule started 3 months ago, that would cover that correct?

Also, being new to this, excuse my ignorance, what does vesting prevent? what does it encourage? First things that come to mind is if there were to be a fall out, the equity would remain under the one who stayed. On the opposite side, it encourages a long term commitment?

The work is part of building the company. As a founder, the company does not owe you $125/hr for every hour you worked.

However, if you "loan" the company $4,500 to pay a designer for something, it absolutely owes you that money back.

My first advice would be that this friend has to put money into the company. You need him to show commitment. It doesn't have to be a lot, maybe just $ 10,000. If he refuses to put any money into the company, you have an employee, not a partner.

Trust me on this one, you want to test risk tolerance as soon as possible.

Second question, will he work full time? If he doesn't work full time, you should give him very little equity, or just relative to the amount he invested in the company with maybe a little extra relative to the value he brings.

If he doesn't want to work full time and doesn't want to put money, just pay him by the hour. Pay him by the hour can also be a way to start the business relationship and build trust.

Third question, how much can you pay him if he works full time? For example, if he works full time but you can only pay him $ 50,000 instead of $ 100,000 the first year (assuming $ 100,000 is what he could get), he's putting $ 50,000 into the company.

Now, the last part: value your company. The best indicator is profit, when you reach it and how long you hope to sustain it (for ever, possibly). There are many tools and formulas, your accountant can probably help you. Because you have an accountant right? And a business plan, right? ;)

Another approach is that if he puts a decent amount of money (enough to give several months of runway) into the company and works full time for a well below market salary you can give him 49% (or 50%, up to you).

Joel's Canonical Guide

http://www.businessinsider.com/how-to-allocate-ownership-fai...

Google "Startup Lawyer If I launched a startup 2014", which sums up most legal questions including equity splits. Founders Dilemma by Wasserman covers the topic from a scientific research point of view.

tl;dr as far as I remember from that book: Make sure it is fair, and enough equity for both to be motivated. You have to discuss with each other to find out. It can be everything between 95/5 to 50/50. If you value the friendship more than you value the company, you should go for 50/50. Otherwise 50/50 is not a good option according to Wasserman's research.

5% would be absurdly predatory for essentially a cofounder. (If they're building the company from the ground up rather than merely shaping it, then they're a cofounder.)

I agree. With 95/5 you're more like a first employee. My guess is that more popular splits are 50/50, 40/60, 70/30, 80/20. In that order.

Ask her what, in her mind, is fair. If she says "we should do 50% 50%" and she won't give you the credit for starting the venture, you should think twice if you want to establish the partnership with this person. If she says "you did most of the work. 20% is fair" you should do 50/50 with IOUs and vesting.*

*Partners are working full time on this.

Here is a good summary of how to pick a cofounder http://venturehacks.com/articles/pick-cofounder

Find someone who you believe to be your equal (strength of skills he/she brings, intelligence, future potential) and treat them as your equal (50/50, same vesting schedule) -- you remain CEO. If you don't believe they are your equal, then find a way to hire them (as an employee, contractor, whatever) instead. Most other strategies are recipes for resentment in the long-term. As others have said, weathering the first 4 months will be nothing like what it takes to deliver a success story in 4 years.

I'd like to bring in a good friend of mine who I believe can contribute

This is the key sentence. Work together for a month, with no equity. See how much this potential co-founder actually accomplishes. You'd be amazed by the gap between what you dream may happen and what actually happens. Success is hard.

If after a month, you are still super-excited about this co-founder, start discussing an equity split. Always with vesting. No cliff (or very short, that was what the 1-month trial period was for).

If a co-founder doesn't receive a salary, then the minimum equity split would be 90/10, all the way to 50/50. FYI, at 90/10 I would behave like a super-adviser, but not a fully committed co-founder. 75/25 is the first "true co-founder" deal I can think of.

"No cliff" is wishful thinking. Everyone has had the experience of hiring someone who ended up not working out. It almost always takes more than a month to come to that conclusion, and a little longer still to act on it. And finding a viable cofounder is harder than hiring.

Having someone who worked for you for a couple months walk away with tens of basis points of ownership is a pathological situation, not something you should deliberately optimize for.

Funny you ask this here. In 2012, 1 in 4 Y combinator starts up broke apart due to founder disagreement. You can bet a large part of that was due to equity distribution issues. Equity issues can get really messy - and easily damage friendships.

Read the reviews for Slicing Pie. It's about maintaining a dynamic model that eventually vest into shares (if the company works out). I read it. It's great quick read. Ideal for your situation, I think. And it may preserve your friendship.

http://www.amazon.com/Slicing-Pie-Company-Without-Funds-eboo...

If I was in your potential business partner's position, I'd ask for 50/50 vested with a schedule of (say) 12 quarters, so every 3 months I'd get 4.1% of the company, with a cliff of 6 months to test whether the relationship will actually work (e.g., no equity transfer if the relationship breaks down in that time) That would recognise the work you've done already, but also appreciate that if the business lasts a long time the initial work will become less important. There's no good reason why you should have more equity than your business partner after a few years - by that point the risk each of you have taken is effectively the same.

Here is some advice from 1996: don't have equal partners. Make sure someone can call the shots or else no one will call the shots: http://yesatyale.org/wp-content/uploads/2014/06/lecture_06-1...

EDIT This moves around so much I uploaded to Scribd: http://www.scribd.com/doc/234962516/Entrepeneurial-Death-Tra...

Do you plan on an LLC, an S-Corp or a C-Corp?

An LLC would require to define terms of ownership, decission and cashout in its charter beforehand. A Corp is much more flexible, especially if you do not know how much your "partner" will contribute in the future. So you might want to copy the unusual way Wizards of the Coast did: 1 share = 1 hour = $50

So you own already 600 shares, and your partner owns zero. If he invests money or time he earns share and dilutes you, if you invest money or time you earn shares and dilute him.

WotC shares later sold to $1400, iirc - so it was a good deal for the artists who painted those tiny pictures for magic the gathering.

PS: Peter Adkison later wrote that he had no clue how a normal Corp works, and did not consult a lawyer because he had no money for it, and just handwaved a way, that sounded fair to him, to pay the artists without having any money. It worked out, thats all that counts.

I don't think it's true that an LLC requires you to allocate equity statically at the time of formation. LLCs routinely issue equity to employees long after formation, and, to the best of my knowledge (I cofounded, co-managed, and eventually sold an LLC with several tens of employees), without modifying their charter.

No matter what your corp structure is, this is an issue you need to spend a few hundred dollars on an attorney on.

I wouldn't give any equity away in this case.

Why?

He has not done anything yet.

This sounds like you are afraid of sales/marketing/biz dev/something and you think he will solve your problems.

I warn you: he will not solve your problems, you will have more on your hands.

it all depends what is he contributing.. You said that you believe "he can contribute a lot in many areas that need to be covered in order to build a succesful app company", but what is it exactly? Who's coding the app? You've already done first app, if he's contributing to marketing of the first app then he can get less than 30% of profits from that app. If you've already built second one, the same thing. If he's building the second app with you and brings more skill you might consider splitting evenly just for the second app, you don't have to give away equity within the company, you can make an agreement to split profits just for the second app, since he can decide to leave.

My experience is it should always be evenly distributed at such an early stage (3 months is still considered early). I've started two companies and it has never failed me. This eliminates any drama and holds each founder accountable for the work that is required. If you don't trust this approach, then there are deep underlying issues that need to be addressed first. This could be not trusting the incoming founder to make up for the time that has passed while you were running the company initially.

Joel Spolsky has weighed in on this: https://gist.github.com/isaacsanders/1653078

"if someone goes without salary, give them an IOU. Later, .. you'll pay them back in cash ... when the money comes rolling in ... pay back each founder so that each founder has taken exactly the same amount of salary from the company."

This doesn't seem fair. The founder who takes an IOU rather than cash bears the very real risk that he never gets paid back. There should be an interest rate attached to the IOU: something like 15-25% to account for the risk.

how does the tax work on that I can see the IRS wanting to get their cut of the gain

More importantly in the short term: are payroll taxes due on the face value of the IOUs? You've gotta pay taxes in cash...

That's something I believe, too, but I never see it mentioned.

If it's "just like cash", then you've made a significant early investment in the company. How is getting paid back what you put in fair?

There should be an interest rate, because the value of money changes over time. There is a difference between the value of $50,000 in hand today, and the expectation of being paid today's $50,000 a year from today. That difference is reflected in the interest rate. Risk is also accounted for in the interest rate, although fundamentally, not all risk can be accounted for. There is always going to be the risk that the startup goes bust before it can pay back its IOUs, and it would be silly to expect an interest rate exorbitant enough to account for all of that risk. A rate of 15-25% is probably fair to the individual in a nominal sense (more than fair, actually), but it is unfair to the company. This is a case where the individual will need to bear some of the risk in the financial interests of having a successful company. He is not a loan shark, after all.

"A rate of 15-25% is probably fair to the individual in a nominal sense (more than fair, actually), but it is unfair to the company."

I think we are in agreement on the first part, i.e. that a rate of 15-25% should adequately compensate the individual for both the time value of money and for the large risk of default.

I don't agree that it's unfair to the company. Consider:

- The company has no alternative, cheaper sources of debt financing

- The capital and interest will be deferred until such time as the company has money to pay (e.g. from a Series A) so will not cause any hardship by constraining cash flow

- These IOU are non-participating, i.e. they don't get any of the upside should the company do well.

If you think about it, it's similar to an investment by an angel: you want to compensate for the risk, you don't know when you will be able to return the cash, you don't have a reliable way to come to consensus on valuation.

Perhaps the right way to structure these IOUs is as a capped note with a low coupon (2-5%) but a reasonable conversion discount. That way the equity-like element of the note compensates for the risk, instead of requiring a large coupon on the debt-like part.

Here's a link to an in depth talk & infographic that'll help you see a more detailed view of what might impact how you approach equity splitting someone.

http://blog.saasu.com/2014/03/28/ceo-insights-webinar-record...

Disclosure: I work at Saasu but think this is relevant.

I like, a lot, the Grunt Fund idea of Slicing Pie (no affiliation): http://www.slicingpie.com/

The point is: why split the pie before it gets done or after? why not dynamically split based on the actual resources (money, time, equipment, whatever) people put in in the early days?

While I suspect that Professor-of-Entrepreneurship has a lot of the details worked out in his book, I would be concerned about tax implications (higher-basis/more-recordkeeping) and the distractions/morale-risks of constant rolling renegotiation about "latest contributions".

For example, when the company hits a rough spot, it may be best for a team of N to be thinking, "We all need to work extra hard this month so that our 1/Nth shares wind up worth something, rather than nothing." Rather than, "I need some recharge time, I'll let others earn a little more this month, and re-engage for my increments if and when it gets less crazy."

> I'd like to bring in a good friend of mine who I believe can contribute...

Work to keep him as a friend. Channeling Steven Covey, it would be helpful to first understand what he would like to get out of the business arrangement and what he's committed to invest on his end. Beyond a mutual agreement, find a win-win scenario.

Look into dynamic equity models. eg. Grunt Funds (http://www.businessweek.com/articles/2012-12-18/grunt-funds-... )

What you've done to date is simply what was required. All of the really hard work is in front of you. If your partner isn't worth an equal share they're not worth being partners with.

> can contribute a lot in many areas that need to be covered in order to build a succesful app company

You told us what you've done until now, but are those "many areas" ?

What is the other person bringing to the table? Just treat them as a first hire and offer the minimum equity needed to get such a person.

Sounds like a good time to use the equity equation:

  http://paulgraham.com/equity.html

Neat article. I think OP is trying to discern _how_ to map the friend's contributions to outcome of the company.

Equitably

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