Business Proposal & Share of Profits

If a business is being proposed with an initial setup where:

  • 2/3 of the partners are investing their money as their business capital
  • 1/3 of the partners are investing their time as business capital

How does one makes sure that the share of profits is fair?

What are the things that should be made clear from the very beginning so that there are no issues going ahead?

This was posted a reply to another question and I think it still applies here even though the questions aren't quite the same. It's worth a full read, but the tl;dr for your situation is to really be considered founders they should all fully commit their time. Other assets like money or intellectual-property can be paid for later in cash.


This is such a common question here and elsewhere that I will attempt to write the world's most canonical answer to this question. Hopefully in the future when someone on answers.onstartups asks how to split up the ownership of their new company, you can simply point to this answer.

The most important principle: Fairness, and the perception of fairness, is much more valuable than owning a large stake. Almost everything that can go wrong in a startup will go wrong, and one of the biggest things that can go wrong is huge, angry, shouting matches between the founders as to who worked harder, who owns more, whose idea was it anyway, etc. That is why I would always rather split a new company 50-50 with a friend than insist on owning 60% because "it was my idea," or because "I was more experienced" or anything else. Why? Because if I split the company 60-40, the company is going to fail when we argue ourselves to death. And if you just say, "to heck with it, we can NEVER figure out what the correct split is, so let's just be pals and go 50-50," you'll stay friends and the company will survive.

Thus, I present you with Joel's Totally Fair Method to Divide Up The Ownership of Any Startup.

For simplicity sake, I'm going to start by assuming that you are not going to raise venture capital and you are not going to have outside investors. Later, I'll explain how to deal with venture capital, but for now assume no investors.

Also for simplicity sake, let's temporarily assume that the founders all quit their jobs and start working on the new company full time at the same time. Later, I'll explain how to deal with founders who do not start at the same time.

Here's the principle. As your company grows, you tend to add people in "layers".

  1. The top layer is the first founder or founders. There may be 1, 2, 3, or more of you, but you all start working about the same time, and you all take the same risk... quitting your jobs to go work for a new and unproven company.

  2. The second layer is the first real employees. By the time you hire this layer, you've got cash coming in from somewhere (investors or customers--doesn't matter). These people didn't take as much risk because they got a salary from day one, and honestly, they didn't start the company, they joined it as a job.

  3. The third layer are later employees. By the time they joined the company, it was going pretty well.

For many companies, each "layer" will be approximately one year long. By the time your company is big enough to sell to Google or go public or whatever, you probably have about 6 layers: the founders and roughly five layers of employees. Each successive layer is larger. There might be two founders, five early employees in layer 2, 25 employees in layer 3, and 200 employees in layer 4. The later layers took less risk.

OK, now here's how you use that information:

The founders should end up with about 50% of the company, total. Each of the next five layers should end up with about 10% of the company, split equally among everyone in the layer.

Example:

  • Two founders start the company. They each take 2500 shares. There are 5000 shares outstanding, so each founder owns half.

  • They hire four employees in year one. These four employees each take 250 shares. There are 6000 shares outstanding.

  • They hire another 20 employees in year two. Each one takes 50 shares. They get fewer shares because they took less risk, and they get 50 shares because we're giving each layer 1000 shares to divide up.

  • By the time the company has six layers, you have given out 10,000 shares. Each founder ends up owning 25%. Each employee layer owns 10% collectively. The earliest employees who took the most risk own the most shares.

Make sense? You don't have to follow this exact formula but the basic idea is that you set up "stripes" of seniority, where the top stripe took the most risk and the bottom stripe took the least, and each "stripe" shares an equal number of shares, which magically gives employees more shares for joining early.

A slightly different way to use the stripes is for seniority. Your top stripe is the founders, below that you reserve a whole stripe for the fancy CEO that you recruited who insisted on owning 10%, the stripe below that is for the early employees and also the top managers, etc. However you organize the stripes, it should be simple and clear and easy to understand and not prone to arguments.

Now that we have a fair system set out, there is one important principle. You must have vesting. Preferably 4 or 5 years. Nobody earns their shares until they've stayed with the company for a year. A good vesting schedule is 25% in the first year, 2% each additional month. Otherwise your co-founder is going to quit after three weeks and show up, 7 years later, claiming he owns 25% of the company. It never makes sense to give anyone equity without vesting. This is an extremely common mistake and it's terrible when it happens. You have these companies where 3 cofounders have been working day and night for five years, and then you discover there's some jerk that quit after two weeks and he still thinks he owns 25% of the company for his two weeks of work.

Now, let me clear up some little things that often complicate the picture.

What happens if you raise an investment? The investment can come from anywhere... an angel, a VC, or someone's dad. Basically, the answer is simple: the investment just dilutes everyone.

Using the example from above... we're two founders, we gave ourselves 2500 shares each, so we each own 50%, and now we go to a VC and he offers to give us a million dollars in exchange for 1/3rd of the company.

1/3rd of the company is 2500 shares. So you make another 2500 shares and give them to the VC. He owns 1/3rd and you each own 1/3rd. That's all there is to it.

What happens if not all the early employees need to take a salary? A lot of times you have one founder who has a little bit of money saved up, so she decides to go without a salary for a while, while the other founder, who needs the money, takes a salary. It is tempting just to give the founder who went without pay more shares to make up for it. The trouble is that you can never figure out the right amount of shares to give. This is just going to cause conflicts. Don't resolve these problems with shares. Instead, just keep a ledger of how much you paid each of the founders, and if someone goes without salary, give them an IOU. Later, when you have money, you'll pay them back in cash. In a few years when the money comes rolling in, or even after the first VC investment, you can pay back each founder so that each founder has taken exactly the same amount of salary from the company.

Shouldn't I get more equity because it was my idea? No. Ideas are pretty much worthless. It is not worth the arguments it would cause to pay someone in equity for an idea. If one of you had the idea but you both quit your jobs and started working at the same time, you should both get the same amount of equity. Working on the company is what causes value, not thinking up some crazy invention in the shower.

What if one of the founders doesn't work full time on the company? Then they're not a founder. In my book nobody who is not working full time counts as a founder. Anyone who holds on to their day job gets a salary or IOUs, but not equity. If they hang onto that day job until the VC puts in funding and then comes to work for the company full time, they didn't take nearly as much risk and they deserve to receive equity along with the first layer of employees.

What if someone contributes equipment or other valuable goods (patents, domain names, etc) to the company? Great. Pay for that in cash or IOUs, not shares. Figure out the right price for that computer they brought with them, or their clever word-processing patent, and give them an IOU to be paid off when you're doing well. Trying to buy things with equity at this early stage just creates inequality, arguments, and unfairness.

How much should the investors own vs. the founders and employees? That depends on market conditions. Realistically, if the investors end up owning more than 50%, the founders are going to feel like sharecroppers and lose motivation, so good investors don't get greedy that way. If the company can bootstrap without investors, the founders and employees might end up owning 100% of the company. Interestingly enough, the pressure is pretty strong to keep things balanced between investors and founders/employees; an old rule of thumb was that at IPO time (when you had hired all the employees and raised as much money as you were going to raise) the investors would have 50% and the founders/employees would have 50%, but with hot Internet companies in 2011, investors may end up owning a lot less than 50%.

Conclusion

There is no one-size-fits-all solution to this problem, but anything you can do to make it simple, transparent, straightforward, and, above-all, fair, will make your company much more likely to be successful.

There is no single right division of equity. There are many factors at play, including the need for cash, the rarity of the founders' skills, and any pre-existing business agreement.

Generally, startups don't want to pay out cash, but founders should also be careful to guard their equity and keep a clean cap table. There are a few ways to do that.

  • A high-rate loan is good, if you anticipate cash coming in sufficient to pay it off. But if you go to friends or family, they may resent be de-equitized and turned into bondholders. They may think they are buying into a future Facebook or Apple, so even a 20% interest rate might seem cheapskate.

  • A forced redemption right is a good way to require people to sell off their equity at some set price - for example, a multiple of their initial investment, factoring in the time delay and maybe the size of the business at the time of redemption. This requires a pretty explicit contractual right to force them to sell.

  • Equity options for active founders as an implicit salary. In this case, the original $X investment of the cash founders is preserved, but the service founders get compensated for their activity. This needs to be openly communicated and understood, particularly if the cash founders were told their stake in the equity in terms of percentages rather than units. After a few years, the cash founders may be quite diluted relative to service founders, so the equity does not seem to painful.

  • Equity compensation can be paired with an anti-dilution provision that allows the cash founders to buy into the company at a level consistent with their existing percentage. For example, if the service partners are awarded equity equal to 10% of the enlarged company, then the cash partners can buy into the new company to maintain the existing ownership ratio - or they can buy some equity from the service founders for cash. This is often suboptimal, and founders should avoid anti-dilution except with angels or VCs, who'll generally insist on it.

  • Obviously the service founders must have a vesting schedule to prevent them from abandoning the project. The cash founders want this as much as anyone else, since their money is worthless if the active founders run away.

If there is already an agreed business deal, then it needs to be explicitly renegotiated. If founders have an honest understanding of the equity arrangement, then it does no good to be subtle, sneaky, or passive-aggressive in trying to rearrange it. It should be defined clearly from the beginning, even before the cash is disbursed. If the arrangement is suboptimal, and the active founder realize how little their time has been valued (e.g. low five figures in exchange for months of unpaid efforts), then there needs to be a clear renegotiation.