Dynamic equity split, summarized and introduced by Professor Noam Wasserman (a long-time Harvard Business School professor) in his bestseller “The Founder’s Dilemmas”*, is a model of equity splitting that focuses not only on “get it initially right” but also on “keep it right” (the ability to adjust as circumstance change). It not only helps founders estimating each other's contributions and abilities, but also effectively replace emotional discussions with rational considerations.
Equity-split is one of the most important and emotional events during the early stage of the life cycle of a startup. During the process, feelings could overwhelm rational considerations. Equity-split is also very often the first time the entrepreneurs paying for lawyers.
Equity-split is not easy, founders need to carefully consider both the methodology and choice of time. Common mistakes include quick-equal split and 51% split.
Don’t do a quick-equal split. Sometimes founders will skip the seemly complex process, and just say “screw it and do 1/N”. They will regret it. Disregard all the other things on founders’ past and future contributions and all the potential issues likely to be caused in the future, it puts the startup at a disadvantaged starting point when trying to raise funds. Institutional investors and sophisticated angels often see a quick-equal split as a symptom of a founding team’s weakness. It shows the founding team’s: (1) lack of experience, (2) lack of methodology, (3) lack of real preparation, and (4) lack of real glue to the idea.
Don’t do a 51%. In investors’ eyes, a 51% equity stake suggests that one cofounder is overly focused on control. (When investors ask, “Money or Control?” The right answer is always “Money”.) In any case, whatever the cofounder is trying to achieve through the 51% equity stake, he/she will lose it after just one round of outside financing.
The criteria for equity-split mainly consist of :
past contribution (including Idea Premium and Capital Contribution),
opportunity cost, and
future contribution.
Among them, the future contribution is the most important but also the hardest to estimate. Factors to consider include (1) founders’ expertise and experience (serial entrepreneur will get a large premium etc.), (2) founders’ commitment (full time vs part time), and (3) founders’ personal life (which will greatly affect commitment and contribution).
When to split
Short answer: after founders knew each other to the extent that they can confidently judge each other’s abilities and commitment to the startup, but before the startup securing any outside financing. The further into the business, the better founders know each other. The closer to the fundraising, the higher the tension would be (hence more emotional, less rational). It's hard to balance.
Solution: Dynamic Splits
The “Dynamic” of the Dynamic Splits is in comparison to the traditional method of splitting equity in stone at one point of time. Dynamic Splits break down the stages of startups development into separate phases, provides a structured mechanism to discuss and weight the importance of each phase and each founders’ contributions in each phase. There can be various ways to break down the stages. It can be simply based on time, on task, or both (see samples 1 -3 below). The team just need to set up a mechanism at first, and then follow it to split the equity through the time.
Sample 1: phases based on time
Sample 2: phases based on tasks (time phase for different tasks can overlap)
Sample 3: phases based on time, sub-divide into task phases under each time phase
*“The Founder's Dilemmas" is one great book that I would recommend to anyone who is thinking of starting a business. I would even say it is “a must-read for anyone who has a romantic on creating and running a startup”, that belongs on every entrepreneur’s bookshelf. The book is backed up by extensive research along with case-studies (such a typical Harvard B-school professor) of first-time and serial entrepreneurs.
**This blog provides general information for educational purposes only. It is not intended to constitute specific legal advice and does not create an attorney-client relationship.