Equity distribution among startup co-founders can be a tricky conversation. Luckily, with the right guidance, equity allocation can be explored in a fair and simple way.
TechUnited:NJ CEO, Aaron Price sat down with Jared Sorin, former Partner at McCarter & English, to dive deeper into the complexities of equity distribution, as well as other common conversations between startup co-founders. For Jared’s best practices to protect your startup, read below and check out McCarter.com.
Have the equity conversation as early as possible
Equity allocation is the primary issue for early-stage founders. When creating an equity structure, make sure to incentivize the key performers in your company by giving them a proportionate amount of shares to the value they add to the company. This ensures that the most valuable people to your growing company will stay for the long haul.
A common misstep for startup founders is falling into the equity “honeymoon stage,” where a 50/50 split seems like the best option for both parties. An even split can actually end up creating more issues for everyone in the future. It creates a precedent of tension where all disagreements about company decisions will result in a deadlock, creating stagnation for your growing business. While a 50/50 structure can work if it is a deliberate choice, it does not reflect the reality of most co-founder relationships. Accurately assess the value created by each of the founders to create a constructive, long-term working relationship.
When it comes to company control, it is appropriate for founders to have board seats as long as they are aware of the risks involved. It’s important to have an odd number of board members to avoid decision stagnation as well. Because of equity structure’s permanent long-term effects and difficulty to change down the line, it is important to discuss as soon as possible.
Set your vesting schedule to attract investors
Vesting is ultimately the practice of earning your shares. Vesting equity is an agreement that gives founders and employees ownership over future company earnings, and provides the company protection from employees who exit prematurely from extracting large amounts of value.
The correct type of vesting schedule will protect equity in the startup’s growing stages and then incentivize your team to stick around long-term. Time-based vesting schedules are recommended over milestone-based vesting schedules for this reason; they will provide growing equity opportunities for employees, and ensure that they see the company’s common vision.
Time-based vesting schedules are also attractive to potential investors. “Investors want to know that the team that they are betting on are here for the foreseeable future,” advises Jared. A typical vesting schedule is 4 years. There is a one-year cliff, meaning that nothing vests in the first year. After the first year, 25% of shares will vest, and then from then on equity will increase in equal installments.
Why you should file a Section 83(b) Election
An 83(B) Election is the decision to pre-pay taxes to the IRS on your equity. This way, you have the opportunity to pay as low a rate of taxes as possible early on f your equity increases along with your business growth.
When it comes to 83(b) election services, “You get what you pay for,” says Jared. Online form-generating services don’t come with the same resources as a law firm, for example. Advice from seasoned experts is valuable, especially if you’re not experienced in finance.
Keep in mind that there is a very finite window for filing this election. You only have 30 days from the date of grant to file. It’s important to file as soon as you create your vesting schedule.
Avoid common fundraising issues by planning ahead
Show potential investors that you are a reliable startup to bet on by taking protective and incentivizing measures in your business structure.
While it’s easy not to consider the possibility of a co-founder exiting your fresh startup in the beginning stages of excitement, it’s a possibility that should be acknowledged. By setting up a time-based vesting structure, it will help you avoid dilution when looking for a new co-founder. Without these protections in place It makes it harder to recruit new talent, and it reduces your professional profile in the eyes of shareholders and investors.
Also, be sure to have an equity incentive plan to retain talent for as long as possible. The primary way to incentivize them is through equity. You want to make sure you’re giving a rational amount. Roughly 15% of equity should be reserved for an equity incentive plan.
With the right mentorship and knowledge, it is possible to avoid the most common pitfalls in co-founder relationships early on to ensure optimal growth for your startup
Thank you again to McCarter & English, a firm that has supported TechUnited:NJ and growing startups for years. McCarter provides flexible fees for early stage companies; to reach out and learn more about their services, visit McCarter.com.