I’ve written previously about the issue of academic teams turning into real companies and the issues that transformation generates. Amongst the thorniest issues for founders is how to divide up equity. Obviously the simplest case is when there are just two founders and they divide up the equity 50/50. And in some ways I believe that’s the ideal team makeup: a builder and a seller, as those are the two jobs in any startup. However, I’ve seen too many teams with CFOs, COOs and other CXOs – mind you these are teams, not companies! Be that as it may, there may be good reasons to have a team of more than two founders, so how do you go about determining a fair allocation of equity in company to be formed.
Shivang Dave, a fellow MIT Sandbox mentor, has been kind enough to allow me to publish this framework. Shivang attributes the framework to his team and mentors.
- Agree on “how close the academic project is to product-in-the-market”?
- Is it 5, 10, 25%?
- The team must agree to this number, which represents the value of the work performed in the academic setting.
- For this example, let’s say the academic project was 10% of the way to product-in-market.
- The team splits the academic setting equity, which in this case is 10%, and it vests before the company forms.
- The remaining 90% of the equity goes to the founders of the company, to an employee pool (typically 15% to 20%) for future hires, and perhaps 1% to 2% to be shared amongst advisors.
The benefit of this methodology is that members of the team who do not join the company, but contributed during the academic phase, feel that their contributions were rewarded. For example, if a team member contributed 30% to the team’s achievements, he or she would then be entitled to 3% equity in the company (30% of the 10% of the way to a product-in-market.)
It also makes clear how much equity those team members who are joining the company have to divide, in this case 90% of the equity, as the other 10% got allocated to the academic team.
- When investors look at the Cap Table they focus on anyone who owns more than a few percentage of the overall equity. They usually ask for justification for why that person has the amount of equity and if its commensurate with their role and if they’re full-time or not.
- I’ve come across a few cases wherein a founder leaves after a company is founded and invested in. In the cases where the founder had “double digit” equity, he/she was asked to give back equity to the company to the point where they were “single digits.” For instance, one founder (a friend of mine) was asked to give back his equity when he chose to leave. He originally had something like 22% and was asked to end with 7-9%.
- There is something psychological for investors when they see someone having “double digit” equity and not being full time with the company.
Basically investors like “clean cap tables.” What that means is that only the active founders have equity, there aren’t “hangers-on” who have left the company but have vested stock. One way to avoid this is to have everyone on the academic team agree that if they leave the team or the Company, the Company has the right to buy back their shares at the fair market value – set by the Board of Directors.
As a team if you are planning on setting up a company and want to divide equity make sure you maintain a cap table from day one, including an allocation for future hires, and some simple guidelines on how to deal with team members who don’t become Company founders. Once you form a company you will have a lengthy Stock Agreement that governs your equity in great detail. Consulting with an attorney before your academic team carves up equity can be a good investment. If you can’t afford an attorney, at least invest in some books that address the issue like Noam Wasserman The Founder’s Dilemmas – Anticipating and Avoiding the Pitfalls that Can Sink A Startup.