The 6 most common equity split mistakes that can kill your business
Equity split is one of the most important decisions every founder who considers having a cofounding team needs to make. It is also one with a very significant impact. Not only does it determine the ownership of the business – it also has direct impact on the decision making and has a significant – or not – motivational element for the team.
“The most common ways in which founders split the equity is also the most hazardous.”
Dr. Noam Wasserman, Harvard Business School
Equity split is also one of the decisions where the seed for most cofounding teams’ failure is planted, if not done right. There are different options to choose from – fixed or dynamic equity split, with or without vesting schedules and there is no one size fits all answer. The most important aspect is its fairness, sufficient flexibility and suitability for the cofounding team and project.
The most frequent mistakes done with equity splits are:
# 1: Avoiding the conversation: The reasons can be ranging from prioritizing the urgent over the important to being uncomfortable with raising the question. The last reason being in the immediate risk flag category – if you do not feel comfortable discussing openly important decisions in the team – you need to investigate why it is and fix it before moving any further.
# 2: Quick handshake: quick handshake is a very short-sighted way to get the relatively sensitive topic of the table. Because equity split conversations usually take time. And there is a good reason why. It does indirectly touch on the team’s roles and contributions, expectations and commitment. Anyone remembering the Facebook outside of the pub conversation from the movie? Not a good idea.
# 3: Equal splits without a good reason: for many experienced investors this is another flag raising moment. Equity split should reflect founders’ contributions. And it is only in rare cases that they are all equal. And having equal split without a good reason is typically an indication of a cofounding team who is either not comfortable or competent to have important conversations.
# 4: Fixing too early with no future adjustment option: the equity split decision happens typically in the early stages of the business. Because it has to. For incorporating a company, you need to define the shareholders and their shareholding percentage. And there is a strong bias to overestimate past contributions for the cost of the future once – which are not easily predictable and often change. Fixing too early without a possibility to adjust leads to unfair splits which inherently lead to cofounders’ underperformance or cofounders’ leaving the team.
# 5: Bad leaver without clear expectations: as much as I would always recommend including equity recovery framework in the cofounding agreement – I have seen too many wrongly implemented bad leaver clauses. Which would typically have some punitive element for the bad leaver. If a cofounder for example is ‘fired’ for non-performance- it needs to be clear against which expectations and milestones the performance is being evaluated. To avoid unclear and costly situations in the future – be specific.
# 6: Operating in unclear waters: it is always good idea – and practice – to try before you buy. To date. To test working together. Before you commit. However, in this period it is very important to define:
- What happens if the cooperation will continue and what are the conditions
- What happens if the parties will part. Is there a right for compensation? Who owns the intellectual property which will be developed within this period?
Be clear. To the benefit of all. Basic memorandum of understanding outlining the framework is the way to do this right.
Learning from the mistakes of others is always cheaper than from your own. Equity split of your own business is neither an easy nor a quick decision and it is one which is not very easy to fix later. Diligence and attention to do it right will pay off!
Jana Nevrlka, JUDr. LL.M. MBA
Jana combines her legal and business background with her entrepreneurial experience, to support cofounders to build teams that last. From where and how to select the right cofounder, through cofounder due-diligence, team composition, equity split up to how to implement it in cofounding agreement. She also writes, teaches and speaks extensively on the cofounding topic, works as a cofounding expert for a number of startup accelerators and organises a startup knowledge sharing platform – the Swiss Startups Club. Jana also coordinates development of slicing pie / equity splits templates across Europe in direct cooperation with Mike Moyer, the author of Slicing Pie.