Founder’s Equity: Deciphering Fairness

Poyni Bhatt is a founding team member and former Chief Executive Officer of SINE, the technology business incubator at IIT Bombay until October 2023. She has an experience of 38 years in industry and academia of which she spent nearly 20 years with SINE. Poyni is a qualified legal and compliance professional- Fellow member of the Institute of Company Secretaries of India.

In my decades of association with the startup and entrepreneur community, I often come across dilemma of founders as to what should be a fair distribution of initial founder’s equity at the time of formation of their company. In many cases, the first-time founders are either friends or have close relations from their previous association. They tend to split founder’s equity equally. While equal distribution of the founder’s equity appears to be fair, it is in fact unfair distribution unless all the founders take risk of starting a venture together, contributing equal in terms of time, commitment, role and responsibility, financial contribution and execution responsibility. Aspects such as founder’s ability to execute ideas into venture, ability to reduce certain risks from the company because of their competence, their past contribution, future commitment with regards to time, roles and responsibilities, their contribution in the company whether in cash or in kind, are determining factors for initial capital structure. There are ample “founder’s equity calculators” in public domain to guide founders decide initial equity structure. Each uses certain parameters to decide founder’s equity.
However, there is no unique formula that can work for all. Initial owners shoulder the inherent risks of embarking on a venture, navigating uncertainties, and transforming their vision into a thriving business. Generally, several key factors influence the allocation of founder’s equity:

  1. Founder’s commitment and ability to take risk
  2. Founder’s ability to lessen risk
  3. Founder’s contribution in cash or kind

Commitment and ability to take risk:

Startups are typically associated with high level of risk and uncertainties. Founders who take risk of starting a venture and their commitment should be the first and foremost parameter to decide equity distribution. Typically, founders are expected to commit full time with the startups they found. If any of the founding team members commits part-time even if he/ she undertakes certain role and responsibilities, equity allocation to such members should be lower than the other founders who commit their full-time for the startup. There are cases when a founder is wanting to join full time only after certain period when the startup achieves a significant milestone. Equity allocation to such founder should be lower even if such founder eventually undertakes a full-time role to lead a particular functional area. Thus, the time commitment and timing of joining the venture full-time would determine the distribution of equity among founders.

Risk factors:

For a startup in its initial 4-5 years, the most critical aspects to manage are technology risk, product risk, market risk, financial risk, business risk. Eventually, a venture also has risks associated with growth management including operations, human resource, compliance and several more depending on the nature of the business. For example, for a healthcare or a BioMedTech startup, addressing regulatory risk is also very important from the early days. Founders are expected to undertake responsibilities in context with one or more of these risks associated with a startup. The initial equity distribution should be in proportion to their assuming responsibility and ability to bring technology, product, commercial and financial strengths in the company.
Hence, the founders should first focus on their complementary strengths while they form a team. Depending on their skill sets, they need to define roles (typically CXO role) for each of them to lead critical functions such as Technology & Product Development, Customers and Sales, Operations, Financial resources, Overall strategy and execution. One yardstick to assess the criticality of the functional area is that if a founder handling that function left, would it severely impact core technology/ product development or the startup’s chance for fund raising. Thus, founders handling CXO roles should have parity of equity holding.

Additional Contribution:

Equity split should also take into consideration founder’s contribution over and above their commitment, defined roles and responsibilities. Such contribution could be in form of pre-existing Intellectual Property or higher capital investment or in-kind contribution such providing cost-free infrastructure, buying equipment or software for the company or contribution by virtue of which the startup would gain commercial or competitive advantage. Equity distribution should accordingly be adjusted in favour of contributing founder.

Other factors:

There are a few more instances where the equity distribution needs to be adjusted. For example, in a startup, one founder is wanting to be paid salary from the beginning, while the rest of the founder(s) forego salary in early days to save cash for business purpose. Thus, the former takes less risk than the latter. In such case the founders not taking salaries should be compensated with more equity compared to the former. Another example, a founder with more domain experience or experience as a serial entrepreneur would expect higher equity on the premise that his/ her association would bring better strengths and execution capabilities in the venture which would enhance the chance of revenue and fund-raising ability of a startup. Equity split may be adjusted considering such additional strengths.

At times, in the early stages of a venture, founders typically agree upon the distribution of equity among themselves. However, situations may arise where one founder decides to exit from the company for various reasons. In such instances, the exiting founder’s equity must be reassigned, with or without compensation, depending on the circumstances, to the remaining founders or to a new founder brought in to fill the vacancy. Conversely, there are occasions when a new founder is brought onboard later to address critical gaps within the company. In these cases, the new founder may expect to receive equity. It is important to note that equity adjustments in such scenarios are generally feasible primarily in pre-funded companies.

The above factors are not necessarily exhaustive. But they are major factors that impact the strength and success of a venture. Founders are expected to assess, at the time of company formation, their respective strengths; understand who bring more value to a venture. It is important for them to pay attention to various aspects while deciding distribution of founder’s equity to avoid any future conflicts between the founders. The distribution of the founder’s equity is neither an intuitive action nor purely driven by a mathematical formula. It is more of a qualitative process to make it fair beyond equal shares.

Founder’s Equity: Deciphering Fairness
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