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One of the biggest misconceptions startup founders have is that equity ownership needs to be negotiated with one another in advance of any work being done. This approach virtually guarantees that a potentially devastating agreement will be made.
The best way a founder can avoid sharing equity is if he or she invests enough personal capital to simply pay everyone a fair market salary. Most people who have jobs are happy enough getting paid and don’t ask for equity.
In a bootstrapped startup, however, founders may not have enough cash to bankroll the company and instead rely on equity to compensate people for their contributions. So, with the best of intentions, founders sit down to negotiate their split with each other, often with the guidance of well-meaning advisors or lawyers. Their goal is pretty much universal: to be fair. Most founders want the split to be fair. Unfortunately, when the negotiations start, the goal of being fair is doomed from the beginning.
Fairness is impossible when people negotiate equity, because they have nothing to base the negotiations on except each other’s promises and predictions about future, unknowable events. It’s a stack of overly optimistic assumptions upon other overly optimistic assumptions. It must be. Why start a business in the first place if your assumptions aren’t overly optimistic? Nobody starts a business with the assumption that they will fail or just squeak by!
Fixed equity splits
The outcome of a typical equity negotiation is expressed in percentages. Two partners, for instance, will “go in” 50/50 or 60/40. Three partners might do a third each or some other variation. Equal splits are common. This is known as a “fixed” or “static” equity split.
The problem here is that no matter how carefully founders forecast or how earnest each participant’s promises are to one another, things rarely unfold according to plan. Things change, and when they change, equity needs to be renegotiated.
Renegotiations are similarly doomed for two reasons. First, they rely on prediction and promises just like the original negotiate. Second, they are complicated by people’s tendency to assess the quality of past contributions, which rarely leads to consensus. People often think their own contributions are more impactful than those of others. The result of the painful renegotiation process is yet another fixed equity split which, like the first one, is doomed from the start.
Negotiating other stuff
The mistake of negotiating equity happens, because people are so comfortable negotiating other things in business. For example, nearly everyone reading this article has at one time or another negotiated a salary for themselves or an employee. This works for two reasons. First, fair market rates are easy to observe. It’s possible to know the going rate for a burger flipper or a VP of marketing. The amounts change based on the requirements of the position and the skills, education and experience of the applicant. But it’s quite possible to determine a logical range. Second, salaries aren’t paid in their entirety upfront — they are paid over time. If performance doesn’t match promises, the employee can be terminated, thus limiting the financial damage. Many people, therefore, think that slapping a time-based vesting schedule on an equity allocation will suffice.
Time-based vesting doesn’t help
If you simply apply vesting to a fundamentally unfair agreement, the problem is exacerbated, because it vests unfair amounts to people based solely on the passage of time, regardless of the nature of their contribution or the circumstances of possible separation from the firm.
Equity isn’t salary. Salary is limited. Equity stays on the books, potentially forever, and pays dividends indefinitely. An unfair ownership allocation means an undeserving person keeps benefiting from their ownership.
Solving the problem
The good news is that this is a completely solvable problem. What most people forget is that everything in business is quantifiable in terms of dollars and cents. Everything can be accounted for. This means fair equity allocations can be calculated instead of negotiated.
If a bootstrapped startup company doesn’t pay full fair market rates for salaries and expenses, it means that individual participants are essentially wagering the unpaid amounts on the future success of the business. It’s a basic gamble. Every day that goes by, the wagers increase until the company generates enough revenue or raises enough capital to begin to pay full market rates and expenses. Then the wagering stops. When the wagering stops, you can easily calculate the fair market value of each person’s wager. These amounts are easy to track. Most companies track salaries and expenses, so tracking unpaid salaries and expenses isn’t a big stretch.
Logically, a person’s share of the company’s success should be based on a person’s share of the wagers. This creates a perfectly fair, rational and unambiguous result. It’s not based on predictions about future events or the promises of each co-founder. It’s based on facts, not opinions.
This approach, known as the Slicing Pie model, guarantees perfectly fair splits regardless of how events unfold. If commitment levels from participants change, if investment levels change, if new people join or if team members quit, the model automatically re-adjusts to stay fair.
Dynamic vs. fixed splits
The Slicing Pie model is a dynamic, self-correcting equity model that allows the future to be whatever will be. It doesn’t matter what happens, because the calculations are based on known quantities. Fixed models are based on unknown variables. The dynamic model always wins, because it’s based on facts and logic. The fixed model always creates and unfair split.
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