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Co-Founders Often Assume Dividing Equity Evenly Is The Quickest And Fairest Thing To Do

Fools rush in

When setting up a new company, groups of co-founders often assume that dividing the equity evenly between them is the quickest and fairest thing to do. But, Professor Thomas Hellmann argues, they could be setting themselves up for poor performance and difficulties in attracting investment, to say nothing of simmering resentments down the line.

Robin Chase, cofounder of the car-sharing company Zipcar, had heard a horror story from a friend about how the negotiation over founder equity had derailed the friend’s startup. Eager to avoid that outcome, Robin proposed to her cofounder a 50/50 split at their very first meeting, just as they were getting to know each other professionally. The cofounders quickly shook hands and accepted the equal split. Robin breathed a sigh of relief: they had avoided the high tensions that often accompany an equity-split negotiation.

However, she soon became disillusioned with this ‘quick handshake’ decision. She had never worked with her cofounder before, and had made some bold assumptions about how well they would work together, whose skills would be most valuable, and what the level of commitment would be. Robin threw herself into building the start-up, crafting its business plan, and going from parking lot to parking lot to look for those precious parking spots that the company so desperately needed. Her cofounder, however, continued with her day-job and, from Robin’s perspective, contributed from the sidelines at best.

The perils of that quick handshake soon became clear. As the company developed, Robin wanted more shares to reflect her larger contribution; her co-founder disagreed, and a rift developed between the two of them, compromising the team’s longer-term effectiveness.

My research with Noam Wasserman (Harvard Business School) shows that Robin and her cofounder are not alone. Our study of 3782 founders in 1367 companies over a five-year period shows that a staggering 42% of founding teams went for a ‘quick handshake’ solution, taking less than a day to agree on how they would allocate equity. In addition, we found that 32% of all teams split the founding equity equally.

Not only did we discover a strong relationship between equal splitting and quick negotiations, but also a negative correlation between equal splitting and fundraising success. Put simply, companies that have equal splits have more difficulty raising outside finance, especially venture capital.

But why should investors be interested in the way that founders have agreed to split equity? And why should teams that quickly reached a harmonious and equitable conclusion apparently be less attractive prospects for funding? We think the answer is not that investors dislike the idea of an equal split per se, but that equal splits are a symptom of bigger issues with the company. They can suggest that the founders are not very competitive, which does not augur well for future performance. Or they can send worrying signals about the team’s ability to negotiate with others and to deal with difficult issues themselves.

When founders are splitting the equity early in their company’s life, they face the heights of uncertainty — about their business strategy and business model, about their eventual roles within the team, about whether each founder will be fully committed to the startup, and about many more unknowns that will become clearer as they get to know each other. Even people who already know each other socially – or are part of the same family – can find that they operate very differently when in a ‘professional’ context. And, of course, things are even more uncertain for cofounders who have never worked together. Bypassing a serious dialogue about what each of the founders wants or deserves might be easier in the short-term, but is unlikely to be the right thing for the long-term health of the company.

So what do we advise?

Rethink what ‘fair’ means

Equal shares is not the only type of ‘fair’. In fact, arguably, it isn’t fair at all, as it doesn’t take into account each partner’s contribution in terms of resources and time, or the opportunities they may be giving up.

Don’t rush into an agreement

The harder you look, the more likely you are to discover important differences between you and your co-founders. In fact, if you and your co-founders haven’t learned something surprising about each other from their dialogue, you probably haven’t engaged in a serious enough discussion yet.

Be prepared to have a difficult discussion

People often agree on an even split because they don’t want to argue face-to-face that one founder may ‘deserve’ more money than another. But if you can’t steel yourselves to have this discussion at the birth of the company, how are you going to cope with crises and serious disagreements further down the line?

Go organic

Build negotiation and renegotiation of the equity split into the agreement, so you can change as the company grows. Vesting, in which each founder has to earn his or her equity stake by remaining involved in the start-up or by achieving pre-defined milestones, is one way to achieve this approach.

by Thomas Hellmann

Source: Saïd Business School

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