Co-founder Shareholding, Not All Black-Magic

[Co-Founder equity distribution is a big pain and often a reason for most break-ups in Startup. Guest Author Banibrata Dutta takes an analytical approach on how to determine co-founder equity distribution.]

While a brave few take the Solopreneur route, most others like to take the more conventional approach of having a core founding-team, who come together to form a new venture. These are typically individuals who, believe in a common shared vision, have trust and respect for each other, and would provide significant contribution, one way or the other, in the journey, to making the venture a success.

Typically this bunch of merry-men and women would need to fit into some kind of an organizational structure, and even if they don’t, i.e.  adopt a largely flat organization model, they would have to at least decide on the shareholding pattern of the co-founders. This becomes mandatory while registering the organization as a Private Limited Company, as per Indian Company Laws Act. However, even if one takes the alternative forms of incorporation s.a. Limited Liability Partnership (LLP), they may choose to implement a pseudo/virtual shareholding pattern, which clearly spells out the share of ownership, share of profits and share of losses amongst the partners. Now I believe, that there are two approaches (roughly speaking) to arrive at the shareholding pattern, viz — Capitalistic approach and Socialistic approach. In this post, I hope to explore and propose something around the Capitalistic approach.

The shareholding, is not always or mandatorily in the proportion of investment brought in, although it is usually one of the determinants. While there could a equal share of equity for all co-founders, type of arrangement, which is what I call the Socialist approach, we shall see that is need not always be so. My exposure has been limited to some in Silicon Valley and rest in India, and here I have not come accross too many startups with the socialist shareholding pattern amongst co-founders. Note that, the shareholding pattern is not something that is usually disclosed by private companies. My impression is based on my discussion with friends working there, or some of the co-founders.

Until somewhat recently, I was of the opinion that it is “probably fine” to go with the equal-proportion approach. However,  I have increasingly become quite certain that it is not a very practical approach. Note that I am not saying that the co-founders cannot or should not have equal proportion. They very well may. All that I am saying is that, if it turns out that every co-founder deserves to own & bear equal-proportion of the equity/shareholding, after careful analysis of various factors, then so be it.  However, it is not fair, just to bring on-board a not-so-interested candidate as a co-founder, by enticing them with higher-than-just share of equity. It is potentially detrimental to the venture, to the potential co-founder himself/herself being on-boarded, and rest of the co-founders. In the capitalistic-approach to things, it is often believed that “everyone in a venture pulls their own weight”. This is especially true because there is always so much to do, so few resources to actually do what needs to be done, very little time, there are no redundancies and life is generally running on a scarcity mode. In this environment, if someone needs to pull someone else’s weight, especially over an unreasonably longer period of time, it bogs down the whole venture, and demotivates everybody. It is to say that, if you allocate more than the fair-share of equity to a co-founder, and they are unable to contribute value back to the venture in same proportion, you have unfairness breeding in the system. This, eventually affects other co-founders, and potentially even the early employees.

Now, I am a firm believer in the concept that “just an Idea” is not worth much, and also that one who conceives the Idea, cannot or should not stake claim to the largest share of the pie. More often than not, it takes several brains with significant creativity and value-addition to take the idea from it’s original rough-cut (or even seemingly polished) form to a form which is marketable, and monetizable. In taking the idea and converting it into a viable an sustainable business, there is some serious mountain moving involved. While one may consider one’s idea as novel and unique, more often than not, I’ve come across multiple people having the same idea in parallel all around the world, and potentially right there in the same city where you live. In this age of information, creative stimulus and unfettered access to knowledge, this is but obvious.

So, how does one settle on the shareholding pattern between the co-founders. More often than not, I’ve been told that it is just some black-magic, or there is a some secret formula. Through this post, I intend to put forth some thoughts and bring in the open as to what might be one (of the several possible) formulae in methodically, systematically and logically arriving at a shareholding pattern between co-founders. I do not claim the formula to be perfect, and in fact I just give the parameters of the formula, leaving one to fill in the coefficients / factors that assign weights to various parameters, and create the final formula. So here goes –

• Early-belief-in-vision (& early contributions)
  People get attractive pre-launch offers on Apartments, when all legal implications are still not clear, there is no Government / City-planning authority approval, no banks approved loans yet. Beta customers are your early believes, they trust you, put their faith in you, and often are your best & most-loyal evangelists. They deserve a special place. They are typically the ones who would stick along the longest, and endure the pain, hardships of being early on board, so they definitely deserve a price for this. Early stage investors s.a. Angels, or Seed-fund stage VC’s, typically walk-away with rather large share of the pie. So, nothing new here. However, as we shall see, this is not the only key parameter in determining one’s share of equity.
• Risk-taking (degree of risks one is taking)
  One very simple and easy yardstick to determine one’s faith, belief and conviction to an idea, is to see how much risk is one willing to take to prove one’s faith, belief and conviction. This is especially true for people who are known to be otherwise quite smart. Risk is taken in many ways, for example showing confidence without the fear of losing face, by making a sizable investment (time, effort and money), willingness to move out of your comfort zone and take extra pains. Indeed, there is a risk of losing all that you invested and getting nothing in return, but some valuable life lessons, however a risk-taker will be aware yet not afraid of the consequences, because they believe in the idea and believe in doing good. For example, moonlighting by bootstrapping your venture, while you retain your day job, is an indication of lower levels of risk-taking. However, one must however remember that degree-of-risk is highly contextual.
• Depth-of-skin-in-game (what is one sacrificing)
  We all work for predominantly three reasons, viz — (1) Lead a comfortable life, providing for our loved ones; (2) Doing meaningful & interesting work, to derive satisfaction by way of contributing back to society; (3) Achieve the ambitions in our life, which BTW may be limited to (1) & (2) as well. While working for a startup (especially in the pre-funding stage) you would potentially get oodles of (2), and can always look forward to (3), but what takes a hit is (1), i.e. your level of comfort, lavishness of lifestyle and amount of time/money you are able to spend with/on your family, all go down — invariably, unless you are one of those with mega-bucks tucked away in your account, or son of a Rich dad. It is the hardships, which drive us, motivate us to elevate ourselves from the current situation and move to the high plane of not only higher satisfaction, higher sense of achievement, but also better lifestyle, ability to spend/dedicate more quality time with our family, loved ones. However until then, i.e. until we have achieved reasonable success, what and how much you are sacrificing is a measure of your commitment, dedication, faith and contribution to the cause, and thus a very important part of determining your share of equity. One thing that needs to be clarified here is that if you are a High Networth Individual, with loads of cash in bank and choose to make a sizable investment, that doesn’t demonstrate your skin-in-game, as much as it would, for a similar level of investment for someone who probably has only as much as cash in bank.
• Volume-of-Investment
  Even if the founders who are boot-strapping the venture, i.e. not taking any salary from the venture, or even if they are, then it’s the bare minimum ‘sustenance’ salary (probably a small fraction of the market salary), most typical ventures still have expenses, overheads, cost of doing the R&D — computers, furniture, internet connectivity, telephone bills, hosting charges, water, tea-coffee, snacks etc. All these cost money. So investments are required. Also, there are stages in the evolution of any venture, where some sizable investment is required to cross the Chasm, or do enough to enable a Scale-up. This may not be the ones where the venture is trying to move from few thousand subscribers/customers to their first million, i.e. not exactly the level you’d see being raised by VC funding, or large Angel funding rounds, but typically what you expect from an organically growing company. These investments are still fairly risky investments, done by people who are already potentially not drawing salary from this venture, but contributing to it in real/hard ways. These investments are the life-blood of the venture, and also of the individuals. Thus, these deserve their due respect.
• Value-delivered / Value-contributed, it’s criticality & significance
  In any startup, each and every hand is a useful hand, or at-least, should be. There are no redundancies, and always more work to be done than are people to do those. However not everyone delivers the same amount/degree of value. There would be some who work 16 hours a days, with high level of sincerity, dedication and focus, and then there may be some who are contributing not more than 2-3 hours each done. Apart from the question of volume, we have the question of quality. Some 8 hours dedicated with extremely high level of dedication & focus, with demonstrated productivity / outcomes, is lot more valuable, than 14 hours spent in-office or in-front of computer, with 6-8 hours spent on Facebook, Orkut or just chatting away or playing Farmville. However, if one does it with the intention of gaining traction in the Social-Network, for the organization, this is definitely useful & significant (okay, not including Farmville or Mafia-Wars). Significance, is a key term here as well, i.e. how significant is the work that you are doing, at the given point in time, given the current context of the startup. A person who sees himself as an out-n-out salesman, but not willing-to or able-to contribute in the grunt-work of coding, in a startup that is in very early stage of development, is not yet making significant value contribution. The same person becomes significant and critical ones the product / offering is ready to be taken to the market.

It is not too hard to imagine that the parameters mentioned above, are all quite subjective, and there is no absolute high/low, good-bad, too-less/too-much but relative between the co-founders themselves, and also subject to interpretation. Thus the final equity distribution would probably be subject to discussion, negotiation between the co-founders. How, I expect this post to help, is put some structure around this discussion, and knowing some of the key parameters, that should help put some reasoning behind the process. In spite of this analytical approach, it would be highly undesirable to have one or few of the co-founders harbor the feeling of being short-changed and thus distrust. This is the last thing one needs. Therefore, an amicable negotiation, and settlement arrived at early, for the share-holding pattern between co-founders is likely to prove to be a very good idea.

This post has been an attempt to capture some of my thoughts around the subject, but I do reiterate that readers are welcome to (rather encouraged to) share their thoughts and leave some constructive comments.

[Reposted from author’s blog.]