What You Need To Know About Dividing Business Equity Among Founders and Investors
New business owners are often faced with the dilemma of dividing equity amongst themselves and their investors. With this, there is no fixed way of execution as such negotiations normally happen on a case-to-case basis. You are a recently established aquarium construction business, looking to find investors, but lack the knowledge of dividing equity.
The purpose of this article is to provide insight into navigating such negotiations. It might sound a bit confusing, but by the end of the article you will have a better understanding of the process.
Dividing The Business Amongst The Founders
Founders are awarded stock in exchange for their contributions. It is entirely up to the collective to determine how much of the business they own as a result of their investment. However, there are several things to think about.
- Contribution in terms of timing, volume, and duration: The sooner, larger, or longer a founder contributes to the business, the more equity he or she should earn.
- Equity gives you voting power and control over the company. Founders who plan to remain with the company for a long time should have the most leverage.
I’ve heard it suggested that one person own at least 51% of the business to ensure clear decision-making when a problem arises. Equal partners, though ideal in principle, will kill a business if the partners cannot agree and have no means of resolving fundamental differences.
- Capital: Early money is a type of equity contribution. Money has the unintended consequence of increasing the company’s value. If you give 10% of the business to someone who contributes $50,000, the company is worth $500,000.
If you want to raise money right away, the valuation could damage your bargaining position. However, if significant infrastructure has been developed in the interim—for example, if clients have been added or a larger team has been assembled—a higher angel/VC value is justified.
- Contribution type: A founder may make a variety of contributions. Some people carry patents or product innovations with them. Some contribute business experience and ongoing efforts to grow the company. Some people carry money with them. Some people are good at making associations.
Some can carry big names or reputations, which VCs and/or clients find credible. A big name who provides immediate credibility might be more valuable to the company than a founder who works to develop the company.
Going back to the aquarium design business, say you need to buy filter media for aquarium, have them fitted, and get the best price clients out there. The big-name partner ensures you get and keep the bigger clients, this partner together with the one that brings in the capital will have a higher stake than the one responsible for fitting in the filters on the aquariums.
Make sure you know what each founder’s contribution is and how much you can respect it.
Business Scenario: Five Founders
A large number of founders may be problematic. You will need to make several choices about equity, contribution, and dilution as the organization seeks outside capital. The more stock investors there are, the more negotiating power each of these decisions has.
It’s difficult to keep everyone fairly rewarded when there are many founders. The founding party should expect to own 20 to 30 percent of the company by the time it is harvested (IPO or acquisition). That can mean a lot of money for a single founder. When there are many founders, this may mean dividing the pie into so many parts that no one is satisfied with the worth of their slice. In short, having fewer big-equity investors is preferable.
The Investor Dilemma
The basic formula is straightforward: if you need $5 million and an investor thinks the company is worth $15 million, you are required to give him/her 33 percent of the company in exchange for their capital.
Companies are valued differently by different investors. Some consider the idea’s content, finances, market size, and management team. Some people depend on financial forecasts. Some people look for “huge ideas” and then negotiate their percentage ownership.
A better question is how much do management and the founders strive to keep before the IPO? Answer: as much as you can, but no less than 25%.
When it comes down to capital (as it always does these days), the percentage ownership at harvest compounded by the harvest valuation is what matters. Owning 1% of a company valued at a billion dollars is still more appealing than owning 10% of a company valued at $50 million.
What About Part-Time Contributors You Ask
Not a whole lot. The truth is that most start-ups necessitate 100+ percent effort from all parties involved. Venture capitalists demand equity in exchange for a long-term commitment. Also, founders who remain with the organization have a vesting schedule that spans many years. Many VCs refuse to offer equity to part-time workers or contractors.
Giving capital is a one-time contribution for stock that is made regularly. Cash investment in stock entitles the investor to full ownership of the stock with no further contributions needed. Part-time contributors could be better included in the agreement if they buy the stock outright.
A Sample: Ownership After The First Round
The division of equity after the first round may have founders holding a 20-30 percent stake, angel investors 20-30 percent, the venture capitalist holding a 30-40 percent, while the option pool gets 20 percent of the business.
Dividing equity can be confusing at first, however, having a clear understanding of each individual’s contribution eases the headache. Once you and your founding partners decide on how much each one holds, you should contribute and agree on the percentage you would be willing to give up in exchange for investments.
We hope this article answers all your questions. Good luck with your new business!
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