EQUITY DISTRIBUTION

FOUNDERS

Division of equity can have a profound effect on the dynamic between founders. The bitter disagreements that may arise from these discussions can foreshadow disaster down the road. Some may work together on a startup for a prolonged period of time before finally sitting down to decide what each founder's share will be. Others may divide the company amongst themselves before any significant work has been done. There are problems with both scenarios.

In the simplest of cases, partners divide the company equally. However, this agreement assumes that each partner has contributed and will contribute equally to the company, which is rarely the case. If there is a lead founder who has clearly done more work and will continue to contribute more to the company than others, he deserves a larger share of the company. However, a team leader may not feel comfortable making such a claim on his own behalf. The lead founder may hope that one of the other founders will suggest it out of fairness. On the other hand, a founder may have an exaggerated opinion of his contribution to the company and try to insist on a larger share of the company than he deserves. Ultimately, a distribution that gives too little to some and too much to others for the sake of diplomacy will lead to unrest among the founders. Those who feel undervalued may cut their productivity to a level they feel is on par with their stake in the company. Unfortunately, those who got too much probably won't increase their contribution proportionately.

When distributing equity among founders:

  1. Do not discuss equity until it is clear who is and is not a founder. Allow enough time so that potential founders can prove their dedication and abilities by actually contributing to the startup.
  2. Discuss equity distribution before investors become involved. Your attorney should prompt you to settle this issue before incorporation.
  3. When you finally decide to divide up the founder's stock, assemble all the founders for a conference and have an open discussion at which everyone can present what they have contributed to the startup and what they can contribute in the future.
  4. Do not be afraid to ask for what you believe is your fair share. Be mindful of others' contributions.
  5. Once all the proportions are established, factor in vesting schedules, mandatory buy-back clauses, and all the other legal gadgets that will make sure that everyone will continue to work for their shares or risk losing them. You can agree that people who contribute above and beyond what is expected of them can be rewarded with additional options.
  6. Decide what happens if a founder wants to quit or wants to sell his shares. Founders should be required sell their shares to the company and the other founders before being permitted to sell them to an outside party. This ensures that the remaining founders retain more control of the company.
  7. Finally, put all of the above terms into writing in a Shareholder's Agreement. Any objections to the terms should be voiced before signing the document. Once signed by all the founders, this agreement will dictate the rules of fair play.

DIRECTORS AND SCIENTIFIC ADVISORS

At the pre-financing stage, you can compensate directors and advisors with founder shares that vest over 3-5 years, subject to restrictions that you should discuss with your attorney and accountant. There are two ways to think about how many shares to give to each director/advisor:

  1. The average board member should be compensated between $25K and $50K per year in stock. If the person will be with the company for four years, the stock should be worth between $100K and $200K at the end of the 4th year, and one-quarter of the stock should vest each year. This method is cumbersome and inaccurate because it requires you to estimate your company's current valuation and rate of growth. You will have a hard time justifying your math.
  2. If still a startup, offer between 0.1% and 1% of the company, depending on how badly you want that person to join. Very rarely should a non-founding director or advisor receive more than 1% of a company.

The two methods described above may not give you different answers. Depending on growth estimates, 0.1%1% of the company today may be worth $100K or more after 4 years, allowing for dilution from financings.

In addition to shares, directors and scientific advisors may be compensated for their time with cash. Some say $1,000 per meeting; others suggest 2%-3% of the CEO's annual salary ($3,000 - $5,000 per year). Assuming that you have quarterly meetings, these two calculations yield equivalent estimates. You will likely need to compensate them for their expenses. Cash compensation is not as commonly discussed as stock, but you should bring it up with each board member early on to avoid disputes. Board members who recognize that the startup has little cash to spare may not expect to receive cash at first.

CEO

Although a seasoned CEO may be the most expensive recruit, this individual may have the most to contribute to the value of the company. Founders overly eager to retain cash and equity may end up owning a larger piece of nothing if the company fails.

Based on a 1998 PricewaterhouseCoopers (PWC) Survey of medical device firms, the CEOs of private companies with valuations under $5M were paid $120K - $130K per year and CEOs of companies with valuations greater than $25M were paid $180K. CEOs received $50,000 worth of stock options each year. Keep in mind that salaries have increased by as much as 6%-10% per year for some positions and may be higher than reported here. At the startup stage, industry experts estimate that CEOs should receive about 10% of the founder stock of the company, vested over 4-5 years.

You get what you pay for. Experienced CEOs know their own worth and will calculate the value of what they are offered in much the same way investors calculate how much their contribution is worth. Also, if a CEO joins the startup team before the first financing, consider including that person as a founder, particularly if the CEO then goes on to raise money.

A CEO who is also a founder should distinguish between equity granted for being a founder vs. being a CEO.When venture capitalists finance a company, they may insist that founders and management agree to a vesting schedule. Founders may be allowed to hold onto part of their equity and have the rest vest over time. Likewise, a founding CEO may be able to keep the founder portion of his equity but agree to vesting of the CEO portion. In the event that the founder CEO is replaced, he will only have to forfeit rights to the CEO portion of the stock options and will continue to receive founder options as long as he remains with the company in some capacity. CFO AND OTHER EXECUTIVESAccording the PWC survey, smaller companies (<$25M valuation) typically hire controllers for about $60K - $100K. Larger companies hire CFOs at >$140K and grant them about $20K worth of stock options each year. Industry experts tend to address equity compensation using percentages, suggesting that the CFO of a startup should receive between 2%-4% of a startup company, vested over four years. If a CFO is hired at a later stage, the equity allocation may be much smaller.

In smaller companies with $0-$12M valuations, salary ranges were between $70K and $90K for Heads of Operations, R&D, Marketing, and Business Development.Their annual stock option grants were $15K-$30K.

MANAGEMENT AND EMPLOYEE OPTIONS

The founders should set aside 10%-20% of the company for management options and another 10%-20% for employee options. You will need to use these shares to recruit people, give them incentive to stay with the company, and reward them for performance.

When employee/management options are allocated after an investment round, the investors and other shareholders are diluted equally. When options are set aside prior to financing, only initial shareholders experience the dilution.For example, an investor purchases 50% of a company for $12M and receives 4M shares at $3/share from a total of 8M shares outstanding. If the company issues 2M shares for the employee option pool (bringing the total number of shares that will be outstanding to 10M), the investor will be diluted down to 40% ownership. However, if the investor insists that the 2M shares be set aside for the employees before he purchases 50% of the company, then he will own 6M shares of a total 12M outstanding at only $2/share. The investor thus protects himself from dilution at the expense of the original shareholders and the employees. In this case, $2/share is referred to as the fully diluted share price.

Not surprisingly, investors will negotiate with management over the size of options pools and insist that these shares be set aside prior to investment so that investors are not diluted. Strong companies that can afford to haggle with investors may be able to compromise by setting aside a small pool pre-financing and then issue additional shares later on when the investors also have to suffer dilution.