Start-up dilemma: How to divide up the founder’s equity?

Here’s how the question is typically posed to me: “I’m in the process of starting a new business. I’ve developed some new technology — with patents pending. But I have no experience commercializing new business ideas. So I was able to find a veteran CEO who wants to be a part of the venture. How much equity should I grant?”

There’s no easy answer. And there is no rule book. You may be tempted to hand out a lot of your equity to hire the talent you need. But what if your start-up turns into the next Google (NASDAQ: GOOG), eBay (NASDAQ: EBAY), or the latest hot IPO, like VMware (NYSE: VMW)? Might you risk giving away the store?

Over the years, I’ve talked about equity splits with many pros. For example, last week I discussed the topic with Todd Dagres, a founder and general partner of Spark Capital.

Here’s the easy part: In the beginning, go for an equal split among the original founders. After all, in the early stages of a business, there is really not much value anyway.

Although, if a founder contributes hard cash, customers, partners, or technology, he or she deserves additional equity. But somehow there needs to be a way to value the contribution, which can be complex (except for cash) and may result in some heated exchanges.

It can also be complicated to decide who will be considered a founder. Include only those that will be critical for the success of the company in the first couple years. For all others, it’s probably a better idea to hire them or bring them on as consultants.

How then to treat early hires? It’s typical to set aside 5% to 10% of the company’s equity for employees. But it’s a good idea to have vesting. For example, you could set it up so an employee may vest 20% of the equity for each year with the company (for a term of five years). This can be helpful in attracting strong employees — and keeping them on board. Another benefit — if an employee leaves, there will be more equity available to give to new employees.

Now, let’s say you contribute technology, cash, or some other asset to the new venture. When you’re determining your equity stake, it’s also smart to provide a way to take back the asset in the event of a liquidation, dispute, or other problem. In the start-up world, the probability of survival is not good. So, make sure you don’t lose something that may still have value.

Finally, I highly recommend that you hire your own counsel. Many founders will hire an attorney to represent them as well as the company. While it may save some legal dollars, it could be expensive for your long-term financial interests.

Tom Taulli is the author of various books, including the Complete M&A Handbook and the EDGAR-Online Guide to Decoding Financial Statements. He also operates DealProfiles.com.

Source: HERE