2016-02-25 11:03:41
Noam WassermanThomas Hellmann
February 23, 2016
Founders face a wide range of decisions when building their startups: market
decisions, product decisions, financing decisions, and many more. The
temptation is to prioritize these choices over decisions about how to structure
their own founding teams. That s understandable, but perilous. Our research,
forthcoming in Management Science, identifies one of those important pitfalls:
founder equity splits, i.e., the way founders allocate the ownership amongst
themselves when starting their company.
Since 2008, we have studied the equity splits adopted by over 3,700 founders
from over 1,300 startups in the U.S. and Canada. This builds on Noam s work
over the last fifteen years, which has shown that even the best of ideas can
falter when the founding team neglects to carefully consider early decisions
about the team: the relationships, roles, and rewards that will make the
founders a winning team.
It is said that a team has succeeded at splitting the equity if all of the
cofounders are equally unhappy. Unfortunately, founder unhappiness tends to get
even worse with hindsight; the percentage of founders who say they are unhappy
with their equity split increases by 2.5x as their startups mature. Increasing
discontent within the founding team is a prime indicator that destructive
turnover may be on the horizon. Exhibit A: Facebook. As memorialized in the
movie The Social Network, Mark Zuckerberg s initial equity split with Eduardo
Saverin went sour as the company evolved. Mark s attempt to reclaim Eduardo s
equity landed him in court maybe good for winning Academy Awards, but not good
for business, let alone personal relationships.
When and How to Split Founder Equity
Different teams have different ways of splitting the equity: some do it
up-front, others wait to get to know each other; some go through a careful
negotiation process, others are quick to shake hands and get on with it. Most
important, some divide the equity equally amongst all founders, others come to
the conclusion that the fair outcome is actually an uneven split that reflects
differences among founders.
Robin Chase, cofounder of Zipcar, a car-sharing company, 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 right after they had started the company, just as they
were getting to know each other. 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.
At Smartix, Inc., which created a smart-ticketing system for sports venues, the
founders adopted a very different model for splitting the equity. The founding
team believed that it s best to delay [the equity split] because things are
still unknown and changing. When they finally split the equity, they took a
very deliberate approach, fearing the effects that might emerge if any founder
felt that the equity-split process was unfair. In their dialogue, the team
delved into each founder s past contributions, outside opportunities,
preferences, and anticipated future contributions. They decided to split the
equity unequally, with the founder-CEO receiving more than twice the stake of
the cofounder with the lowest stake.
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. 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.
Dive In or Take Time to Discover?
Robin Chase of Zipcar soon became very disillusioned with her 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. She threw herself
into building the startup, crafting its business plan, building partnerships
with the car companies that would be key players in her business, and going
parking lot to parking lot, looking for those precious parking spots that her
company so desperately needed. Her cofounder? She didn t even quit her day job,
and contributed from the sidelines, at best. Robin soon came to realize the
perils of that quick handshake. Her rushed negotiation had compromised her team
s longer-term effectiveness by causing her a huge amount of angst over the
next year and a half.
Our research sheds light on what Robin learned the hard way. We look at the
amount of time founding teams spend discussing their equity splits, and find
statistically significant differences between teams who split quickly
neglecting to have a serious dialogue about personal uncertainties and expected
contributions and those who have a lengthier and more robust dialogue. Robin
rushed through that discussion, forfeiting the chance to discover what made her
cofounder tick, whether her cofounder was enjoying her existing job, whether
she was even willing to join Zipcar full time, and so on. In our data we find
that those teams that negotiate longer are more likely to decide on an unequal
split: the harder you look, the more likely you are to discover important
differences. More generally, we argue that if cofounders haven t learned
something surprising about each other from their dialogue, they probably haven
t engaged in a serious enough discussion yet.
The Perils of Family
Our data also indicate that splitting founder equity well between family
members is particularly challenging. Cofounders who are relatives usually
believe that they already know each other intimately and therefore don t have
much to discover about each other. However, we often act very differently at
home than we do at the office, and also very differently under the extreme
stresses that accompany startup life. If you ve never cofounded together, it s
likely that you will be surprised by how your relative acts as a cofounder,
often in negative ways. In short, relatives bypass detailed founder discussions
at their peril, yet they are statistically more likely to do so.
Equity splits are a microcosm that beautifully reflect this. In our analyses,
we find that founding teams that include relatives spent significantly less
time negotiating equity splits. They were also much more likely to split the
equity equally. Indeed, our research suggests that many founding teams care
about displaying outwardly visible equality: not only does everyone gets the
same equity share, everyone also gets exactly the same salary. This way no one
can say afterwards that it wasn t fair. This logic frequently trumps the
alternative logic that a fair split should take into account that different
founders contribute different skills, spend different amounts of time on the
venture, or give up different job opportunities.
Equity Splits Have Longer-Term Impacts
Founders tend to think our equity split is just between us; it doesn t affect
anyone else. However, that first deal between founders could be a first sign
of what troubles lie ahead. What do investors make of teams that split the
equity equally? Our data suggest that they are less than thrilled. Even after
statistically controlling for a lot of factors, our data still suggest the same
basic message: companies that have equal splits have more difficulty raising
outside finance, especially venture capital. Venture capitalists could
obviously tell the founders to come up with a different equity split, but that
causes a lot of strife and heightens cofounder turmoil and turnover. Given that
venture capitalists invest in less than one out of every hundred companies that
come across their desk, they are looking for reasons to say no. An equal split
can send worrisome signals about the team s ability to negotiate with others
and to deal with difficult issues themselves. Interestingly, our research
suggests that equal splits are more a symptom than the cause of trouble. It is
not the equal split per se that turns off the investors, it is that equal
splits are a symptom of bigger issues with the company.
Go Organic
Robin Chase s painfully-learned advice: Adopt a more organic agreement than
the static one typically adopted by founders. Vesting, in which each founder
has to earn his or her equity stake by remaining involved in the startup or by
achieving pre-defined milestones, is one way to achieve the dynamic approach
advocated by Robin. Yet, for founders initial equity splits, such agreements
are still the exception rather than the rule because there are many barriers to
having the difficult conversation about adopting such mechanisms.
Essentially, such agreements are the equivalent of a newly engaged couple
grappling with adopting a pre-nuptial agreement. Despite knowing about the high
rate of divorce among married couples, we can t bring ourselves to discuss the
adoption of pre-nups with our fianc s. The same goes for the discussion of a
pre-nup within a founding team. Setting up an agreement up front that outlines
negative scenarios that might occur in the future, with corresponding actions
to help avoid them, could help founders avoid headaches and increase startups
chances of success.
Noam Wasserman, a long-time Harvard Business School professor and author of the
bestseller The Founder s Dilemmas: Anticipating and Avoiding the Pitfalls That
Can Sink a Startup, this summer will become the founding director of the new
Founder Central initiative at the University of Southern California.
Thomas Hellmann is the Professor of Entrepreneurship and Innovation at the Sa d
School of Business, University of Oxford, the Academic Director of its
Entrepreneurship Centre, and a long-time researcher and teacher of
entrepreneurship and entrepreneurial finance.