Shareholder Equity-How to Spilt Equity in Startup

Second most common reason for startup ventures floundering is acrimony between founders. How can this be resolved?

One of the most difficult aspects of being a startup founder is deciding how to decide equity shareholders. You can only give away so much before it no longer feels like yours.When starting a business, founders tend to divide ownership equally among the partners. Many start-ups are conceived with founders knowing each other.

When friends join together, they are equal and hence they must get equal share in the venture they are starting with. If the partners are not contributing equally, is it desirable?

What is a shareholder in Business?

Shareholders are part-owners of a business, whereas directors are in charge of the company's business operations. Shareholders' duties are generally limited to any unpaid amounts on shares they own, whereas directors are subject to a variety of obligations under federal, state, and territory law.

An equity shareholder can own as few as one share of a company. Shareholders are subject to capital gains (or losses) and/or dividend payments as residual claimants on a company's profits.

How many shares should a founder have?

When a startup is first formed, it is customarily authorised to issue 10,000,000 shares of common stock. The initial distribution of this equity will be divided into three categories: The founders will be given $8,000,000. These shares will be distributed in proportion to each founder's ownership percentage.

 Source- priceonomics.com

Is a founder a shareholder?

A majority shareholder is a single shareholder who owns and controls more than half of a company's outstanding shares. Majority shareholders are frequently company founders in many cases, and in older companies, majority shareholders are frequently descendants of company founders.

Difference between member and shareholder

Member: A person whose name is entered in a company's register of members becomes a member of that company. The register contains every detail about the member, such as name, address, occupation, date of joining, and so on. It also includes anyone who owns a company's stock and whose name is listed as a beneficial owner in depository records.

Shareholder: A 'Shareholder' is a person who owns a share of a public or private company. A share subscriber is not considered a shareholder until the shares are actually allotted to him.The shareholders own the company to the extent of the share capital that they hold.

To understand difference between member and shareholder,  let me share an example, Ankit, Joseph and Dimple were in the same college. Ankit is one year senior to the other two and is also the harbinger of starting this venture. He knew Joseph, for his technology passion and Dimple for her outgoing public speaking and reach-out skills.

Ankit, quite convinced with his idea, shares it and asks them to join him. Joseph has issues with non-supporting family to his start-up idea and Dimple can’t relocate to the city the venture is starting in.

Still, Ankit is left with these two, as he has approached many others in the past three months, with a promise of they joining him but never did. Ankit settled for this option.

They agree that Joseph and Dimple will be in full time jobs and support the venture by contributing Rs 20,000 each month, besides shouldering some responsibilities relating to their area of passion, for an equal share in the venture. Dimple plans to join Ankit, full time in a year’s time.

The understanding is innovative as is expected from a startup founder. But there are two problems in this arrangement. One, Ankit is left alone to manage the affairs of the enterprise with very selective and specific role shouldered by others. That makes his team a no-go before any investor.

Second, the venture needed about Rs 20 Lakhs over two years, 50% of which Ankit will need to invest from his side. Ankit is full time. Joseph and Dimple are not. Major risk is borne by Ankit.

If we analyze further, simplistically, let’s take only two key parameters into consideration – role and investment.

There are roles of CEO, CFO, CTO, CMO and CHR to say the least in any venture. In the above case example, CEO and CFO roles are with Ankit, CTO with Joseph and CMO/CHR with Dimple.

If not in full time engagement, would Joseph and Dimple be able to perform their CTO and CMO roles completely or any spill over will need to be managed by Ankit himself or through outsourced help? Joseph being at Mckinsey argues that his technical prowess and work environment will help him come up with better technical solutions faster, to make up for his less time involvement.

The investment share of three is in 50%, 25%, 25% composition. It is also unequal.

In such a scenario, should the share of three in the venture be equal? I feel no.

What is likely to be fallout from such an arrangement? Is it not an innovative method of win-win-win situation created by the founders of this venture?

The venture soon will see the frustration of not only Ankit, but also of other two. Most likely decisions will be taken by Ankit, sometimes not in consultation, as generally is demanded of the situation in any small organization.

Also, Ankit’s un-intentional encroachment on CTO or CMO roles, as necessitated, may not find approval from Joseph and Dimple. Soon, based on human psychology, every chance is for Ankit to feel cheated and frustrated for doing ALL the work, while others are not contributing enough, but is equal partner.

The solution thus is to make unequal partnership based on these two factors – role and investment. Give weightage of 70% to the role and 30% to the investment. This is also the way to indicate defined leadership with adequate authority to make final decision and sufficient compensation to remain motivated.

Source- dynamictutorialsandservices.org

In the scheme of things, only distribute 90%, keeping about 10% of the share reserved for ESOPs that will come handy to attract key talent later. Considering each of Joseph and Dimple are able to contribute about 75% to their role in this fashion and kind of investment mentioned, the share of partnership should be 38%, 26%, 26% amongst Ankit, Joseph and Dimple respectively.

When Dimple joins full time after a year, this percentage should change to 35%, 26% and 29%. Whatever is the share, keep a period of vesting from 3 to 4 years at least.

It is equally important to note what happens in the real life. Circumstances change and partners do quit. In the identified situation, some partners due to their peripheral involvement have low risk to quit the venture and thus have more likelihood.

It is pertinent to design the smooth exit safeguarding the interest of all involved. As revenue results and valuations may not be available (quit decision less likely if they are available and sound) by the time quit decision comes from any of the three, it is prudent to provision for about double the market rate returns (of 10%) on the invested amount in the year 1 and triple the returns in the year 2.

The given solution is indicative and variations in situation may impact a change in the share, keeping approach the same.

Conclusion

I support the arguments of un-equal share in partnerships even if all the co-founders are on-board full time. Differentiate by small percentage, based on the amount of investment, but the governance structure must be clearly defined in case of disagreements.

 All significant decisions must be made on consensus, transparency kept fully else partnership will break sooner than one thinks. However, clearly defined conflict resolution goes a long way in smooth running of the enterprise and bringing in order.

Ashish Jain

About Author - Ashish mentors founders of start-ups on strategy