How To Split & Structure Your Equity Amongst Your Co-founders (Part 1)
Now now, after constantly being bombarded with all the hype & tech jargons from TechCrunch about startups getting acquired and listed on your FB feed, you thought it was cool and you've got the calling that there is no better time than now to do your own startup.
So after weeks of bouncing ideas with your partner or colleague or sibling or girl/boyfriend (for that matter), you've found the perfect idea and have decided to start your startup immediately.
First thing first, you and your co-founder(s) will have to incorporate the company with your nearest co-sec. While doing so, you've been smacked with the question of who own what & how many shares?
Bear in mind that one of the reasons why startups failed are because of the lack of knowledge in equity structures. It's very crucial for all entrepreneurs to understand at least the basic equity structure before jumping into the startup scene.
To simplify the foundations of this topic, the 3 core terms that you have to understand are:
1. Cliffs & Vesting Schedule
2. Acceleration; and
Generally, based on my experience - the most commonly used equity structures are made of these two:
1. Co-founders Terms, whereby it has a 3-5 years of vesting schedule, with an option of 1 or 2 years cliff for everyone, including you.
2. Advisors Terms, typically a 2-4 years of vesting schedule, with an optional cliff and a full acceleration on exit for 0.5% to 2.0%.
Getting the structures right
As mentioned above, there are only a few basic things to understand when it comes to equity structures (cliffs, vesting, acceleration & exits). For example, assuming that my partner and I decided to form a company after several discussions, and we have agreed to split the company into 50-50.
One of the biggest problems we’d like to avoid is if suddenly one of us decides to quit the company much earlier than we intended it to be, whilst taking half the company’s equities/shares alongside with them - because If this were to happen, the other co-founder would be fucked upside down (figuratively…), this is simply because the remaining co-founder do not have enough shares/equities left to attract investors and talents (with option pool, which will be explained next time). Plus, it doesn’t make any sense nor fair for the other co-founder to stop working on the startup and still get the same, or even more rewards in the future.
So the big question is, "How can we prevent that from happening?"
Cliffs & Vesting
Vesting is the answer, it’s the only way to prevent this catastrophe from happening. Every-fcking-one who has equity should, really, REALLY be vested (I can’t emphasize it enough).
Definition of ‘Vesting’, “the process by which an employee accrues non-forfeitable rights over employer-provided stock incentives or employer contributions made to the employee’s qualified retirement plan account or pension plan”, source: Investopedia.
On a layman term, vesting means that instead of us getting our 50% as agreed immediately, the equity will be given to us regularly over some period – typically between 3 to 5 years. So in a hypothetical scenario where we have agreed to be vested out in 4 years and one of us quit after 6 months, the person who quits will only earn 1/8 (6 months over 48 months) of the total 50%, which is 6.25%. If one of us were to quit after 2 years for instance, they’ll get ½ of the 50%, which is 25%.
However, one of the biggest problems that you will encounter with this structure is that you ended up having a tiny bits of percentages owned by lots of people (who may or may have not quit the company). That will eventually make your legal work pain in the ass (not that it’s not already, it’ll just make things worse).
So this is where Cliffs come in and save the day.
Definition of ‘Cliff’, “a steep rock face, especially at the edge of the sea”, as you can see below;
Just kidding, Cliffs allow you to do a testing-run or trial a partnership, director, or hide without an immediate equity commitment. It pretty much protects the company by ensuring that if for some reason that your partner part ways (via quitting or firing) before the cliff period ends, the leaving party will get no equity even though you guys have agreed on the equity amount and vesting period.
Well, remember our first agreement of 50-50 split with a 4-year vesting? Now let’s add an additional 1-year cliff into it.
With those terms, if I decided to quit the company after 9 months, I’d actually get nothing, but the moment when the first year hits in (the agreed cliff period ends), immediately I’ll be reimbursed with a full quarter of what I’m entitled to, because I’ve made through the first out of four years of vesting – after the cliffs period ends, I’ll get the remaining equity or shares every quarterly as time passes on. So once I stay on for the full vesting period (in this terms, 4 years), as long as I’ve contributed and did what I’m required to do, I will receive the full equity as initially we’ve agreed upon, regardless if I choose to stay or leave the company by then.
Hope this helps – I’ll continue explaining the Acceleration & Exits on part 2. Stay tune!