Joel’s Totally Fair Method to Divide Up The Ownership of Any Startup

Joel’s Totally Fair Method to Divide Up The Ownership of Any Startup

Joel’s Totally Fair Method to Divide Up The Ownership of Any Startup

This is such a common question here and elsewhere that I will attempt to
write the world’s most canonical answer to this question. Hopefully in
the future when someone on answers.onstartups asks how to split up the
ownership of their new company, you can simply point to this answer.
The most important principle: Fairness, and the perception of fairness,
is much more valuable than owning a large stake. Almost everything
that can go wrong in a startup will go wrong, and one of the biggest
things that can go wrong is huge, angry, shouting matches between
the founders as to who worked harder, who owns more, whose idea was
it anyway, etc. That is why I would always rather split a new
company 50-50 with a friend than insist on owning 60% because “it
was my idea,” or because “I was more experienced” or anything else.
Why? Because if I split the company 60-40, the company is going to
fail when we argue ourselves to death. And if you just say, “to heck
with it, we can NEVER figure out what the correct split is, so let’s
just be pals and go 50-50,” you’ll stay friends and the company will
survive.  

Thus, I present you with Joel’s Totally Fair Method to
Divide Up The Ownership of Any Startup.  

For simplicity sake, I’m
going to start by assuming that you are not going to raise venture
capital and you are not going to have outside investors. Later, I’ll
explain how to deal with venture capital, but for now assume no
investors.

Also for simplicity sake, let’s temporarily assume that
the founders all quit their jobs and start working on the new
company full time at the same time. Later, I’ll explain how to deal
with founders who do not start at the same time.

Here’s the principle. As your company grows, you tend to add people in
“layers”.

The top layer is the first founder or founders. There may
be 1, 2, 3, or more of you, but you all start working about the same
time, and you all take the same risk… quitting your jobs to go work
for a new and unproven company. The second layer is the first real
employees. By the time you hire this layer, you’ve got cash coming
in from somewhere (investors or customers–doesn’t matter). These
people didn’t take as much risk because they got a salary from day
one, and honestly, they didn’t start the company, they joined it as
a job. The third layer are later employees. By the time they joined
the company, it was going pretty well. For many companies, each
“layer” will be approximately one year long. By the time your
company is big enough to sell to Google or go public or whatever,
you probably have about 6 layers: the founders and roughly five
layers of employees. Each successive layer is larger. There might be
two founders, five early employees in layer 2, 25 employees in layer
3, and 200 employees in layer 4. The later layers took less risk.

OK, now here’s how you use that information:

The founders should end up with about 50% of the company, total. Each of
the next five layers should end up with about 10% of the company, split
equally among everyone in the layer.

Example:

Two founders start the
company. They each take 2500 shares. There are 5000 shares
outstanding, so each founder owns half. They hire four employees in
year one. These four employees each take 250 shares. There are 6000
shares outstanding. They hire another 20 employees in year two. Each
one takes 50 shares. They get fewer shares because they took less
risk, and they get 50 shares because we’re giving each layer 1000
shares to divide up. By the time the company has six layers, you
have given out 10,000 shares. Each founder ends up owning 25%. Each
employee layer owns 10% collectively. The earliest employees who
took the most risk own the most shares. Make sense? You don’t have
to follow this exact formula but the basic idea is that you set up
“stripes” of seniority, where the top stripe took the most risk and
the bottom stripe took the least, and each “stripe” shares an equal
number of shares, which magically gives employees more shares for
joining early.

A slightly different way to use the stripes is for
seniority. Your top stripe is the founders, below that you reserve a
whole stripe for the fancy CEO that you recruited who insisted on
owning 10%, the stripe below that is for the early employees and
also the top managers, etc. However you organize the stripes, it
should be simple and clear and easy to understand and not prone to
arguments.

Now that we have a fair system set out, there is one important
principle. You must have vesting.Preferably 4 or 5 years.  Nobody earns
their shares until they’ve stayed with the company for a year. A good
vesting schedule is 25% in the first year, 2% each additional month.
Otherwise your co-founder is going to quit after three weeks and show
up, 7 years later, claiming he owns 25% of the company. It never makes
sense to give anyone equity without vesting.  This is an extremely
common mistake and it’s terrible when it happens. You have these
companies where 3 cofounders have been working day and night for five
years, and then you discover there’s some jerk that quit after two weeks
and he still thinks he owns 25% of the company for his two weeks of
work.

Now, let me clear up some little things that often complicate the
picture.  What happens if you raise an investment? The investment can
come from anywhere… an angel, a VC, or someone’s dad. Basically, the
answer is simple: the investment just dilutes everyone.

Using the example from above… we’re two founders, we gave ourselves 2500
shares each, so we each own 50%, and now we go to a VC and he offers to
give us a million dollars in exchange for 1/3rd of the company.

1/3rd of the company is 2500 shares. So you make another 2500 shares and
give them to the VC. He owns 1/3rd and you each own 1/3rd. That’s all
there is to it.

What happens if not all the early employees need to take a salary? A
lot of times you have one founder who has a little bit of money
saved up, so she decides to go without a salary for a while, while
the other founder, who needs the money, takes a salary. It is
tempting just to give the founder who went without pay more shares
to make up for it. The trouble is that you can never figure out the
right amount of shares to give. This is just going to cause
conflicts. Don’t resolve these problems with shares.Instead, just
keep a ledger of how much you paid each of the founders, and if
someone goes without salary, give them an IOU. Later, when you have
money, you’ll pay them back in cash. In a few years when the money
comes rolling in, or even after the first VC investment, you can pay
back each founder so that each founder has taken exactly the same
amount of salary from the company.

Shouldn’t I get more equity because it was my idea? No. Ideas are pretty
much worthless. It is not worth the arguments it would cause to pay
someone in equity for an idea. If one of you had the idea but you both
quit your jobs and started working at the same time, you should both get
the same amount of equity. Working on the company is what causes value,
not thinking up some crazy invention in the shower.

What if one of the founders doesn’t work full time on the company? Then
they’re not a founder. In my book nobody who is not working full time
counts as a founder. Anyone who holds on to their day job gets a salary
or IOUs, but not equity. If they hang onto that day job until the VC
puts in funding and then comes to work for the company full time, they
didn’t take nearly as much risk and they deserve to receive equity along
with the first layer of employees.  What if someone contributes
equipment or other valuable goods (patents, domain names, etc) to the
company? Great. Pay for that in cash or IOUs, not shares. Figure out the
right price for that computer they brought with them, or their clever
word-processing patent, and give them an IOU to be paid off when you’re
doing well. Trying to buy things with equity at this early stage just
creates inequality, arguments, and unfairness.
    
How much should the investors own vs.
the founders and employees? That depends on market conditions.
Realistically, if the investors end up owning more than 50%, the
founders are going to feel like sharecroppers and lose motivation,
so good investors don’t get greedy that way. If the company can
bootstrap without investors, the founders and employees might end up
owning 100% of the company. Interestingly enough, the pressure
is pretty strong to keep things balanced between investors and
founders/employees; an old rule of thumb was that at IPO time
(when you had hired all the employees and raised as much money
 as you were going to raise) the investors would have 50% and
the founders/employees would have 50%, but with hot Internet
companies in 2011, investors may end up owning a lot less than 50%.

Conclusion There is no one-size-fits-all solution to this problem,
but anything you can do to make it simple, transparent,
straightforward, and, above-all, fair, will make your company much
more likely to be successful.