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In the last article, we discussed the ESOP trend in Start ups, and took a broad view of the pros and cons of such an arrangement. We will take this discussion further by turning the angle of view.
In this edition, the part 2 on ESOPs for start ups, we will consider the arrangement from the perspective of the promoters – on how to split equity and structure ESOPs to get a win-win for all and the company.
For a startup founder, discussing the equity split up with co-founders can be a daunting task and an uncomfortable “to-do” that he/she may prefer to avoid for fear of project failing to take-off.
Founders usually prefer to go with a 50-50 split to make it seem fair. In most cases though, it is never really fair as co-founders bring different talents and contributions to the table that are not always equal. While the founder who bounced off the idea and got all the other founders together may feel it is his baby and internally feels he deserves more, the co-founder who is the actual executor may feel he is the one who is actualizing the whole idea and is therefore entitled to a higher share. And so, due to these variances in perceptions about each founders share, it is always advisable to get done the actual discussion on splitting equity. If the co-founders can’t have constructive discussions on uncomfortable but critical matters, and arrive at an agreement in equity, then chances are that they are not the right co-founder match. The startup would end up a failure at a later stage.
So, how does one split equity, if not shared equally? Here it is important that the founders arrive at a framework that can be used to determine the allocation of equity. The framework could take into account various attributes, resources, skill-sets that are important to the company, so that equity can be split fairly if not evenly among the co-founders. It is important to play emphasis to sweat equity. While capital contributions are great, what is also important is sweat equity. Equity should be allocated on who has put in the most work and will continue to do so in future.
Founders can also avail of automated cap-table management tools, frameworks or co-founder equity calculators to arrive at the percentages. These tools incorporate a lot of factors that make the decision making more scientific than emotional.
While it is important to determine the equity split, co-founders should not ignore structuring considerations. Not thinking through the structuring can lead to resentments, company failure and lawsuts. Key notes:
Vesting Rights – There is a usually a vesting schedule attached with founder stock. This is typically done to safeguard the interests of the company and founders from any of the co-founders who choose to leave early and rewards those who stay long term. Founder vesting is also a requirement for many VCs. Under a typical vesting schedule, the stock vests in monthly or quarterly increments over four years.
Right of First Refusal – Here the founder gets the right to buy the co-founders’ share, lest it gets sold to an unknown party who thereby becomes involved in the company’s management and decision making.
IBS Consultants Corporate Legal can help in working out a systematic arrangement on equity split and structuring that can help iron out differences that may crop later in the course of business. Founders may also consider working out a co-founders agreement that could spell out shareholding structure, management structure, ownership over IP assets, resolution of deadlock issues, founder exit clauses, restrictions on transferability and more. As they say, A job well begun is usually well done.
This blog is authored by A. Loganathan, representing India Business Solutions (IBS) which is a boutique advisory firm helping a lot of Start ups in India and Singapore in fulfilling their aspirations. Loganathan is heading the Singapore operations of IBS and can be reached on email@example.com