Founder Challenges: Equity Distribution

During the early stages of company inception and growth, you and your co-founders may feel like a family. All of you are working together, investing your time and passion in a shared vision of the future and weathering the risks and rainy days side-by-side, just as you embrace a world of amazing possibilities on the days when things are going well.

But working together with family can bring obstacles as well as benefits, and even though they may feel completely new to you, the challenges that you face during this chapter are surprisingly common. One such challenge is the need to discuss equity distribution. This can feel like an awkward disruption to the harmony and flow you’ve cultivated as a close-knit group. And if you’re like most groups of co-founders, you’re probably pushing this discussion to a back burner in the interest of teamwork.

But this conversation needs to happen, and the sooner the better. The stakes are high, and the decisions you make now can have long term ramifications as your enterprise grows and moves closer to public offering or sale.

As you sit down with your team to make these decisions, keep in mind that looking for shortcuts and a quick resolution to a difficult conversation can be dangerous—both for your relationships and your long-term profit potential. Ask these critical questions before you begin generating an equation that makes sense for everyone, including your investors and shareholders: What do we need most? What kinds of value will each of us bring to the table, both in the present and over time? And how can we measure those forms of value and find a way to make them comparable?

As corporate counsel, we often advise founders that we can help play a mediator-like role in helping them come to something that’s fair. And in our experience, the best way to reach a resolution as to what is fair is for everyone at the table to think and feel like what they are getting in terms of equity is fair. This sounds like a hopelessly vague standard, but it isn’t. Market data can help educate what “market pay” or “market equity” might be, but that’s one data point we use with founders. The key is for people to feel aligned and well compensated. Sometimes, that means everyone gets an equal share of the Company. Sometimes, that means someone gets a little more than others.

It’s important to emphasize why this conversation is so critical. In our practice, we’ve seen horror stories come to life, where founders are literally on different pages as to what their equity is. We’ve seen people negotiate compensation over text message and WhatsApp. This is very poor corporate practice, both from a legal as well as from a bookkeeping, accounting and tax perspective. These types of practices create the potential for huge headaches and giant lawsuits down the road.

Once everyone is on the same page about equity, work with counsel to memorialize the arrangement with stock purchase agreements. If there is a vesting component, every founder should file a Section 83(b) election with the IRS. Create a stock pool for future grants to lower-level employees. This sounds like common sense, but common sense is unfortunately not very common.