The Co-Founder Equity & Compensation Playbook

The dream of many entrepreneurs is to turn a great idea into a thriving business. However, going it alone is incredibly difficult. That's why most founders choose to bring on co-founders who complement their skillsets and share the startup journey.

While having co-founders provides many benefits, it also introduces complexities around how to divide up the ownership, rewards, and responsibilities. Issues like determining equitable equity splits, fair compensation, founder roles and accountability can become sources of conflict if not handled properly.

Avoiding misaligned expectations and uneven contributions that breed resentment is crucial for keeping your founding team motivated and working as a cohesive unit. This playbook aims to provide a framework for how startup co-founders can equitably split equity, compensation, profits and more from the very start.

Determining Equitable Equity Splits

For most startups, the founders' contributions of sweat equity in the form of time and efforts make up the majority of early value creation. As a result, founders typically receive sizable equity stakes, often in the 10-50% range depending on the number of founders, their individual inputs, and whether employees were brought on pre-seed.

There is no one-size-fits-all formula, but some common considerations for dividing founder equity include:

Whose idea was the core concept? The idea originator(s) may receive a larger slice.
What capital, resources or IP has each founder invested or transferred?
The skillsets, experiences, connections and responsibilities each will contribute.
The amount of time committed by each founder, both currently and going forward.

A common approach is to divide founder equity equally to start, and incorporate vesting schedules where equity is earned over 3-4 years to incentivize long-term commitment. Graduated vesting can also be used to compensate more for early contributions.

Tools like the SlicingPie model or Dynamic Equity Splits can provide a more data-driven way to attribute equity based on each founder's inputs and circumstances. These approaches factor in contributions in different areas like ideas, code, product, business, etc.

Whatever split is decided, it's critical to document the equity distributions and vesting schedules through proper founder agreements created with the aid of an attorney. This establishes a legal operating agreement from the start.

Deciding Fair Founder Salaries/Withdrawals

In the early days when growth needs to be prioritized over founder income, most startups choose not to pay themselves salaries and instead live off personal savings or capital raised. Minimizing cash burn is key until revenues build and investor funding is secured.

However, some founders may need a source of income from the start, whether due to lack of savings or to avoid draining personal funds. Additionally, as the business grows, establishing fair compensation should be a priority to retain talent and motivation.

If paying salaries, some factors to consider in determining appropriate income levels include:

The founders' previous salaries or market rates for their roles/skills
Differences in responsibilities, commitment levels, geographies
The company's financial situation and growth plans
Salaries relative to the funding raised and employee compensation bands

An alternative approach is to institute a founder draw or disbursement policy where each founder receives the same fixed or percentage-based payment from revenues or funding rather than a salary. Many founders opt for a combination where they take modest salaries plus a revenue/profit share.

Either way, it's important that differences in income levels align with the founders' responsibilities, time commitments, locations and overall contributions to the business. These arrangements should be agreed to in writing.

Evaluating and Adjusting Contributions Over Time

At the start, the various responsibilities and contribution areas of each founder may seem clear - one leads technology, another heads product, another runs business operations, and so on. However, as roles and priorities evolve, imbalances in individual contributions can emerge over time.

To ensure fair treatment and incentives, it's wise to continually evaluate each founder's performance and the value they are delivering to the company. This can be done through regular performance conversations as well as more formal processes:

Use OKRs (Objectives & Key Results) or KPIs to track each founder's core responsibilities and ownership areas. This increases accountability.
Conduct quarterly or annual performance reviews that holistically assess each person's contributions across areas like product, technology, business, operations, etc.
Incorporate feedback from other founders, employees and even customers/partners on each founder's impact.

If major imbalances are identified where one founder is delivering significantly more or less value than what their equity stake or compensation affords, this provides justification to make adjustments through:

Awarding makeup or refresher equity grants to those who are outperforming
Shifting equity percentages and vesting schedules
Increasing compensation for those taking on extra workloads
Reducing salaries or removing performance bonuses/profit shares for underperformers

The key is to have an open dialogue, documented processes, and a fair system for properly incentivizing the contributions required from each founder for the company's success.

Handling Underperformance Situations

In some cases, if the gaps in founder contributions and commitments become too severe, more decisive action may be required. Examples of these underperformance situations include:

A founder who has effectively checked out and become disengaged from their duties
Unable to execute on their core responsibilities in areas like technology, sales, etc.
Conflicts between founders that are hindering productivity and growth
Ethical violations, change in commitment levels or a founder's role has been rendered obsolete

In these scenarios, the other founders should move quickly to address the issues directly with the underperforming party. They may restructure responsibilities, oversee improvement plans, or in the most extreme cases, vote to remove the founder through a termination process.

To protect the company, founders should get advice for implementing protective provisions like:

Involving outside advisors or the board of directors as an unbiased third-party
Single or double-trigger accelerated vesting of the founder's earned equity
PNG (Permanent Non-Compete and Non-Solicitation) clauses
A separation agreement with related payouts, continued vesting, release of claims, etc.

While it's never an easy decision to part ways with a co-founder, sometimes it is necessary to preserve the business, the working team's morale and momentum. Having clear processes documented from the start can make navigating these situations more amicable.

Setting Yourself Up for Success From the Start

Given how complex and emotional the topic of splitting equity, compensation and upside can become for co-founders, it's wise to establish a solid foundation from day one. This involves:

Having open and honest dialogues with each founder about motivations, expected roles and commitment levels. Aligning on values and aspirations.
Bringing in qualified legal assistance to properly document all agreements around equity distributions, vesting, salaries/draws, separation processes and dispute resolution.
Building in detailed accountability mechanisms through clear responsibilities/metrics, performance reviews, and adjustments when contributions change.
Taking personality, working styles and personal relationships into account and how conflicts may be handled. Defining rules of engagement.
Fostering a culture of trust, open communication and fairness. Most disagreements are unintentional.

The healthiest founding teams are those who have proactively walked through these considerations before problems ever arise. With the right start, co-founders can build a company as true partners over the long journey.

In Summary

For co-founders, the challenge of dividing up the ownership, financial rewards and responsibilities while keeping everyone motivated is one of the trickiest aspects of running a startup. An equitable approach requires:

Making fair, incentive-aligned decisions around equity splits, compensation, vesting and performance-based adjustments
Having a framework for evaluating contributions, resolving issues and parting ways if needed
Open dialogue, proper documentation, and alignment from the very beginning

While no path is perfect, co-founders who are proactive about navigating these dynamics will lay the strongest foundation for capitalizing on their collective efforts and working as a unified team to grow their business.

28th March 2024