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.
Splitting Equity
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.
Structuring Considerations
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 loganathan.a@consultibs.sg
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