Finding a formula for equity distribution in a new start-up
Many new entrepreneurs ask me this question.
How much equity should I give to my cofounders and other employees?
This is what I tell all of them.
There is no “ correct “ answer or number for this. No golden rule either. But there is a general principle that you can use.
This is based on the assumption that your end goal is the financial success of your startup which will translate into wealth creation for yourself.
While most founders worry and think about the quantum of equity they will give away and consequently how much money they will be able to make when the big payday arrives, they don’t spend as much time understanding how this quantum ( of equity distributed ) affects the chances of success of the startup, which in turn determines whether any wealth creation happens or not. Without that understanding you can’t make a good decision about equity distribution.
You could represent this principle in the form of a formula.
Wealth Expected for founder = Equity held by Founder x Chances of Success
Chances of success depends on the percentage of people who have meaningful equity. If more people have it then there is a higher chance of success. But you give them too little then it’s not meaningful and doesn’t increase your success percentage.
Meaningfulness for a person depends on the ratio of the notional value of their equity versus their market compensation. The more you give, the more they are likely to see it as a life changing wealth creation opportunity and work towards making it happen, thereby increasing the probability of success.
If equity is meaningful, motivation is high and and you need super motivated people in a startup.
For a cofounder who joins on day 0, motivation comes at a very high number, whereas it comes at much lower number for a very junior person.
So the new formula looks like this
Wealth Expected for founder = Equity held by founder x f(No of motivated people holding meaningful equity)
Now understand the balance needed to maximise the founders wealth as per this formula. If you increase one, the other decreases and vice versa. Which means you have to find the right balance.
To apply this principle, you need to understand who are your key people and what kind of equity will make them feel like owners.
So remember this. Err on the side of giving more and not less.
Whatever amount of equity you have it won’t matter if the startup goes bust. It will be worthless. So base your decisions on what will increase the likelihood of success.
There are obviously lots of other factors which determine a start-ups success. The idea, the business model, capital, the competition and the industry etc etc. This formula only concerns the people part of the startup’s success.
