(Article by Mike Moyer)
Most founders struggle with trying to determine the right amount of equity for early employees, investors and partners. They want to provide enough equity to be motivating, but they also want to keep plenty for themselves. Concrete answers to the question, “how much equity should I give?” are often predicated by the dreaded, “it depends.” What follows is vague advice, rules of thumb, complicated valuation models. Mostly, it boils down to negotiation skills and straight up guessing.
To make matters worse, most people use “fixed” equity models. This means that chunks of equity are doled out to people in advance of any work being done. This leads to conflict when individuals deliver something different than they promised. If they under deliver founders wish they gave less, if they over deliver employees wish they had more. Fearing this, founders layer on vesting schedules and buyback provisions in hopes of mitigating the damage caused by incorrect equity grants. Unfortunately, all fixed equity grants are incorrect.
Easier Equity Grants
Dynamic equity models, unlike fixed models, are based on a person’s actual contributions rather than promises of contributions. This is how people normally get paid. We work, we get paid, we work some more, we get paid some more. Giving someone a fixed chunk of equity upfront is like giving them their entire salary on day one. If it sounds ridiculous, it’s because it is ridiculous.
Until recently, dynamic equity models have not been widely used because they have not been widely understood. The Slicing Pie model is a foolproof framework for implementing a dynamic equity model. It has two parts 1) allocation and 2) recovery.
The allocation framework tells you exactly how much equity to give someone based on their actual contributions of time, money, ideas, relationships, supplies, equipment and anything else that has value. People earn “slices” in the pie instead of cash. A slice is a function of the contribution’s fair market value times a risk multiplier. The fair market value is the price that the company would pay if they had the cash. The fair market value of a person’s time, for example, is equal to the salary they would earn if the company could pay them what they are worth. Anything the company pays that is less than fair market is considered “at risk” and, therefore, would be paid in slices.
Everything gets converted to slices and a person’s equity stake is equal to the number of slices they contribute divided by the number of slices contributed by everybody. At any given time, each person will always have an exact, unambiguous slice of the pie.
The recovery framework determines the fair buyout price (if any) when a person leaves the company. The framework takes into account the nature of the separation and imposes consequences when appropriate. For instance, if an employee flakes out on the job and gets fired, he might lose some or all of his slices. On the flip side, if the company fires an employee for no reason he might get to keep his slices or sell them back a premium. Everyone gets treated fairly.
Fairness is Real
When using a traditional fixed split fairness is elusive. Equity becomes a hoarded asset with allocations guided by greed. Using the Slicing Pie model, fairness—total fairness—is real. Equity becomes a tool that reflects the relative contributions of the various participants. Equity agreements are about doing right by each other rather than taking as much as possible for yourself.
You don’t have to guess at equity splits and you don’t have to be paralyzed by them. A fair split is a possibility for all startups. When you see what fair looks like you will never go back.
Mike Moyer is an entrepreneur, and teaches Entrepreneurship at Northwestern University and the University of Chicago Booth School of Business.
He is the author of Slicing Pie: Funding Your Startup Without Funds
Mike can be reached via Twitter @MikeMoyer