Once upon a time, I was speaking with a company founder and they mentioned that they had a VP of Engineering to whom they have given a 1/3 stake in the company. I immediately commented that was too much and then said “I’ll write this down in a blog post” – and then I never did. Last night, oddly, I woke up from a deep sleep with the desire to write this down. And that brings us to this post.
Here’s what I can remember from that conversation:
- Company Stage: Pre Funding
- Company Type: Medical
- Equity Split with the VP of Engineering: 1/3
- Founder Title: Yes
- Did VP of Engineering Put in Cash: No
You Need to Understand This
One of the basic rules of the startup world is that on Day 1, you, the founder, own 100% of something that is worth absolutely nothing. The goal, by the end, is that you own a much smaller percentage of something actually worth something. As an example, owning 10% of something worth $10 million is actually much, much better.
The Basic Rules of Thumb for Equity Allocations
Here are my rules of thumb to use for equity allocation:
- The more risk you take, the more you get
- The earlier you join, the more you get
- Putting time in is one type of risk
- Putting cash in is a greater type of risk
- If you, the founder, give too much equity to someone else then you can be pushed out by simply having that other person align with the investor or investors
- You only have 80% of the equity to play with - 20% generally goes to an ESOP (employee stock option plan)
- Make damn sure that you give out options not stock and a long vesting schedule (incremental over say 4 years)
The bottom line is that equity, in whatever form, is a reward for taking risk. And the earlier you are involved in a startup, the more risk there is.
My Personal Experience from Feedster
A long, long time ago, I founded a blog search engine named Feedster. I merged with another RSS search engine shortly after coming to market to address some technical limitations in my architecture. We did the typical nerd founder thing and simply split the equity down the middle and both took the Founder title.
In retrospect that wasn’t a fair allocation because I committed significantly more time to Feedster but it avoided a difficult conversation that I was simply not brave enough to have – and that was a mistake.
Once we realized that blog search was actually a viable business, my first hire was a CEO to handle the operations and capital raise. This CEO:
- Came in after the technology was built
- Came in after the site had traffic
- Came in after growth was proven
- Did not have to put in any personal money
The equity allocation for that CEO, bear in mind that this was 16 years ago so my memory may be fuzzy was between 9% and 10%. That CEO’s advice to me is that if we filled other VP level slots, we’d be talking about between a 3% to 5% stake.
If you contrast these numbers with the 1/3 equity split mentioned above, it is considerably less and the reason was that an awful lot of the risk had already been addressed (functional technology, working product, site with traffic, no capital investment, etc).
There are two important disclaimers to understand here:
- I am not a lawyer (IANAL) and my focus is always on making great technology NOT on the best personal economic return. This means that there are aspects of capital raising and equity allocation that I don’t now and likely never will fully understand.
- I should also note that equity allocation is a particularly sensitive topic for me because, even though I was the founder, I was forced out by the people I hired and then voted off the board. And while I am over it (somewhat), had the equity allocations been handled differently, that might not have happened.
What Should This Founder Do?
My advice to this founder is to get Marc Randolph’s book, That Will Never Work, about the founding of Netflix and read pages 180 to 189. Marc Randolph was the founder of Netflix and the original CEO. In these pages, Reed Hastings not only told Marc that he needed to step down as CEO and be replaced by Reed but that he needed to give a substantial portion of his equity to Reed in order for that privilege.
After reading these pages, I think that the founder needs to talk with the VP of Engineering and negotiate the equity split down, the 1/3 is just too high. Once upon a time, I would have said that once you make an agreement, you have to keep it at all costs. What this book has illustrated to me is that if circumstances change, you actually can renegotiate even on a sensitive topic like equity allocation.
Note: Marc Randolph stayed with Netflix for years even after being replaced as CEO and losing equity in the process. So even difficult discussions don’t necessarily end relationships.
Lest you think that I’m pulling this information out of thin air, I did try and confirm my thoughts a bit:
- AVC on Equity Allocation; Honestly just read everything that Fred Wilson writes.
- The Joel Spolsky answer that Fred Wilson is referencing above is offline but I managed to find it in the Internet Archive.
- Google’s Equity Allocation: Eric Schmidt, the former CEO of Sun, only got 5.4%; Omid Kordestani, VP of Sales I believe, only got 1.8%. Both these individuals joined later so they weren’t really founders but this illustrates the basic concept that the later you join, the less risk so the less equity.
- CooleyGo on Equity Splits; this has a VP of Marketing getting 17% at a founder stage.
None of the numbers are exactly the same as the Feedster situation but that’s normal. Every startup is different. As the founder of this company, they need to examine the risk that this VP of Engineering candidate is taking and assess whether or not a 1/3 stake is actually warranted (example - is the VP of Engineering writing the prototype that is used to raise capital).
And you can always run a google search for Startup Equity Allocation.