Allocating Founder Stock
One of the first decisions startup founders must make is how to split up Founder Stock. Founder Stock is the first stock issued by a newly formed company and is highly desirable because it can be bought at an extremely low price- often $.001 per share. It also becomes the lion's share of all employee stock over the lifetime of the company. If you are the only founder allocation is easy- 100% goes to you. If you have a co-founder that has the same level of skill as you do (e.g.- you are both VP-level in your respective functions) and will spend the same amount of time on the business as you will, the allocation is also pretty simple- it's 50/50. However, these scenarios are becoming increasingly rare, and even if one of these scenarios applies to you things change. For example, if you are the only founder now, what if you want to bring on a co-founder later? If you have a full-time co-founder now, what happens if the time spent becomes unequal, or you have different skill levels?
Unfortunately, despite the desirability of Founder Stock there isn't a widely recognized formula or industry benchmark for allocating it. When a company has enough money to pay full salaries equity compensation is easy. There are tons of benchmarks and if your company has a valuation determined by investors you can put a dollar figure on equity. Until that point, stock allocation is a murky practice. There are a few popular online tools where you answer some questions about each co-founder and out comes the stock distribution, but the questions are too high level and there is no visibility into the formula being used. So, as all innovators do, we created a mechanism that is better- the Cumulative Contribution Model (CCM). CCM is based on a few key principles:
1. Founder Stock is allocated based on the ratio of each founder's uncompensated contribution to the company. In other words, if one founder contributes 3 man-months of work and another contributes 1 man-month, the split is 75/25.
2. Up until a company starts paying all contributors full salaries *or* investors put a valuation on the company (let's call this the "Inflection Point"), the company valuation does not change. Note that we don't care what the valuation is, we just assume it doesn't change.
3. Founders Stock should only go to contributors who are able to join the company full-time after the Inflection Point (we'll call these contributors "Founders" of course).
4. Every hour of work contributed to a company has a dollar value. The dollar value might be different for each contributor, but assigning a value is important because some contributors may not be able to be Founders but should still be compensated for their contributions.
Now that we have the principles, calculating the percentage of Founders Stock for each founder is easy. Add up the dollar value of the contributions of each founder and divide that by the total dollar value of all contributions. If you've issued Founder Stock before you probably noticed something- with CCM you cannot allocate shares until right before the Inflection Point because you can't predict what everyone's contribution is going to be (things change, remember?). However, if you create a C-corporation you need to allocate shares right away. There are two solutions to this: a) start as an LLC first and only start the C-corp right before the Inflection Point, or b) allocate a small number of shares at first (maybe with a very long vesting cliff) with the expectation that these shares will be hugely diluted or bought back at the Inflection Point when the "real" Founder Shares are issued.
Let's look at an example. Founder A is a technical founder that starts coding the product half time (20 hours per week) on January 1. On April 1 of the same year (13 weeks later), Founder B joins the team and starts coding on a half time basis as well. On July 1 (another 13 weeks later) the MVP is finished and Founder C joins on a full-time basis to sell the product to customers. On October 1 (another 13 weeks later) the company closes a $1m financing round due to sales attributed to Founder C, and all three founders get salaries to start working full time. For this example, let's use weeks as the unit of time rather than hours and assume all three founders are the same skill level for their function (e.g.- all are rock-stars). Founder A contributed (13 + 13 + 13)/2 weeks. Founder B contributed (13 + 13)/2 weeks. Founder C contributed 13/1 weeks. The total accumulated contribution is 45.5 weeks, so Founder A gets 19.5/45.5 or 43% of the Founder Stock. Founder B and C both get 13/45.5 or 28.5% of the Founder Stock.
Now let's say Founder B decides to not join the company at the Inflection Point (perhaps he likes his other side project better). His 13 weeks of contribution translate to 520 hours at $150/hr, or $78,000. When the investment funds are in the bank $78k gets paid out to Founder B, leaving Founder A with 60% of Founder Stock and Founder C with 40% of Founder Stock.
Here's a Google Sheet you can use to track contributions and calculate Founder Stock allocation.
There are several grey areas you'll need to sort out, including:
- when is the official start of the contribution accumulation? If you're a "business guy" and you've been trying to sell your idea for the past year with no tangible results, you'd be hard pressed to convince a technical co-founder that the date should start a year ago. However, if you're technical founder and built the product from scratch working full-time for 3 months it's reasonable to think the start date should be three months ago. The the split is very uneven, it's a good idea to give your co-founder the ability to catch up (for example, if they start putting in a lot more hours than typical full-time or you start backing off a bit).
- what happens when you raise a small amount of money, but not enough to pay full-time salaries? Usually you raise this money using convertible equity like a SAFE or KISS, and these documents have a valuation cap. Is your startup valuation now worth the valuation cap? At Wivity we decided to extend the Founder Stock contribution period through convertible equity rounds, but allocated part of the Founder Stock at the close of the convertible equity round in order to give our investors a cap table they feel comfortable with.
- once the Inflection Point is reached, how do you calculate the start of vesting and the vesting cliff? Usually stock and option contracts require 4 year vesting with a 1 year cliff. If people have been contributing for a while you can shorten the cliff to compensate for previous contributions.
- will you allow non-founder contributors to take part of their payment in equity? If so, this is pretty simple. Part of the cash is put into a convertible equity or a Series A document just like the investors. In the above example, Founder B can buy $50k in convertible equity and take $28k in cash (perhaps to pay for taxes on the $78k).
Of course there are many variations on CCM such as calculations for different skill sets (although I would argue that teams work best when they are all at the same skill level) or reduced contribution ratios following certain meaningful company milestones on the way to the Inflection Point (such as signing a "lighthouse" deal).
By Alfred Tom on November 22, 2016