There are many approaches one could choose when running a venture Some have preferences for proprietorship, others for partnerships, others for LLPs, private limited firms, and so on. Without getting into specific choices, we focus on private limited firms
Equity is defined as a residual risk in academic literature. While many stock traders understand equity and engage with it day in and day out for a living, there is limited understanding that we have about how one could use it in the early stages of entrepreneurship. In early stages, entrepreneurs that split equity often do so based on parameters like – who came up with the idea initially, what skillsets people get to the table, opportunity costs for compensation, etc.
If you are to effectively use equity as a tool in the early stages of entrepreneurship, you must consider the uncertainty that entrepreneurs must deal with. Entrepreneurs make decisions with limited information and often without enough safeguards or clarity about the future. Equity is a useful tool they could use in this situation. Here are some simple suggestions to help you retain equity in the early stages and handle the inherent uncertainty.
a. Have a well-designed cofounder’s agreement, where you could allocate the decision rights on various aspects of business separately
b. Do not split equity in equal proportions!
c. Let most of the founders earn their equity (think about vesting periods! Periodic peer reviews)
d. On decisions where the allocations are not in the cofounder’s agreement, the one with the highest equity would have to take the call. After all, that person has the highest equity!
e. How do you decide to resolve deadlocks? How about a person specifically to help in tie-breaks?
f. Have you planned to get some high-quality employees through ESOPs?
g. If you are using equity as compensation, could you think of alternate ways of compensating – say through commissions, etc.?
Ask yourself:
What is the basis to allocate equity among founders?
How do we know all the founders will stick together through the journey?
Have we thought of scenarios when we can possibly get someone like Elon Musk on board if we meet them on a flight?
Have we separated decision-making rights among the founders? Are there alternatives to distributing equity as compensation?