TwoSense’s Recipe for Equity Distribution

My equation for equity assignment is proportional to “risk” x “skills” x “commitment.”  I have discussed this so often with fellow entrepreneurs, and while we all seem to agree on this, I have never really found something that quantified it to my satisfaction.  This is the metric that I’ve come up with that fits how I operate.  What everyone wants is an objective function where you put in facts and get out a good split.  Unfortunately, the “facts” are almost always the subjective view of the founders.  This metric is for taking those subjective views and estimating a good distribution.

When you found a startup, there are so many blogs, books and webseries on how to assign your equity.  Vesting is a great tool that motivates founders, and safeguards for eventualities where founders leave, can’t join, or cease to get along.  Vesting is all about rewarding hard work while safeguarding against accruing “dead equity” in the cap table.  Some experts say they want to see all founders with similar equity.  Others advise that equity should be split 2-to-1 for partners working full time vs. part time.  I argue that these are all great guidelines, but don’t do the complexities of the issue justice.  Vesting is great, but how much should you be allowed to vest?  What if one partner is exponentially more valuable than another?  When you distill it down to the most essential components, there are three aspects that need to be taken into account:

Everybody wants a piece of the pie.

Risk: a startup is defined as a business operating in the face of abnormally high risk.  Imagine the total risk that the company needs to overcome is an enormous vat.  Every step the team takes reduces the risk left in the vat asymptotically (it’s never empty) until the startup becomes an established business.  But every step does not yield an equal risk reduction.  For example the work to establish initial market viability has a much higher opportunity costs than say testing product color schemes later on.  Investing energy at that level of risk is what should be rewarded, and the more risk the individual carries (or removes from the vat), the more they should be rewarded in equity.  However, if the individual is being paid at market rate, the risk they actually bear is the risk of losing their job if all goes south, which I would argue is substantially less than the opportunity cost of a founder.  This issue is usually covered by the standard pay-vs-equity tradeoff that is prevalent among startups.

Skills: what each team member brings to the table should affect how much equity they get.  Is someone the only person in the world who can fulfill a role? Does the company sink without their specific skill set or experience (max skill points)?  Can the company hire someone easily to replace them (min skill points)?  These are all tough questions that have to be addressed earnestly.  I have seen many companies where the person with the most specific and crucial skill set is undervalued (usually the executing technical co-founder), giving privilege to a non-crucial person who “had the idea.”

Commitment: there are many types of commitment: emotional, financial, legal, temporal, etc. For a startup, building a team all of these are necessary. There is plenty of work on rewarding financial commitment, that’s what Venture Capital is all about. Emotional commitment is par for the course: everyone believes in what they are doing or they wouldn’t have joined.  Time commitment is the most important and is usually handled using vesting, but needs to be addressed within the context of risk taken and skills brought to the table.

equity  “risk taken” x “skills brought to the table” x “commitment.”

The great thing about proportional equations is that absolute values are not needed, you can do all computation with relative values.  As long as everyone is judged on a uniform scale and the size of the equity pool is fixed, the rest of the math just works itself out (the basis for efficient probabilistic machine learning).  I’m not an expert in all things startup related, nor do I have all the answers, but this is what I believe and it’s how equity distribution is being modeled at TwoSense. Unfortunately, I have yet to find a dynamic vesting model that accounts for all of these aspects explicitly. Specifically, risk is the hard aspect to model.  If anyone has any feedback or ideas, please feel free to send them to us through our “info@” address on the contact page.