Negotiating Equity Splits at UpDown
The case of Negotiating Equity Splits at UpDown is a very common scenario for start-up companies. At the beginning stages of an idea, there are a lot of different emotions and aspects involved which are not necessarily helpful when the idea comes to fruition as a new company or business model. The UpDown case also tells us that past experience doesn’t translate into founders really learning from their mistakes at the conception of their idea. When a group of people gather to plan and talk about a potential idea or product, all emotions are very high in excitement and, usually, everything seems all great. The underlying principle of developing something and making it bigger and better seems to be an idea that joins people together for a common goal. It is precisely at this point where naivety can turn very costly unless terms and expectations are well established in any new project/business. This case is a clear example that no start-up story is the one of the same and that many situations along the creation of it will result in a fluid change of opinions that if not mitigated from the start can become the demise of a start-up company.
Equity splits terms must be established and determined as soon as possible to avoid getting into (what could turn into) personal issues with the founding members of a company. It is not only establishing an equity split, but also laying the groundwork for what can evolve from that point forward. Founders must start developing their equity term sheets mitigating for ever changing differences in workload, responsibilities and/or time invested. At the beginning of a new idea these aspects might be hard to have in mind, but this is why building logical frameworks will always give the entrepreneur an upper hand.
In the case of UpDown there were three equity holders involved: Michael, Phuc, Georg, and an angel investor Joachim. Joachim was responsible for providing the funding and have a hands off policy in return of equity of 20%. The three equity holders initially agreed on a set of rules and created only a page partnership agreement which listed basic principles and responsibilities of each member. Michael was the most passionate and most involved with getting UpDown off its feet and regularly put in extra hours; such as visiting angel investors and actually trying things to get its business off the ground. Georg and Phuc were mostly off hand partners who were not performing as much as Michael.
Even though Georg had met a few angel investors he did not follow it up with more serious investors. He also did not cut his vacation short when Michael had achieved initial funding.
Phuc on the other hand had much less interest in the business idea since he wanted the other partners to support him on his idea of creating a social network for people to organize events easily. He was responsible for programming the group and when approached by Michael to work on UpDown, he wanted to be compensated for taking time off his consulting business to work on UpDown. Even though all three individuals agreed on working on the start up equally it was Michael who was putting the most work in.
To say the least, their interest varied as well as their impetus, but the ultimate intention was pointing in the same direction. The interest of early employees can be very different depending on their strengths and their focus. The case of UpDown this is one of the aspects that could have complicated negotiations if they did not address these things clearly and establish the expectation for the each role they had in the company.
The initial decision for the equity split of the company was to distributing equity equally. This could have work up to a point, but when when external capital was contributed, equity split should have been based on performance. If one member of the employee did the bare minimum, he should not get the equal split of equity. UpDown should have come up with a performance based compensation plan which divides equity based on member contribution.
Another approach, and perhaps an alternative to re-negotiating equity when external capital has been injected, is to not get involved in splitting equity initially until the business is making returns, which would be a much more viable business plan. When returns come in, the partners should then divide equity based on performance of the company and its members based on a predetermined framework.
The UpDown Team
To understand the possible framework that can help determining how to split equity in UpDown, it’s very important to look at the individuals involved by their strengths and weaknesses in regards to information they have or abilities and skill set that they brought to the company.
Risks can vary from the direction that Michael chooses to take the company. Asking for more equity from other members might force other to abandon the company or band together against him in the decision making processes. If Joachim fails to execute on the funding required to operate or start UpDown, Michael will be left searching for other investors or abandoning this idea all together. Another potential risk is the opportunity cost of operating in this business, if Michael feels that not everyone is working equally or efficiently he should consider opportunity costs where he can utilize his skills much more.
Transactional Costs of Negotiation
In the UpDown equity renegotiation there would be minimal transaction costs since the parties can potentially negotiate among themselves as partners of the same company. That being said, their might be some costs to the different relationships after negotiations. It was clear, at least for Michael, that he was doing a lot of the work (compared to the other two), and that he should be compensated more in equity because of that opinion.
From the case, it’s said that the initial idea for how much more equity Micheal would have in comparison to the rest would be something around 5% more. At the point where Michael was having the thoughts of negotiating those terms, that number looked more around 9%, but I’m sure that was only in his mind, as we can assume that others would most likely say something about that.
There will never be an ideal time to negotiate an equity split because they are usually complex and highly emotionally-charged conversations. The art of it comes from choosing the timing in order to cause the least impact possible. At this point for UpDown, before embarking on the next steps, it would have great to have this discussion at that. Although ideally, they should have figured various things out some time before.
Even more important than the timing will be the crafting of this agreement. An idea for a versatile agreement could be broken down into the following frame simplified on three main priorities (not by order of importance):
- Phuc – needs a salary in order to focus on the company
- Georg – needs to focus on the company
- Michael – needs to calm down (“relax”) and delegate some tasks to Georg
The idea for Phuc is to leverage his expertise in systems to be able to allocate a systems contract through his consulting company. The contract would involve Phuc taking charge of all system functions in the company as the new CTO. His salary would be broken down into: 1.) a contract for his consulting company, with the intention of Phuc handling all system related functions in the company; 2.) the other half of his salary will be compensated in a split between equity and a $1,500 monthly stipend to cover other expenses. These terms would be renegotiated once the business would be generating revenue.
The idea for Georg is to establish and solidify his commitment to the project. This part of the agreement would entail establishing the expected responsibilities for Georg. By establishing expectations this would make it easy for an equity split to have a frame of reference. This in turn will give Michael the necessary assurance that he won’t be the only one that is working hard to accomplish the company goals. Given that responsibilities and priorities would be set forth once this framework has been established, the equity distribution can be done with objective measures.
How should Michael approach this?
Michael needs to do something that he should have done long ago. As the leader of the group (and the most hard-working), he should establish clear roles and expectations in order to make the equity split objective and this couldn’t have been done in a single sheet of paper. Perhaps the lack of detail and specificity was underestimated (as it is so many times with early stage of development companies) and this is what lead him to the situation he sees himself at that point.
The central idea that Michael should keep in mind with these equity splits is how fair and objective can people be in regards to their perceived contribution and desired compensation. In order to keep tensions from rising there is a necessary framework that start-up’s should adhere to, which goes beyond a simple equal-parts split and/or the “here is a bit more equity” because you are the “CEO of this company” strategy.
If this is not done from the beginning it’s imperative to get it done as soon as possible. Michael at this point should start by establishing roles and expectations in regards to equity and compensation. Most important of all, the contingencies for the failure to comply with the established agreement and its repercussions should be clear in order to avoid having to renegotiate terms. Negotiating terms that would most likely be revisited with a predominantly subjective, rather than objective point of view.