Startup founders are nothing if not optimistic. Without optimism, not much happens.
Step one: have a world-changing idea. Step two: build a team. Step three: the company takes off. Step four: rich. That’s living the dream.
But many founders blow it at step two by setting up a deal that’s doomed to failure: the 50/50 equity split.
If two founders assume they’ll each contribute the same amount to the success of the company, then it makes sense to split the ownership 50 percent each, right? What could go wrong?
Everything.
The Slicing Pie Model Definition
The Slicing Pie model is a dynamic equity split framework that ensures fair distribution of ownership in startups based on each co-founder’s actual contributions.
How Do You Get Stuck in a Bad Equity Decision?
When one co-founder is doing much less work than the other, the best case scenario is usually that the deadbeat founder will agree to an adjustment in their equity and continue working. But the adjustment often results in yet another fixed split, like 70/30, which is bound to fail just as the original fixed split failed.
In some cases, the deadbeat founder digs in their heels and insists that a deal’s a deal and they deserve to keep their 50 percent or get a buyout, which redirects scarce funds into their pocket instead of growing the company. The worst place for startup money to go is into the pockets of founders.
So, fixing a fixed split lies somewhere between another faulty fixed split and a partner buyout, which wastes money. There must be a better way.
Count Your (and Your Co-Founder’s) Bets
Instead of doling out equity in fixed percentages at the beginning of the venture, use a dynamic equity split that will self-adjust as you do work. This way, instead of basing the split on what might happen, you’re basing the split on observable facts (what actually happens).
A startup is a gamble. When someone contributes to a startup they are, in effect, placing a bet on the future success of the company. If the company fails, participants lose their bet. If the company succeeds, their bet will pay off in the form of profits and capital gains.
Bets aren’t one-time events. Every day, founders place additional bets in the form of time, money, ideas, relationships, facilities, supplies, equipment or anything else they contribute.
Here’s the best part: It’s easy to track and quantify each person’s bet. A person’s bet is always equal to the unpaid portion of the fair market value of the contribution. No more, no less.
In business, you can quantify everything in terms of fair market value. We know this is true because markets exist for people, supplies, equipment, facilities and anything else your company needs. You wouldn’t buy a copier without knowing how much it costs. Same goes for rent, web hosting, etc.
If someone contributes something to a startup and is not paid the fair market price for the thing, the unpaid amount is a bet. Plain and simple. You can keep track of each person’s bets over time in the same way you would track paid expenses and salaries.
You should base each person’s share of the equity on their share of the bets.
What Is the Slicing Pie Model?
Back to the hapless co-founders in a terrible 50/50 split. The solution is to add up the fair market value of each person’s bets from the beginning. If the hard-working co-founder placed 75 percent of the bets, they deserve 75 percent of the equity. The adjustment is simply a math problem.
Notice I said fair market value and not value. Value is subjective, and fair market value is not. What’s the value of a ream of copy paper that you use to create a fundraising document for millions of dollars? That’s a difficult question. Without the paper there would be no document and no deal.
What’s the fair market value of the paper? Easy: $5.80.
Accounting for potential value is futile. Accounting for fair market value is what most business people do every day.
Like copy paper, people also have fair market values. Most people have jobs for which they get a paycheck, but not equity, because they’re paid in full. Paid in full means they aren’t betting, and no bets means no equity. When someone is paid a full fair market salary for a management position, it’s their job to do great work, have great ideas and create exceptional value for the business.
Each person in a startup company has a fair market salary that captures their skills, experience and the job requirements. If the company pays them their fair market salary, they aren’t entitled to equity. If the company doesn’t pay them their fair market salary, they should get equity in proportion to the unpaid amounts relative to the other unpaid participants.
In a startup, the betting stops when the company reaches breakeven or raises enough money to substantially cover salaries and expenses. When the betting stops, each person has exactly the equity they deserve — even the deadbeat founder.
Should You Fire the Deadbeat Founder?
The co-founders in this story may not be able to resolve their differences. The dynamic model, based on the logic of fairness, will determine the disposition of equity in the event of separation.
In a startup, everything you bet is at risk of being lost. If a solo entrepreneur sucks at their job, the business will fail and they’ll lose everything. Similarly, if the solo entrepreneur stops working and walks away, the business will fail and they’ll lose everything.
Follow this logic to the co-founders: If the deadbeat co-founder sucks at their job, they’ll get fired and, subsequently, lose their share. Similarly, if the deadbeat co-founder just quits, they’ll lose their equity. There’s no need to negotiate a buyout for someone who separates under these conditions.
On the other hand, what if the deadbeat co-founder is unaware of the problem? The hard-working co-founder needs to give the deadbeat co-founder a chance to redeem themselves. They need to have a discussion about expectations and provide reasonable accommodations. Maybe the deadbeat only appears to be a deadbeat because they don’t have the right tools or training. Correct this problem to recover lost productivity.
If you don’t give the deadbeat co-founder a chance to redeem themselves, their bet remains on the table and will become equity relative to the bets of the other co-founder. The hard-working co-founder should think twice about firing someone without warning. The dynamic model aligns with doing the right thing.
The beauty of the dynamic equity split is that no matter what happens in the startup, the equity split adapts to stay fair.
