The First Deal: The Division of Founder Equity in New Ventures
Executive Summary — Sooner or later every entrepreneurial team has to face a tough decision of how to divide founder shares. This can be difficult because it requires founders to assess the relative value of each other's contributions. A simple solution is to value all members equally; this avoids making value judgments and requires minimal negotiation. However, an equal split of founder equity may not always be appropriate, for some founders may feel like they are contributing relatively more and thus expect to receive more shares. This paper examines the division of founder shares in entrepreneurial ventures, focusing on the decision of whether or not to divide the shares equally among all founders. The authors develop a simple theoretical model of the central issues involved in founder equity splits. The model includes negotiation frictions, based on the cost (or discomfort) of valuing relative differences. The authors then test these predictions on a unique, proprietary dataset comprised of 1,476 founders in 511 private ventures. While arguably the division of equity is one of the key decisions taken by founder teams, findings show a surprisingly high incidence of equal splitting. The authors theorize that founders have a choice between accepting an equal split without having to negotiate, or undertaking costly negotiations to come up with a differentiated allocation of equity shares. The theory generates several empirical predictions that are borne out in the data. Moreover, calculations suggest that the amount of money at stake is far from trivial, estimated at 10 percent of the firm equity, 25 percent of the average founder stake, or $450,000 in net present value. Key concepts include:
- In the first financial arrangement within a new entrepreneurial venture there is a surprisingly high incidence of equal splitting.
- Founders usually face a choice between accepting an equal split without having to negotiate, or undertaking costly negotiations to come up with a differentiated allocation of equity shares.
- A great deal of money is at stake: approximately 10 percent of the firm equity, 25 percent of the average founder stake, or $450,000 in net present value.
This paper examines the division of founder shares in entrepreneurial ventures, focusing on the decision of whether or not to divide the shares equally among all founders. To motivate the empirical analysis we develop a simple theory of costly bargaining, where founders trade off the simplicity of accepting an equal split with the costs of negotiating a differentiated allocation of founder equity. We test the predictions of the theory on a proprietary dataset comprised of 1,476 founders in 511 entrepreneurial ventures. The empirical analysis consists of three main steps. First we consider determinants of equal splitting. We identify three founder characteristics-idea generation, prior entrepreneurial experience, and founder capital contributions-regarding which greater team heterogeneity reduces the likelihood of equal splitting. Second, we show that these same founder characteristics also significantly affect the share premium in teams that split the equity unequally. Third, we show that equal splitting is associated with lower pre-money valuations in first financing rounds. Further econometric tests suggest that, as predicted by the theory, this effect is driven by unobservable heterogeneity, and it is more pronounced in teams that make quick decisions about founder share allocations. In addition we perform some counterfactual calculations that estimate the amount of money "left on the table" by stronger founders who agree to an equal split. We estimate that the value at stake is approximately 10% of the firm equity, 25% of the average founder stake, or $450K in net present value.