The First Deal: The Division of Founder Equity in New Ventures

by Thomas F. Hellmann & Noam Wasserman
 
 

Overview — When starting a company, entrepreneurs must decide how to divide shares among the founders. The simplest way is to split the shares equally, which is what one third of startups decide to do. But that may not be the fairest or most effective way—especially in cases where some founders are doing more for the company than others. In this paper, Thomas F. Hellman (University of British Columbia) and Noam Wasserman (Harvard Business School) examine when and whether teams are likely to divide shares equally among all the founders, and explore whether such an equity split is good for the company. Key concepts include:

  • The researchers consider four founder characteristics: years of work experience, prior founding experience, whether the founder contributed to the founding idea, and the amount of capital invested into the venture. They find that greater team heterogeneity in entrepreneurial experience, idea generation, and capital contributions predict a lower probability of equal splitting.
  • The larger the founding team, the less likely it is to divide shares equally.
  • The more combined work experience a team has, the less likely the team will split the shares equally.
  • Teams where founders are related through family are more likely to split the equity equally.
  • An equal split is associated with a lower valuation than an unequal split, especially in cases of quick negotiations.
  • Founders who split equally when they should split unequally may be giving up a substantial amount of financial value. (Related research suggests that such teams may also be less stable.)

Author Abstract

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 percent of the firm equity, 25 percent of the average founder stake, or $450,000 in net present value.

Paper Information