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How to split equity equitably for your startup

ANN ARBOR—It's a question every startup struggles with—how to divide the equity before a product, an app or service is developed?

Startup founders are often compensated initially with equity shares until the business starts making money, and equally splitting shares seems like the default.

Equally splitting these shares can create problems such as free-riding behavior. The conventional wisdom in the entrepreneurial community indicates it's much better to connect rewards to the contribution made by each team member.

Evgeny Kagan, a University of Michigan doctoral student at the Ross School of Business, said that many startups just go with an even split and then end up like the case of Zipcar co-founders—one wanted more than 50 percent, a power struggle ensued, and both eventually left the company.

"Some startups do simple contracts, some do more intricate contracts, and some startups wait longer to see which founder will take which role," Kagan said.

He and co-authors Bill Lovejoy and Stephen Leider, both professors of technology and operations at Ross, set up two experiments to determine how individual behavior played a role in the way startup teams set up equity contracts. It's the first experimental test of the relationship between contract form and contracting time, effort and value generation in startups.

"Our results confirm the conventional finding that equal splits are poor choices, but suggest that this is driven not by the incentive differences between contracts but mainly by the differences in personality types," Kagan said.

That is, the results reversed cause and effect relative to the conventional wisdom. Instead of contract incentives driving behaviors, as is usually assumed, personality types and behaviors were relatively stable and different personalities lobbied for different types of contracts.

Equal shares are bad, but not because of their weak incentives. Rather, relative slackers opted into them. The advice to startup teams: Don't count on incentives to alter behaviors; learn the work habits and dedication of your teammates first before writing up a term sheet and capitalization table.

This is partly why Kagan also found that later contracting reduced the significance of contract type on the eventual venture value. By delaying contracting, teammates had time to learn more about their colleague's personalities so the contract form itself was reduced in significance relative to all the other signals they then had about their teammates' contribution habits.

Kagan began with a pilot study of 50 subjects from the U-M student body, which he randomly formed into two-person teams and asked them to negotiate contracts in a context where each could choose how much time and effort to invest in the venture relative to a more certain outside opportunity. Each team was free to negotiate however they wanted and faced no time limit. The idea was to find out what sorts of contracts subjects would write.

Nearly three out of four, or 73 percent, of the teams chose equal contracts in this pilot study.

"The subjects were similar in demographics to startup team members," Kagan said.

Then Kagan ran a second experiment with 104 U-M subjects, with choices restricted to the types of contracts uncovered in the pilot study, so that different contract forms received a critical mass of data. They found that equal contracts were associated with lower effort levels by team members when compared to non-equal contracts. Over 70 percent of the effort gap is driven by differences in personality types of founders.

"He's addressing issues that haven't been explored before," Lovejoy said of Kagan.
"The bottom line for teams is don't count on contract incentives to change behaviors. People are people. What you want to do is use their behavior in performance to know who they are before you contract and then contract accordingly."

Startup investors should avoid startups that equally split equity between founders as teams choosing this split generate only half of the value relative to those choosing non-equal contracts. However, equal contracts chosen further downstream in the entrepreneurial process are markers of a more desirable personality mix, relative to equal contracts selected early on.

"Information about when and how the contract was chosen is as important as the contract form and should be included into the investors' due diligence process," Kagan said.

 

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