Establishing a Fair Equity Allocation within a Startup Venture

A while back, when I was offered an exciting consulting engagement, I had to determine how to establish a fair consulting rate. I did a lot of research, found some excellent resources on the web, and posted some notes on an approach that I adapted to compute a rate that I considered to be fair to everyone.

Recently, I became excited about the prospect of someone who wanted to join the company I founded, Interrelativity, Inc. Aside from the aforementioned consulting engagement, Interrelativity has not generated revenue, so I'm not in a position to offer anything beyond a share of the equity and/or a share of future revenues, and I want to do so in a way that is as generous as possible but also fair to all past, current and future associates of the company. Unfortunately, unlike my last search, I wasn't able to find much useful information on the web; fortunately, I have some friends in the Northwest Entrepreneur Network who provided tremendously valuable help in this quest for a fair way to allocate equity in the company.

Doug Miller, who has founded several startups and now offers his insights and experiences to other startups as a business and strategy consultant, shared some of the data he had collected about equity allocation and other compensation factors in technology startup companies. Although the data varied by different years, industries, company sizes, funding stages, etc., they were fairly consistent with respect to the relative proportions of equity based on title or role in the organization (e.g., the ratio of shares allocated to CEOs vs. VPs of Business Development ranged between 7:1 and 10:1). This provided a good start, but applying this to a company of one was somewhat problematic, since [in this case] the roles are not clearly delineated.

Mike O'Donnell, another serial entrepreneur, and current Chairman of the Board of NWEN, presented another way of approaching the allocation of equity in a startup during his Entrepeneur University 2005 presentation. Mike argued that entrepreneurs should use contractors rather than W2 employees, and offer 3-month contracts that clearly specify deliverables for each contractor. He also offered his approach to determining an amount of shares to offer for each contract: determine the valuation of the company and the number of outstanding shares, use that to calculate the share price, and then for the three month contract, offer an amount of shares whose value equals the hourly rate that the contractor would normally charge for his or her services.

This sounds like a very reaonable approach ... assuming one can determine a valuation of the company. Unfortunately I didn't have a good sense for how to do this. Instead, I decided to use what I did know: I knew how many shares I had allocated myself, and I knew my own consulting rate (from the previous exercise). So I determined how my shares would vest in quarterly installments over four years (the vesting schedule I've been using for all my calculations, based in part on my experience at former employers, but also on recommendations in "The Entrepreneur's Guide to Business Law", a fabulous resource for this, and other, legal issues for startups). I estimate that I'm working somewhere between 60-80 hours per week on this venture, so I divided the number of shares that would vest in one quarter by 720 (60 hours / week * 12 weeks / quarter), and used this as the valuation basis. Actually, I've invested a fair amount of money, as well as sweat, into this venture, and so I used this valuation to go back and subtract out the number of shares that would equal the financial investment, and then used the difference as the basis for the division by 720 (well, actually 11,520, since I was using 16 quarters).

In my discussions with the candidate who wanted to join Interrelativity to help with business planning, development and sales (areas in which I have no experience), we determined that his current salary was pretty close to my own when I left my last job, and so, assuming we would be adding relatively equal value to the success of the venture per hour worked, his hourly rate would be the same as mine. Since he intended to continue on in his full-time [day] job, he proposed to work 20 hours per week on Interrelativity business, and so I offered him a 3-month contract that included an allocation of stock equivalent to one-third of what I would be earning in a 3-month period.

Unfortunately, this offer fell considerably short of the candidate's expectations, and so our discussions concluded amicably, but without an agreement. On the plus side, I was given a powerful opportunity to practice Don Miguel Ruiz' second agreement (don't take anything personally) -- since, according to my reasoning, my assumption about "equal value per hour worked" must not have been shared (although, as I write this, I recognize that this may have been a missed opportunity to practice the third agreement, don't make assumptions) -- and I now feel much better prepared for any future discussions with other candidates who may be interested in joining Interrelativity. And, as always (or, at least, as is increasingly often the case), I trust that this will all work out for everyone's greatest good.