Jun 23, 2010
Equity split between founding partners has been recently described by Noam Wasserman of Harvard Business School and Thomas Hellmann of the Sauder School of Business as ‘The First Deal’. Indeed, splitting equity can be an unpleasant process and source of discord within founding teams. In light of important research done by Wasserman and Hellmann indicating that splitting equity equally among co-founders is negatively correlated with pre-money valuations, we felt it important to further explore equity splits and how founders incentivize early hires with equity.
We sent a survey of ten questions on equity splits to the Y Combinator mailing list. Y Combinator is a seed-stage investor that provides seed money, advice, and connections at two 3-month programs per year. In exchange, they take an average of 6% of the company’s equity. Usually this amounts to $11,000 + $3000 per founder for a total of up to $20,000 for three or more. Y Combinator founders are young and predominantly male, with an average age of about 26. Most of them have a technical background and are working on their first venture.
Y Combinator has invested in over 150 companies since 2005. 79 of them are publicly disclosed on the Y Combinator web site – the rest are either in stealth mode, are defunct, or have exited. Those that are not defunct are very likely to be on the Y Combinator mailing list. We received responses from 90 web sessions out of the likely 213+ founders.
The survey was anonymous. Duplicate responses from the same company were possible due to multiple founders taking the survey. But while one respondent corresponded to one web session, we believe there were few, if any, incentives for respondents to misrepresent data. All questions were optional.
Here’s the list of the survey questions we sent:
|1||Choice||How many founders held or hold equity? (pre-angel/VC)||90|
|2||Choice||Is equity (stock or options) an incentive you have offered or are willing to offer to hire critical (non-founder) people?||84|
|3||Choice||Did you split your founder equity equally among the original cofounders?||81|
|4||Text||If split unequally how did you determine what share to give each cofounder and why?||26|
|5||Choice||Ignoring founder equity and only considering key hires which of the following factors are MOST deserving of equity (shares or options)?||69|
|6||Choice||Did you have a stock valuation in mind when determining equity to offer early hires? In other words another way were stock or options also presented in terms of dollar value?||65|
|7||Text||What percentage of pre-series A equity do you think should be allocated for employee (non founder non advisor non investor) incentives?||49|
|8||Text||Please describe as much as you’re willing to share about your equity split history (e.g. YC 6% 1% to an advisor 46.5% to each of the 2 cofounders. 6 months later we sold 30% to angels). Note: we are not asking for valuations.||26|
|9||Text||In retrospect was there anything you would have changed about how you split your early equity? Any lessons you would share with future YC teams?||26|
|10||Text||Leave an email if you want to be notified of the aggregate results. To maintain anonymity use something like Mailinator.||
Survey answers led us to the following conclusions:
52% of the sample split equity equally. Larger teams had a greater likelihood of having unequal splits. Almost every Y Combinator company is willing to use equity as an incentive to non-founders, with 54% actually having offered equity incentives.
The predominately technical founders put very little premium on using equity to incentivize founders or early hires with complimentary skill sets. They also seem to undervalue personal sacrifices (opportunity costs) made by some founders to join a start-up. In contrast, the founders overvalued early contributions (usually only several month of difference). Indeed, Y Combinator start-ups place a higher value on technical expertise above any other form of expertise, which dovetails with the common belief that much of the value of an early stage technology-oriented start-up lies with its technical know-how and design.
One conclusion from the Wasserman and Hellmann article referenced here is that larger founding teams might be sacrificing significant amounts of individual equity for only modest gains in pre-money valuation. Wasserman and Hellmann find that, ‘team size [is] only slightly positively correlated with a firm’s pre-money valuation’. However, Y Combinator’s funding structure contravenes this, since its start-ups receive $3,000 more for each founder on the team (for up to three founders). Interestingly, Y Combinator has departed from its original funding structure of a smaller fixed $5,000 per start-up and a bigger variable component of $5,000 per founder. Moreover, Y Combinator used to place a larger cap on the number of founders.
The founders’ financial “unsophistication” is evidenced by 70% of the founders not having a stock valuation in mind when determining equity offers for early hires. Given that Y Combinator usually acquires 2-10% of common stock, there is an implied valuation for every Y Combinator start-up. In other words, stock or options were not presented in terms of dollar value.
The largest area for additional investigation is why Y Combinator founders don’t significantly consider valuation issues when founding their start-ups. Our research does not give conclusive reasons for this. Other potential areas for research include post-equity split satisfaction and the role of individual persuasiveness or personality strength in equity allocations.
(Jeffrey Vyduna, Manuel Duenas and Alexander Angerer (all MIT Sloan ’10) conducted a survey with founders from Y Combinator start-ups as part of a MIT class project. Jeffrey Vyduna is one of the founders of Poll Everywhere (www.polleverywhere.com), a Y Combinator company. The opinions expressed in this article are the authors’ own, and not necessarily those of Y Combinator)
 Wasserman, Noam and Hellmann, Thomas. The First Deal: The Division of Founder Equity in New Ventures. HBS. April 2010.