“If you have multiple business partners, how do you determine who gets what percent of the equity in the company?” – This is probably one of the most common questions I get asked from first-time entrepreneurs, and it isn’t an easy one to answer.

If you’ve ever been to an investor pitch for seed capital, potential investors will always ask: “How much have you put into the company?” Usually this means, how much money and time have you dedicated to or will you dedicate in the future. What you dedicate is often referred to as ‘skin-in-the-game’. . .the more you’ve put into the company, the more committed you are to the cause and the likelihood that you will do what it takes to make sure the company succeeds increases – it’s a simple equation.

When determining what partners get what percent of the company as you’re starting up you should follow a similar methodology – determine first how much ‘skin-in-the-game’ each person will have and then allocate the equity appropriately even before moving forward. And, you should do this at each major milestone (e.g. first six months, 12 months, 18 months, alpha test, beta launch, etc.) Then, make sure you draft a solid partnership agreement to protect that decision – you’ll be glad you did!

More often than not when people start businesses for the first time, or go into business with friends, they allocate equity without real quantifiable justification for why person X gets a x% of equity while person Y gets y%; that was the case in in which I helped start. We arbitrarily distributed the equity at the beginning, not knowing quite sure what was appropriate. We believed that we would all contribute an equal amount of work, passion, dedication or in some case, money. Of course; as time goes by, someone will usually bear the brunt of the work and there will be shift in equality. This often will be the cause of tension and frustrations on many occasions.

After spending some time with many of my colleagues and trusted advisors, who are successful serial entrepreneurs and investors, I now calculate equity allocation much more systematically, right from the start. Even though, in some cases, it still may feel the allocation is a bit unbalanced, at least all dilutions (pre-outside investor money) are justified using quantifiable measurements, which leaves little room for argument. Here’s how to go about it, first determine;

1. How much money will each partner invest?
2. How much time will each partner dedicate to the company?
3. What key relationships / resources / industry expertise does each partner have that will directly benefit the company?

How much money will each partner invest?

This is the easy part. First, calculate how much money you’ll need to make it through the first milestone, let’s say 3 – 6 months of the company, or until the alpha and / or beta launch of the product. Then determine how much money each partner will put into the company – this is what I call your INVESTMENT VALUE.

How much time will each partner dedicate to the company?

This was a new one for me – but probably just as important as investment dollars, as you can’t start a business without people doing the work. You’ll likely find out pretty early on how dedicated people are to the company by the effort they put into it. Starting a company is a 24 x 7 job, spending 2 or 4 hours a week won’t get you very far and probably means you have a hobby-not a company. Starting a company is all about passion and persistence; passion to dedicate the effort and persistence to keep going even when it gets rough.

To calculate this part of the equation, put a value on people’s time. . .are you worth $100/hr or $50/hr? Then determine how many hours you’ll each need to put into the company for the first milestone based on the activities that each partner will be responsible (use the same timeframe as above). Based on that, you can then calculate the value of your time during that milestone – this is what I call EFFORT VALUE.

HOW MUCH INDUSTRY EXPERTISE AND CONNECTIONS DOES EACH PARTNER HAVE?

This is something I think should be added to the equation, but is much more complex to figure out. Ask this about your partners or with anyone you offer equity to who can bring growth opportunities i.e. strategic partners, investors, customers. This is much harder to value early on, but you may want to consider equity based on goals they meet or exceed (i.e. number of investment dollars, customer sales, etc) or increasing the dollar per hour rate for that partner based on what they can bring to the table as it may not always just be on a per hour basis – this I what I call EXPERTISE VALUE.

TOTAL EQUITY ALLOCATION

After you’ve valued each area: investment, effort and expertise, you can then determine each partner’s total investment into the company – hence, determine the allocation of equity as a total of the three.

Once you get external investors involved, such as angel investors or venture capitalists, the valuation and equity allocation will take a different path. In the beginning though, think of your company in short-term milestones and gradually adjust the equity allocation at each milestone using the same equation. In the end, it’s harder for partners to fight if the allocation of equity was justified using an appropriate methodology.

DO NOT forget to create and sign a partnership agreement. Take it from me, I wish we had done all this sooner. . it would’ve saved a lot of sleepless nights and tense discussions with my business partners.

HELPFUL EXAMPLE:  I’ve included an Excel worksheet example / template, which I hope can help some of you first time entrepreneurs as you prepare your first partnership allocation. It will show you how different equity can be broken out based on dollar investment, hours allocated by partner and rate per hour for areas where partners have more expertise. I hope you find it useful, as it has come in handy for me recently!

Tags: Equity allocation, Ownership breakdown, Partners, Starting a small business