NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

The Division of Founder Equity in New Ventures

Roughly one third of founder teams divide their equity stakes equally.

The shares of entrepreneurial companies can be divided among the firm's founders in a number of ways that may, or may not, take account of the relative value of each one's contributions. One simple solution is to value all members equally, which avoids making value judgments and requires only minimal negotiation. However, an equal split of founder equity may not always be appropriate -- some founders may feel like they are contributing relatively more and thus expect to receive more shares.

In The First Deal: the Division of Founder Equity in New Ventures (NBER Working Paper No. 16922), authors Thomas Hellmann and Noam Wasserman focus on these issues. Using a proprietary dataset including information on 1,476 founders in 511 private ventures, they find a surprisingly high incidence of equal splitting. Roughly one third of founder teams divide their equity stakes equally. Arguably, the division of equity is one of the key decisions taken by founder teams. Even simple calculations suggest that the amount of money at stake is significant.

Hellmann and Wasserman theorize that founders have a choice between accepting an equal split without having to negotiate or undertaking costly negotiations to come up with a differentiated allocation of equity shares. They then consider the determinants of equal splitting and they identify three important founder characteristics -- idea generation, prior entrepreneurial experience, and founder capital contributions -- that would reduce that likelihood. Next, they show that these same founder characteristics also significantly affect the share premium in teams that split the equity unequally. Finally, the authors show that equal splitting is associated with lower pre-money valuations in first financing rounds. As predicted by their theory, this valuation effect is driven by unobservable founder differences, and it is more pronounced in teams that make quick decisions about founder share allocations and negotiate very quickly -- in less than a day.

The authors also perform some counterfactual calculations that estimate the amount of money "left on the table" by stronger founders who agree to an equal split. They estimate that the value at stake in a typical start-up is approximately 10 percent of the firm equity, 25 percent of the average founder stake, or $450K in net present value.

--Lester Picker

The Digest is not copyrighted and may be reproduced freely with appropriate attribution of source.
 
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