Splitting Up Equity in a New Venture
When forming a business venture with a partner, one of the most important decisions is how to split the new company's equity between the two parties. In many cases, partners may agree to divide the equity equally, 50-50, for simplicity's sake but this is not always a good idea. Doing so may be unfair to one of the parties and detrimental to the business itself. Although there’s no textbook approach to splitting equity, thoughtfully analyzing each partner's contributions is recommended before signing the partnership agreement.
While cash is undoubtedly essential, other factors such as sweat equity, resources (labor, technology), experience, direct sale contributions and industry connections must also be factored into the equation when calculating each partner's contributions to the business.
One approach to determining the right equity split is listing every partner’s contribution and assigning a monetary value to each item. Both partners should discuss each other's contributions and mutually agree on the estimated value contribution for the partnership. Subsequently, each contribution item can be ranked and weighted to obtain a final adjusted contribution amount. For example, the cash contributed upon the formation of the business should be weighed more heavily than an intangible such as potential future sales. These criteria are subjective and can be negotiated and agreed upon by the partners. The idea is to quantify some of the more qualitative aspects and be on the same page.
In the example below, a business requires $400,000 to launch, and one of the partners invests 75% of the capital while the other partner puts in her time with her stellar track record. They are a great fit and the more interdependent they are of one another, the more equitable the split should be.
Partner A contributed 75% of the cash to form the business but ended up with a 66.1% ownership percentage when all factors were considered.
One of the key advantages of conducting this exercise is that it compels both parties to openly express their opinions on how each can contribute to the business, and ensures that everyone is compensated fairly. Remember, for a partnership to work, both parties must be happy and motivated, so strive to balance fairness while keeping the other party satisfied. If you struggle to compromise with your partner at this stage, it might indicate that the partnership will likely fail.