How to Allocate Sweat Equity Between Co-Founders When One Invests and One Does Not
Q: How do I determine equity (sweat equity and cash) between two partner/co-founders at launch and then later on when one partner makes a $50k cash investment post-launch?
A: Let’s start with an example of two partners that agree to the following:
Their startup is worth $1m
They are launching with 1m shares
They both agree to contribute equal amounts of time and that their time is of equal value (though that is often not the case)
One partner will invest $50k in cash.
There are two parts to nailing down the details:
Contribution of co-founder time - Let's tackle the issue of the two co-founders agreeing to contribute equal amounts and value of work. Invariably one partner will work longer, harder hours than the other, the value of their various contributions can start to diverge dramatically, and disagreements will typically arise when they individually feel that their role is more important. For example, the co-founder doing all of the sales and marketing might fee like their role is more valuable at the same time that the co-founder cranking out the code will feel that their role is more critical. These potential differences of opinion will place tremendous pressure and stress on their relationship, even to the point that it can torpedo the startup or lead to a split up. To guard against that scenario, it is a good idea for the partners to agree on a vesting schedule for their initial $1m equity split so that if one partner leaves, their equity stops vesting. It’s also best for the partners to agree on which one is in charge (and, ideally, with more equity) and ultimately the tie-breaker to avoid a potential impasse. Many 50-50 partnerships end in a mess because of such deadlocks.
Partner investment of $50k - The partner that also puts in $50k of cash should simply get another 50k shares of equity on top of the 1m shares outstanding because they’ve already agreed to a $1/share valuation.
This is what the Cap Table would look like at founding with the 50-50 split, followed by a $50k investment by one partner (Note that the investment will tip the scale of ownership in favor of the investing partner):
If the investment came from a third partner that is not one of the co-founders, then the Cap Table would look like this: