The Quick Handshake: A Valuation Penalty?

When do co-founders split the equity equally, and does an equal split affect their venture’s later valuation?

We are currently conducting our annual CompStudy survey. (I’ll soon be posting details about how to participate.) Over the last two years, I have enhanced the Founding Team section of the survey, so we can get a deeper view of various founding issues.

The first issue I am revisiting is how founders split equity among themselves, an issue that I first surfaced in a series of posts over the last few years (e.g., Splitting the Pie: Founding Team Equity Splits, Equity-Split Results, Part 1: When Do Teams Split Equally?, Equity-Split Results, Part 2: Implications for Team Stability, The Idea Premium: How Much (Equity) is Your Idea Worth?, and New: “A Note on the Legal and Tax Implications of Founders’ Equity Splits”).
For these new analyses, I have been collaborating with Prof. Thomas Hellman, and our initial paper has just been accepted for the annual summer-time conferences of both the Academy of Management and the National Bureau of Economic Research (NBER).

In the paper, we take a detailed look at the drivers and the financing consequences of founder equity splits. Below I outline the core results in each of these two areas, and would love to get your input about them (especially about the financing consequences).

Note: For these analyses, we combined the data from the 2008 and 2009 CompStudy surveys, including both Technology and Life Sciences ventures. Across the two years, we received complete survey submissions from a total of 576 multi-founder teams. Dropping 65 repeat respondents in 2009 gave us a full dataset of 511 ventures, which included 1,476 total founders.

Part 1: Drivers of the Initial Split

In the initial models, we examine whether the founders’ backgrounds affected whether they split equally (the “1/N” model) or unequally. The core hypothesis is that negotiating an equity split is “costly” (both directly and indirectly), so teams that are relatively homogeneous (e.g., they are “close enough” regarding their years of work experience, prior founding experience or lack thereof, and other factors) should be more likely to avoid the negotiation and just split equally. In contrast, more heterogeneous teams should be more likely to engage in the negotiation, in order to arrive at an unequal split that tries to match equity stakes to expected contributions.

The analyses support that hypothesis, and also suggest that less experienced teams are more likely to split equally. More specifically, the following teams were more likely to split equally:

  • Teams with more homogeneous founders
  • Teams with lower average years of prior work experience
  • Teams with founders who are related to each other
  • Smaller teams

On the flip side, the following teams were more likely to negotiate an unequal split:

  • Teams with more heterogeneous founders
  • Teams with higher average years of prior work experience
  • Teams of non-relatives
  • Bigger teams

Within the teams that negotiated an unequal split, the following founders received significantly bigger equity stakes:

  • Founders who had prior founding experiences (i.e., serial entrepreneurs)
  • The idea person(s)
  • Founders who invested more seed capital

Any thoughts on these results?

Note: When we controlled for the differences listed above (i.e., prior founding experience, idea person, and seed capital), each founder’s overall years of prior work experience did not affect that founder’s equity stake.

Part 2: Financing Effects

This part of the analysis is a little more tentative, but has interesting initial results. For this, we looked at the determinants of (the natural logarithm of) the venture’s pre-money valuation during its first institutional round of financing. Of our full sample, 298 ventures had raised a round within 3 years of founding, and were included in this analysis.

The question was whether the founders’ equity split (equal vs. unequal) was linked to their pre-money valuations. In these models, we controlled for the following factors:

  • The founders’ levels of pre-founding work experience (mean serial-founding experience, mean years of work experience, mean number of idea people, mean seed-capital invested)
  • The founders’ heterogeneity of pre-founding work experience (i.e., the coefficient of variation of the four variables listed immediately above)
  • The founders’ prior relationships (family, friends-not-coworkers, prior coworkers, strangers)
  • Team size
  • Time until first institutional round of financing

(We also included dummy variables for the venture’s location, industry, and the year in which the round was raised.)

The variables that were significantly linked to a lower valuation were as follows:

  • Equal equity split
  • The co-founders were friends-not-coworkers before founding (borderline significance)
  • Higher variance of co-founders contributing to the initial idea

The variables that were significantly linked to a higher valuation were as follows:

  • Larger initial founding teams
  • More co-founders contributed to the initial idea

We next focused on the “equal equity split” result. We separated it into “quick-equal splits” (the proverbial “Quick Handshake,” where the founding team spent a day or less negotiating the equal equity split) and “slow-equal splits” (the teams who spent more than a day negotiating, but still ended up splitting equally), and reran the models. This showed that the negative impact of equal splits is almost entirely attributable to the quick-equal splitters (which had a significant and negative impact on valuation) and not to the slow-equal splitters (not significant).

We do not believe that there is a direct effect of the quick-equal split on valuation — i.e., that it is the split itself that causes a lower valuation. (Please comment if you disagree!) Instead, we believe that the quick-equal split may indicate something deeper (more indirect) about the founding team: a preference to avoid tough discussions, an inability to negotiate effectively, or some other negative trait regarding individual characteristics or team dynamics.

*** Any thoughts on this linkage between quick-equal splits and firm valuation? ***

Next Steps: At the venture level, we’re trying to quantify how much the valuation is affected. At the founder level, we’re also trying to estimate how much money the strongest equal-splitting founder leaves on the table (compared to if that founder had gotten the full unequal stake s/he deserved). Looking forward to posting those results…

17 Comments
  1. Very interesting analysis. It's not surprising that quick handshakes lead to poorer outcomes. Couple thoughts/questions on that:

    1. It would be interesting to follow these companies and see what % resulted in one of the equal founders either leaving the company or taking a less prominent role relatively early. It would also be interesting to compare this to the slow-equal case.

    2. I think in practice, the perception of equality among founders can really hurt the decision-making of the executive team. I've seen this in many settings, both in startups, non-profits, etc. The slow-equal cases probably do a better job to dilineating responsibilities and have clear power-structures for firm decisions.
    3. For better of worse, I think VC's like to invest behind “a guy” (think of Zuckerburg, Pincus, Hoffman, etc). Someone who is the product visionary and leader of the company and the guy who is expected to be the company's talent magnet. I'd suspect it's harder to identify that leader in a founding team of equals.

    A couple clarifying questions

    1. I don't understand the “variance of cofounders contributing to the idea” variable. Does this mean that the more the idea is “owned” by one founder, the worse the outcome?

    2.I would expect the pre-founding work experience of the team to be an interesting variable as well. I wonder how heterogeneity vs. homogeneity of those factors impact valuations.

  2. Thanks for the thoughts, Rob! Follow-ups about your three questions:

    1. The equity split does indeed have an impact on founding-team stability — details at Equity-Split Results, Part 2: Implications for Team Stability. In subsequent analyses, Matt Marx and I have nailed down that the founders who get less than they “deserved” (based on their backgrounds, pre-split contributions and roles) were more likely to leave their ventures.

    2. The “variance of cofounders contributing to the idea” does capture whether a single founder came up with the idea or whether it was more of a team-developed idea. Might be a reflection of “ownership” of the idea, or of whether the idea was better honed.

    3. In the valuation models, we did include several measures of “The founders' heterogeneity of pre-founding work experience” (see the “…controlled for the following factors:” bullet list). Except for the “variance of cofounders contributing to the idea” variable (mentioned above), none of those other heterogeneity variables was statistically significant. Quite interesting to think about the (possibly conflicting) effects we might expect those factors to have on valuation (e.g., is a team more solid if it has a mix of past experiences, or are there some factors where it should be homogeneous? what are those divergent factors?).

  3. Hi Noam,

    This is fascinating stuff.

    What it brings to mind for me is the research on what standards of fairness are applied in different situations — whether people prefer rules for allocating resources that are either egalitarian (an equal split) or equity-based (proportionate to contributions).

    Here are two thoughts:

    * Friends and friendship: I would dig deeper into your data on how friendships change founder equity shares. There is research in the negotiation literature about how 1) friends don't like negotiating with one another, 2) friends who negotiate tend to favour equal rather than equitable distributions, and 3) friends 'split the difference' and use other inefficient but quick ways of resolving conflict. It would be interesting to consider the following mediational pathways: Friends don't want to spend time negotiating, which leads to more quick handshakes, and even when they do negotiate, they favour egalitarian rules for resource allocation, which leads to slow-equal splits. Their choice of quick-equal and slow-equal splits, by extension, is associated with worse outcomes in the deal stage (as the equal distribution is not favoured by investors).

    * Tokens vs. money, group members vs. economic evaluators: This is a bit more speculative, and more psychological in nature. However, Sanford Devoe and his colleagues have some interesting data from the lab and from experiments with bank employees that suggest that people may apply very different fairness rules depending on the medium of exchange. When people are divvying up cash, they tend to use an equity rule. When people are divvying up equally-valuable non-cash resources, they tend to apply an equality rule. The same goes when people think of themselves as 'economic evaluators'. They tend to prefer egalitarian divisions, until they are provoked to think of themselves as rational actors (by, for instance, provoking them to consider what their time is worth). In this applied context, I wonder whether there is a difference in this initial split by the degree to which people think of their ownership share as a 'cash like' or 'non-cash-like' resource. I'm not sure how you'd test this with this archival dataset, but you might be able to look at things like founders' previous experience with exits, the average 'speed to exit' in the firm's industry, the investment experience of the founders, etc. I'm not sure there's an easy test, but your data make me wonder whether this might be the psychological 'microfoundation' for the phenomenon.

    I think the first thought is a bit more tractable; the second is more speculative and may overstep the data you have. That said – fascinating stuff! Can't wait to hear more of your results.

  4. Great to have your input and thoughts, Lukas!

    I agree with your first set of thoughts, and even have some empirical confirmation of them. In my project with Matt Marx, where we examine how founding-team stability is affected by the equity split and by the founders' prior relationships (in the parlance of my MBA course, by the Relationships and Rewards), we use equity theory to examine those linkages. According to the theory, founders who have a pre-existing social relationship operate under a “social logic” that prizes equality, and we show that they are indeed more likely to split equity equally. In contrast, founders who have a pre-existing business (non-social) relationship operate under a “business logic” that prizes equitable allocations, and they are more likely to split equitably (usually unequally, trying to match equity stakes to contributions).

    That result is partly replicated in today's blog post, by the result that founding teams that include relatives (the extreme of pre-existing social relationships) tend to split equally.

    In that other (i.e., Wasserman & Marx) project (where the outcome of interest is the splintering of the founding team, in contrast to this project where we examine the financing outcome), we find that during the first few months of venture life, friends-teams who split equally seem to be more stable than friends/unequal teams, and as stable as prior-coworker teams that split equitably. However, after that, the friends-teams tend to become much less stable, possibly when the realities of the business intrude on the social logic.

    Your second point provoked some thinking about the tangible things negotiated within the team (equity, compensation, etc.) vs. the intangible things they negotiate (e.g., roles, titles, decision-making control). Each of those could provide an arena in which we can get real-life insights into those “medium of exchange” differences. Looking forward to further thoughts about this!

  5. How big of an affect did previously successful serial entrepreneurs (“PSSE”) have on the split? My gut tells me that PSSEs would have seriously unequal founder splits for subsequent ventures and that VCs would pay a high premium for these ventures as suggested here.

    I think your assessment about the equal split is right. It's a symptom of a founding team that doesn't have any experience or methodology for making the founder split so they just say #$*% it and do 1/N. If that's true, then it means the 1/N thing isn't causal which sort of takes a bit of the thunder out of things….

  6. Furqan:

    We did indeed try to get for each serial founder some indicator of prior founding success, rather than just prior founding experience. The data was too sparse for us to use, but worth trying again. The significance of our serial-experience variable would indeed suggest that serial-success should be at least as significant (though with the caveat that serial-success can sometimes introduce some of its own challenges).

    I agree that the Quick Handshake is probably more a symptom than a cause; that's the point of the last full paragraph of the original post. It's a pretty powerful symptom of fundamental problems, though, not just of not knowing how to split equity (as you suggest) but maybe of more general ignorance about (or avoidance of) sticky issues, or some other value-sapping weakness.

    Also, one possibility I've been mulling would indeed be causal: that a strong co-founder who gets a smaller (i.e., 1/N) stake than s/he deserves will be demotivated and thus not build as much value, resulting in a lower valuation. Any thoughts on this? Anyone have any other potential causal effects to propose?

  7. First, to clarify my earlier comment: I'm essentially asking: What if in certain cases (like when an exit/liquidity event is far off or uncertain), founders treat equity division more like the 'intangibles' you describe rather than the tangible that it arguably is? If the psychology of this allocation is less like splitting cash… and more like dividing up non-cash resources like respect, roles and control… it might promote a more strongly egalitarian approach to the allocation decision.

    Now, as to your suggestion that 'undervalued' founders in a 1/n split will be demotivated and build less value… I'm not (initially) convinced. Two reasons:

    1) From the psychological perspective: The data from compensation research would seem to suggest (for interdependent work, at least) that pay inequality reduces individual and team performance, and that a compressed distribution has salutary effects (cf Bloom AMJ 1999, Bloom & Michel 2002 AMJ, Shaw, Gupta & Delery 2002 SMJ, etc).

    2) From an economic perspective: It's not like founders can smoothly trade off between effort and leisure based on changes to their equity share. If I own 20% of the founder equity vs 33%, I can't make any sort of reasonable predictions about how my effort and economic outcome will be linked. (How much less effort do you put in if you want the company to be worth $80 million vs $180 million, for instance?)

    So, if I were looking for reasons that investors would assign lower valuations to firms with equal splits (particularly quick-equal), the following explanations come to mind:

    1) Opportunism: Even splits speaks to a lack of sophistication and experience in the process of assigning valuation, which tempts investors into trying to lowball the founders on valuation.

    2) Concerns about founder turnover: To the extent that equal splits signal friendship and some sort of social solidarity between the founders, I wonder if investors anticipate more difficulty with firing a founding team member. Does the 1/n split suggest that founders will resist board-led changes to the management team out of a fraternal spirit?

    3) 'Know thyself'. Does a 1/n split suggest to investors that the founding team isn't adequately aware of what each member brings to the table? Do investors want a clearer signal that the founding team knows which kinds of competence, networks, skills and experience are most valuable?

    Phew. Sort of a long comment. Sorry :)

  8. Interesting stuff. If Team Size is plotted against valuation, what does the curve look like?

  9. Greg,

    “Interesting stuff. If Team Size is plotted against valuation, what does the curve look like?”

    The funny guy silicon valley formula is:

    (developers * $500k) – (biz guys * $250k) = valuation

    I say that as a biz guy. :)

    Cheers,
    Tristan

  10. Terrific question, Greg (and entertaining rejoinder, Tristan, with its own embedded insights :->). For my current project (writing a book about all of my founder research), I plan to delve into a bunch of size-of-team analyses, and will add your question to my to-do list. I have done some initial analyses of the effects of having a solo founder vs. a founding team, but within the founding-team part, would also like to look more closely at how different founding-team sizes might be linked to various outcomes (e.g., venture growth, time to complete initial product development, team turnover, A-round valuation, ability for the founder to remain CEO).

  11. *** Any thoughts on this linkage between quick-equal splits and firm valuation? ***

    As for the above question, here's what I have in mind (excuse my grammar, I’m not a natural English speaker/writer)-

    First of all, I take it that if the valuation is lower on “quick-equal split” founders, that means that they didn’t do as well for their start up as the other founding teams. I Don’t think that the VCs noticed they had a handshake split thus lowered the value.

    You mentioned that there is a correlation between quick-equal splitters and their lack of experience. I think that a quick handshake is a symptom for inexperience and/or lack of real preparation, or real glue to the idea, before going on the “tough Journey”.
    Imagine a guy that have a great idea.
    He tells it to few of his best friends till one of them says something like “wow I like it, I want to join”. They shake hands “50%-50%” and go on their voyage… That's not too professional and I’m sure most serial entrepreneurs won't go that way.

    So that's the reason I see for negative correlation between the fast handshake and the pre-round valuation-
    It's more of a symptom for {lack of experience; lack of preparation; lack of a long process to create the dream/idea/partnership} rather than a direct reason for failure by itself.

  12. Interesting to see how your experiences line up with the original post about this, Uri.

    One new thing you add is a supposition about the VC view of Quick Handshake splits. You say, “I Don’t think that the VCs noticed they had a handshake split [and] thus lowered the value.” My observations are that VCs might indeed pay attention to how much equity each founder has, because they want to make sure the key people are incented correctly. At the same time, as discussed briefly in my “Legal and Tax Implications” note about equity splits, some VCs will only raise it as an issue if the split is way off (rather than just a little off).

    For our VCs out there: Do you pay attention to how much equity each founder has? Why? If the founders' holdings don't match what you think they should be, would you raise it as an issue? When and how?

  13. Very interesting research and comments.

    As a VC investing in companies past their startup stage (i.e. $8M+ in revenues), the relative founder equity splits are still a concern and we spend time during our diligence process understanding how they came to be.

    By the time we look at a company for investment, there has usually been enough development so that issues resulting from “quick handshakes” or disproportionate equity splits have made themselves visible. From my experience, both equity split scenarios can lead to suboptimal behavior. The initial equity split can have long-lasting effects on the company's development (well into the Series B, C, D, etc. rounds).

    Interestingly, where quick-handshake splits have been done, we often see investment documents from prior financing rounds with deal terms that are quite “investor” favorable. Indeed, much like the lower-valuation notion discussed above, it would seem that quick-handshake equity splits can also lead to founders receiving (accepting?) less optimal financing terms. This includes terms such as fully participating preferred liquidation preferences, full-ratchet anti-dilution protection, blocking rights on protective provisions, etc..

    I suspect (as others have mentioned in the comments) that this is a symptom of the underlying personas,negotiating styles, experience, etc. of the founders. That is to say, if the founders did a quick-handshake with each other to split the equity as they are conflict-averse or poor negotiators, then it would not be surprising to see this carry through to fundraising and customer negotiations as well.

    Noam, in addition to valuation did you also isolate other deal terms for “quick handshake” equity splits? Or look at subsequent rounds past the first institutional round?

  14. @Scott suggests another way (in addition to subsequent round valuation) to test whether equal-split founders have a bias toward conflict avoidance and hence fair worse in distributive negotiations: liquidation preferences. If I recall, the survey asks for the liquidation preference by investor in each round.

  15. An interesting twist here is that founder splits that are overly inequitable can also lead to scrutiny by venture investors. Lending support to the hypothesis that investors are concerned with founder equity splits (whether they be overly-equitable or in this case, under-), I was the co-founder of a startup and as part of the Series A, the investors actually required my stake to be increased. They felt the original founder's equity was lopsided and wanted to ensure incentives were properly distributed across the team.

    Of course, they did not have a “handshake” view of creating an equal split; the resulting split was still very unequal, but they wanted to calibrate it to a range that they had gained comfort as the appropriate way to motivate the team. I had to post this anonymously to preserve confidentiality of all parties involved, but this is a silicon valley startup with well-known investors.

  16. I have a general question/comment on the overall topic of founder frustrations. As a small business owner and consultant in the Baltimore region, I have had several experiences recently where founder who serve as active company managers are upset with the relative contributions of their other partners (who are also founders and managers), and frustrated by the parity of ownership among the partners. My standard approach is to suggest that the Company attempt to value the ownership position separate from the management position and to compensate each partner for each role. Generally, I propose that they recalibrate the ownership percentages based on stock or option awards, or to address the issue with differences in salary, but oftentimes my suggestion is countered by the other (less active) members/founders who stress that their return is primarily a function of their ownership position and is only peripherally related to their roles as managers. Any comments about what other founders are doing to address this issue? Is there any academic support for supporting one position (return is primarily due to the ownership role) versus the other position (return is primarily due to the management role)? Note the deliberate ambiguity of my question here . . . due meaning “owed to” or “the result of.” I will also note that I remind partners or members that they should have considered these issues when they were drafting the operating agreement.

  17. Great information thanks for sharing this with us.In fact in all posts of this blog their is something to learn. Your work is very good and I appreciate your work and hopping for some more informative posts . Again thanks !

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