When you initiate a business with a co-founder, you must deal with the toughest question: Who gets what?
Breaking the startup pie, or the equity, is not about mathematics, but more about trust. Misjudge it and your relationship may collapse. Get it right and you establish a long-term basis of success.
During my time in startup deals in the past five years, I have observed that great ideas fail due to founders being messy with their shares. I have also observed that complicated deals can also strengthen a company. This guide will also take you through the most important concepts: vesting, cliffs, and tax traps that all founders, be they in Silicon Valley, London, or Berlin, should be aware of.
It is not a brief introduction; it is your handbook to a fair, enforceable, and tax-intelligent equity structure on day one.
The Right Split: How to Divide the Pie
You must determine the percentages before you are even concerned with vesting. Though it may seem like 50/50, it can be the biggest mistake of the new founders.
A 50/50 split creates a deadlock. When you and your co-founder cannot decide on a big issue, such as raising money, selling the company, or dismissing a good staff member, there is no one to resolve the tie. This prevents the company from proceeding.
The idea is to shift to a 51/49 or any other setup that has one individual as the final vote. But who is to have the extra slice?
Key Factors for Equity Allocation
In order to make a case of equity split, you must take into account five fundamental components. Divide according to how much value each of the founders brings to the table nowadays, and how much they are going to work tomorrow.
- Idea and Initial IP (Intellectual Property): Who was the brainchild? Who assembled the prototype or developed the first code? This gives the initial value.
- Money Contributed (Capital): Did either of the founders contribute cash to start-up costs, such as servers or incorporation costs? This contribution should be identified.
- Time Commitment: Are all of them full-time? A full-time founder needs to get more equity as compared to a part-time founder who will join full-time later.
- Ongoing Role and Value: The CEO may be slightly more equity, as the position presupposes dealing with investors and establishing the overall level of vision, which can be burdened with unusual responsibility.
- Risk and Opportunity Cost: Is one of the founders leaving a well-compensated position to begin this business, whereas the other was seeking a change? The risk assumed should be captured.
Practical Tip from Experience: The most prevalent and effective method that I have come across is the simplified point system or online equity calculator serving as a guide to the discussion. Do not simply follow your gut sense. Document why you landed on 55/45 or 60/40. Such a record eliminates future disputes.
Understanding Vesting Schedules (Crucial for Fairness)
The most important idea in founder equity is vesting. It is equivalent to receiving your shares not as a lump sum but as a built-up amount.
Consider it like this: When you incorporate the company, you are normally given 100% of your shares on the spot. There is, however, a repurchase right of the company on those shares. This right lapses, or vests, based on a schedule.
The Standard 4-Year Vesting Schedule
Most startups around the world, particularly those looking to be taken seriously, employ a 4-year vesting schedule.
- Period: 48 months (4 years).
- Release: The shares are vested every month or quarter-to-quarter within those 48 months.
Why it Matters: When a founder quits within one year, he or she does not retain 100 percent of the shares. They retain only the percentage that has vested (25 percent in this case). The rest 75 percent is returned to the equity pool of the company.
This system will ensure that all the founders have to devote time and effort to the business to retain their stakes. It defends what remains of the founders as well as the worth of the company in the future against someone who becomes enthusiastic, quits in six months, and retains a big share of the company.
The Cliff: Your First Big Milestone
The companion of vesting is the cliff. There is a time constraint, a minimum service period, over which no shares will vest.
What is a 1-Year Cliff?
A standard in the industry is a 1-year cliff. Here is how it works:
- You are the one who initiates the company and signs the vesting agreement.
- You work for 12 months. No shares have vested yet.
- At the anniversary date of the first year (day 366), 100 percent of the shares do not become vested. This is normally 25% of your total allocation.
- The rest of the three years is vested monthly (or quarterly) after the cliff.
| Event | Time Served | Shares Vested |
| Start Date | 0 Months | 0% |
| Day 365 (Cliff) | 12 Months | 0% |
| Day 366 (After Cliff) | 12 Months + 1 Day | 25% |
| Month 13 | 13 Months | 25% + (Remaining 75% / 36 months) |
| End of Vesting | 48 Months | 100% |
The Purpose of the Cliff: The ultimate test of commitment. When a founder departs or gets fired prior to the one-year mark, they go away with nothing. This basic principle spares companies a conflict over the worth of a small step in the short term.
Tax Traps: 83(b) Election (The US Founder’s Secret Weapon)
The United States has a complicated tax law in regard to equity, yet there is one area they cannot dispute the Section 83(b) Election.
This is the most frequent and hazardous deadline missed in my time drafting US formation documents.
The Problem Without 83(b)
In the case where you are given shares upon which there is a condition of vesting (i.e., they can be revoked by the company), the IRS treats this as a risk of forfeiture.
Failure to file the 83(b) election will subject you to tax each time part of your shares vests. Why is this bad?
- Year 1: Your company is worth $100,000. Your 25% that vests is worth $25,000. You pay tax on $25,000.
- Year 4: Your company is worth $10,000,000. The final quarter of the vested 25% is now worth 2,500,000. In the same year, you are required to pay income tax on the amount of 2.5 million, although you have not sold the shares, and you have no cash to settle the bill. This is a massive tax bomb.
The 83(b) Solution
The 83(b) election allows you to inform the IRS: I would like to be taxed now, based on the full value of my shares, though they have not vested.
Because the value of the company is typically extremely low (perhaps $10,000) at the beginning, you pay a small tax bill now. As soon as you make this payment, there is no taxation on the rest of the vesting. You get taxed at the lower capital gains rate when you later dispose of your shares at a later time, rather than the higher rate of ordinary income.
The Deadline is Real: You have to submit the 83(b) election to the IRS within 30 days after your receipt of your shares. Practically, there are no exceptions to this rule. When you have missed it, then you cannot go over again.
Lawyer’s Insight: In establishing a business in the US, you will want to create the 83(b) document before the incorporation. Is it that important? The 30-day clock begins to tick as soon as your shares are issued to you.
Global Founder Tax Basics: UK and EU
Although the 83(b) election is a US-based item, in the UK and the European Union, the founders have to navigate their taxation environment. The principle is the same: the local tax authority desires to tax the disparity between the low price you have paid for your shares and their fair market value.
The United Kingdom: EMI and Valuations
Another highly desirable scheme that can be offered by the UK to some early-stage companies is the Enterprise Management Incentive (EMI) scheme.
- EMI: This is a tax-favored alternative compensation plan that is used to assist small companies in attracting and retaining staff. Although it is predominantly an employee-oriented plan, in most cases, founders design their equity to conform to EMI or equivalent tax-beneficial treatment.
- Share Valuations: You have to agree with HM Revenue and Customs (HMRC) on the market value of your shares in the UK by getting an official valuation. A valuation determines the strike price of any options. The idea is to make the value low at the beginning so that you can receive as much advantage as possible in taxation at the later stages.
- Vesting: It is standard, but you are taxed upon vesting (when you get options or shares), depending on what scheme and having options or shares. When you purchase shares at a low price, your gain is generally taxed in the future as capital gain, which is mostly a better result.
The European Union: Options vs. Shares
The EU is not a single taxing jurisdiction; thus, the local rules are diverse (Germany is not the same as France, which is not the same as Estonia). There is, however, a common theme, which is the use of stock options to postpone the tax event.
- Stock Options: Founders are usually given options to acquire shares in the future instead of acquiring shares. This is common since you do not tend to pay any tax until you exercise (buy) the option or sell the resultant shares. This will save the payment of paper profits without cash.
- Founding Shares: In case you purchase shares at the outset, most EU countries demand that you pay tax on the difference in case the shares are found to have a higher value than the one you paid for them. It should be well documented and of low and justified value.
- The Key Advice: All founders will be required to seek advice from an accountant or a lawyer in their respective country within the EU. Tax regulations on the contribution to social security and capital gains are local, and they can cause significant issues when violated.
Drafting Your Documents: Shareholder Agreements
Vesting schedules and tax elections are useless without being duly written and signed. This information is part of two fundamental documents:
1. The Shareholder or Founders’ Agreement
The following is your partnership constitution. It determines the way you work, the way you settle conflicts, and what occurs when a person departs.
Key Equity Terms to Include:
- Vesting Schedule: The date of commencement of the vesting, the vesting term (48 months), and the precise cliff term (12 months).
- Treatment on Exit: What is done in case of a founder being fired because of cause (bad reasons, such as stealing) versus voluntary or without cause.
- For Cause: Generally, the company may buy back all the unvested and vested stock at a very low price (which is often the purchase price).
- Without Cause: The founder normally retains all vested shares.
- Buyback Rights: Provides the company with the right to repurchase the shares of a founding member in case of departure. This is required to regain equity.
- Drag-Along and Tag-Along Rights: These safeguard the founders and investors in case of a sale.
- Drag-Along: A majority shareholder (usually a major shareholder) can use these to compel a minority shareholder of a company to sell his or her shares in an acquisition.
- Tag-Along: This protects the minority shareholders, who will participate in the sale at the same price and terms as the majority.
2. The Restrictive Share Purchase Agreement
This is the document that makes the vesting real. At the time of being issued shares, you will sign this agreement and thereby establish that your shares will be liable to repurchase by the company according to the vesting schedule.
It is the legal system that makes the entire mechanism work. In its absence, the vesting schedule is only a handshake between you.
Semantic SEO Focus: Addressing Founder Concerns
To transform this article into the final resource, we will answer the rest of the exact questions founders are asking:
“Can I Vest Faster Than 4 Years?”
Yes, you can. Although 4 years is the norm that people will consider as a sign of commitment among investors, you may have a 3-year or even a 2-year timeline. But making it too short is a sign of not being committed in the long term and may make investors concerned when you seek to raise funds. I would recommend sticking to the 4-year standard before you have some specific reasons to alter it.
“What About an Advisor’s Equity?”
Options or restricted stock units (RSUs) should be provided to the advisors, rather than founder shares. They tend to have shorter vesting (1 to 2 years) and a significantly shorter cliff (perhaps 3 to 6 months). They are frequently paid in accordance with the FAST (Founder/Advisor Standard Term Sheet) arrangement, which implies 0.25 to 1.0 percent equity, contingent upon the role.
“How Do I Vest Shares After an Acquisition?”
This falls under a legal term known as Acceleration.
- Single Trigger Acceleration: Each of your unvested shares becomes immediately vested in the case of an acquisition. This hardly happens nowadays since it motivates the founders to sell the business at an early stage and exit.
- Double Trigger Acceleration: It is the standard of the industry. Your shares not only accelerate (vest) under two conditions:
- The company gets acquired (Trigger 1).
- You are dismissed or fired in a very short term (e.g., 12 months) following the acquisition (Trigger 2).
This will guarantee you a certain amount of job security once the sale is made, but you cannot cash in early and leave the new owners without key leadership.
Final Summary and Action Steps
The most appropriate approach is splitting equity, outlining vesting, and managing cliffs right to ensure a better future for your company and save your partnership.
- Avoid 50/50: Have a tie-breaker. Split based on contributions (IP, cash) and future roles.
- Mandate Vesting: The normal 4-year vesting with a 1-year cliff. It is the most optimal founder insurance.
- US Founders: Filing 83(b) Election 30 days or less, no exceptions.
- UK/EU Founders: Immediately consult local tax guidance to see the optimal structure (e.g., EMI, options) to reduce your future tax bill.
- Sign Documents: Have all the terms written down into a formal Shareholder Agreement and make it enforceable with a Restrictive Share Purchase Agreement.
This is an indication of a professional, serious startup. Now is the time to establish your base so that you can concentrate on working on the business in the future.
Disclaimer: The guide will be founded on the general principles of startup legal and tax, and my experience in the field. It is informational in nature. Each situation of any country, state, or company is different. In all matters relating to equity or tax, you need to seek the advice of a competent lawyer and tax consultant in your respective area of jurisdiction.
I also write regularly on Medium. If you’d like to explore more of my work, you can read my articles there.
