Why the “contributor model” is a better, less risky, more flexible, and more equitable approach to a startup than the traditional fixed-percentages model
By Sarah Davis, Grant Henderson, and A. J. Sharp
7 February 2014
The issue of how to assign ownership of a joint startup venture is, at first glance, a tricky one. How does a group divide up “nothing” such that the division remains fair when (we hope) “nothing” becomes “something”?
Usually, this problem is resolved by simply assigning percentages of ownership to each “founder” based on (let’s be honest) shot-in-the-dark guesswork as to each person’s future performance and value to the venture. Most startups choose this approach for one or both of two reasons: (1) It provides certainty, something that is in short supply at the beginning of any venture; and (2) no other approach seems to be available.
However, as is readily apparent (and as most startup participants can tell you from experience), this model, while commonly used and easy to implement, is outrageously inflexible and risky, and almost invariably leads to conflict once the venture is up and running, particularly if it is even moderately successful.
The potential risks and inflexibility are easy to see: the percentages assigned may bear little or no resemblance to the actual relative contributions of the founders, and will generate resentment when each founder compares his perceived contribution to his share of the pie. What happens when one industrious founder begins to wonder why he is receiving 30% ownership when he is doing most of the work, while another founder is receiving the same (or more) for doing next to nothing? Unfortunately, as the equity assignment is legally binding from the start, this setup is inflexible when the actual contributions become clear.
In fact, the fixed percentages model is a recipe that rewards slacking and penalizes ingenuity and effort, and actually encourages the failure of the startup as a whole. It’s a question of incentives. Each founder is guaranteed a certain percentage of the result—no more, no less—regardless of how much effort that person puts in.
Remember the group assignments (with one group grade) in school? What always happened? The majority of students contributed nothing, while one or two GPA-minded kids did all the work—and the slackers got the grade those few students actually earned. The exact same incentives apply to the fixed percentages model for a startup — one person does 75% of the work for 30% equity, while others do little or nothing but maintain their respective shares. Unfortunately, in a startup (unlike in a school project), the contributions of one or two people are generally insufficient to succeed. The fixed percentage model is a recipe for failure of the enterprise.
The fixed percentages model also creates problems of “deadweight equity” – the founder who leaves in the initial stages but still owns a significant percentage of the enterprise. This situation tends to scare off potential investors, as a portion of their investment is guaranteed to be eaten up with no potential return.
Startups that employ this model then are forced to rely on various Band-Aids (such as vesting, reverse vesting, or buy-back rights) to ameliorate problems that should have been avoided in the first place.
So how can all of these issues be avoided?
The answer is so simple it will surprise you: the contributor model.
This model incorporates the general idea behind virtually all compensation packages everywhere (other than in startups)—that compensation must be earned, rather than based on guesses about future performance and value. Here is how it works:
Each founder agrees upon an hourly rate for time worked, say $100 an hour. The hourly rate of each individual is determined by his current market rate and an appropriate risk multiplier. Shares are then “paid,” at that hourly rate, in exchange for work performed. Work a lot, earn more shares. Slack off, earn fewer shares. Leave entirely, stop earning when you hit the door - but keep your shares earned, without creating a problem of deadweight equity.
This approach offers several significant and obvious benefits over the fixed percentages model:
The contributor model is designed for startups from day one up to the day of external investment - the period during which startups are most severely (and often fatally) damaged by the risks and disincentives inherent in the fixed-percentages model. When the startup receives external funding, the ownership percentage of each contributor is set according to the relative (and earned) share-holdings at that point in time.
The contributor model requires contributors (especially the original or key founders) to continuously track and document their work performed for the startup. This admittedly requires focused effort from those involved and a commitment to professionalism from the earliest days of the startup. But anyone who will not take a startup seriously enough to put forth that effort should not be founding a startup.
We will post a standardized contributor agreement in the next week, along with a more detailed explanation of its key terms and features, including hourly rates, control, and tax treatment. Ideally, the contributor model will be implemented from day one, but it can be adapted to suit the needs of most pre-money startups.
We've been using the contributor model with great success in our own startup. If you have any questions about the contributor model or how you can make it work for you, we're happy to try to help out with answers. Email
Grant is an entrepreneur whose own experiences led him to the concept of the contributor model. Sarah and A. J. are business-minded attorneys who find ways to make things work properly the first time.
© 2014 Grant P. Henderson, Sarah M. Davis and A. J. Sharp