No Free Ride for Free Riders

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Of all the plethora of popular economic concepts, none is more aggravating to the hard-working entrepreneur than the free rider problem. This occurs when someone enjoys the benefits of an activity without paying for it or, in the case of a start-up company, without working as hard as others. Of course, this is a problem in all aspects of life, but especially poignant when a start-up team member, having received equity compensation, reaps the benefits of a liquidation event even though their contribution to the company’s success was smaller than the others.

The free rider problem is prevalent in start-ups because we lack a model for allocating equity to the right people at the right time. The right people would be those who participate in the success of the company, the right time would be when they actually make their contribution.

The Fixed Equity Split Model

Most start-up companies use a fixed model to allocate equity to founders and early employees. In this model equity is doled out to members of the team based on what the founders think the other team members will produce based loosely on past performance and promises of future commitment. This method is widely used, yet fraught with danger when founders are forced to renegotiate equity splits when changes occur as they inevitably do in a start-up company.

For example, three founders with similar backgrounds and abilities decide to start a company and split the equity 1/3 each. One founder works hard, the next founder works really hard, and the third founder slacks off (our friend the free rider). The first two founders will eventually get tired of the behavior and attempt to renegotiate the equity split with the third. To make matters worse, there is an imbalance of effort between the first two founders creating a very awkward negotiation to say the least.

The Dynamic Equity Split Model

The solution to the free rider problem in start-up companies is the dynamic equity split model. A dynamic model allows for changes that occur during the early stages of a company’s life and allocates equity based on the contributions of each participant. Using this model, for example, the person who makes 25% of the contribution will ultimately receive 25% of the reward when it comes.

To use a dynamic equity split managers track the various contributions from participants. Contributions include not only a value for time, small investment, intellectual property, equipment and supplies, but also a premium for risk given the likelihood individuals may not get paid. A Grunt Fund is one such model. It applies a theoretical value to the various ingredients. Because start-up equity has virtually no value, a theoretical value allows managers to make meaningful calculations with regard to the contributions of the team.

Although a dynamic equity model is intrinsically fairer to participants, fixed equity splits will continue to be the norm because 1) dynamic models are a relatively new concept and 2) fixed models allow experienced entrepreneurs to take advantage of less experience entrepreneurs.