Xu Xiaoping: Three Core Principles of Startup Equity Design

Xu Xiaoping’s three core principles of startup equity design. First: hold a large stake without standing alone. When good friends start a business together, it is difficult to discuss who should get more shares. Two people? Split 50:50. Three? Make it 3:3:3. No hard feelings. But such structures reveal one thing: the team has no leader. A startup faces enormous uncertainty every day. Nobody knows the next step, and founders are very likely to disagree. Someone must be the leader, or the business cannot move forward. At the same time, the leader’s stake must be “large without standing alone.” Competition today is intense, and starting a business alone is almost certain to fail. You need genuine partners fighting alongside you. If you hold 98% and two others hold 1% each, they are not really your partners. Why would you choose people ninety-eight times weaker than you to build a company together? If they really are that weak, the problem is still yours: you cannot attract strong partners. What should you do? Find at least one partner with a double-digit equity stake. The second founding shareholder’s abilities should merit a stake of 10% or more. How much exactly? Depending on abilities, 6:2:2, 6:3:1, 5:3:2, or 7:2:1 can all work, but the largest shareholder should hold at least 50% and the second at least 10%. That is a large stake without standing alone. Second: earn before receiving. What if you misjudge someone? You give a person 10%, then discover they are unsuitable. Should you take the shares back and give them to a new partner? That is a serious misconception. The 10% is not “given” to the partner on day one. It is gradually “earned” over four years. This is what we often call “exercising rights” (vesting). The 10% stake is this cofounder’s irrevocable “right.” But only after one full year of satisfactory service can a quarter vest, amounting to 2.5% equity. After two years, 5%; only after four years is the entire 10% earned. If, at the end of the first year, you find the person unsuitable or they decide to leave, they can take the 2.5% they have earned. The remaining 7.5% is recovered. This is “earn before receiving”: aligning contributions and equity fairly so the startup can develop healthily amid change. Third: add rather than take away. If founders divide all the shares at the outset, what happens when a strong new person arrives? Ask the founder and cofounders each to surrender some? That is another serious misconception. Once shares have been granted, they cannot easily be taken back. Doing so would severely damage the team’s morale and confidence. What should you do? Add rather than take away: expand an “option pool” instead of reducing early shareholders’ shares. Suppose your company is valued at 10 million and the partners divide it 7:2:1: your portion is 7 million and the others’ portions are 2 million and 1 million. You want to bring in a new partner whom you consider as important as the second partner, whose stake is worth 2 million. What do you do? Do not say, “I will give up a few percentage points, and you should too.” That is taking away. You can instead issue options over 2 million additional shares specifically to the new partner. That is adding. Most startups reserve a 10–20% option pool on day one. This approach gives the company considerable flexibility in allocating equity as it develops. You can even use the pool to adjust the ownership proportions among founders.