Fifteen Points To Consider When Startup Founders Split Equity
There is no sustainable model for equity splits among Founders.
It’s always unfair. And its just one of the innumerable unmanageable risks of launching a Startup.
Plan for emergencies, plan for catastrophes.
Startup Founders may experience life changing circumstances that makes the risks of a Startup unbearable.
Founders may have a gradual change of heart fueled by self-doubt and pessimism.
Founders may burn out and fail to make meaningful contributions to the venture for months prompting the other Founders {and the VCs} to ask the underperforming Founder to improve performance or face termination.
Good Founders are, in fact, rarer than good Startups. Good VCs heavily scrutinize the relationships and agreements of Startup Founders because they know that the Founders are the most important part of the Startup.
This document provides guideposts for Startup Founders who are concerned with laying the proper Foundation for a smooth functioning Founder relationship.
Leadership-the Startup founder that distinguishes herself/himself in regard to consistently acting as a dynamic catalyst forging new ideas, teambuilding, consensus building, project management, administration, networking, and business planning should receive additional equity consideration.
Relationship-in instances where your Cofounders are relatives {not recommended}, friends, classmates, or coworkers {highly recommended} it is customary for equity splits to be based on attributes that pertain to personal affairs and not business matters.
Just remember that baseless, arbitrary even splits are, in fact, the most uneven splits of them all. Make decisions that are justifiable by facts.
Risk-founders often differ in regard to marital status, financial background, annual income, career prospects, etc., etc., therefore, the question of personal risk arises:
How does the risks involved in a Startup affect my personal life?
Is the risk proportional among the Founders?
How can we create risk parity among Founders?
The presence of significant risk variance among Founders creates a situation where additional equity can be rewarded to Founders shouldering the greatest risks. Such Founders are compensated additionally because they may experience significant tangible and intangible losses in the interim period prior to a successful exit, if and when that occurs.
Disproportionate risks occurs whenever an experienced senior executive in good standing becomes a Founder in a Startup with three grad students. The senior executive works for one of the leading public companies in a fast growing market. She/He has six children and two homes.
All three grad students live at home with their parents. Most serious seed stage Startups offer very limited salaries, if any. The senior executive takes on far more risks than the three grad students, therefore, justifying a consideration for additional equity.
Cash Contributions-when Founders provide funds to a Startup at the onset of its formation, the funds must be repaid with equity as part and parcel of the equity split agreements {This method of handling the repayment of Founder cash contributions is straightforward. Other ways may require a legal opinion, CPA review, and the filing of ancillary paperwork. Moreover, complicated corporate structuring may act as an impediment during the VC funding process}.
POC (Proof of Concept) Role-the Founder that plays the greatest role in developing and testing the prototype should receive additional equity for completing the Startups’ Solution or Service.
Business Strategy Role-when a Startup offers a Solution identical to others in the market, then the significance and value of the business model and strategy increases dramatically.
At the onset of the Startups’ formation, the Founder that contributes a sustainable business model and strategic direction that is agreed upon as being unique, valuable, and executable by all Founders can be granted additional equity.
Prior Work Experience-Founders that have significant work experience in areas that are specifically analogous to the Solutions produced by the Startup should receive additional equity consideration.
Quality Of Network-Founders that leverage their previously existing network of relatives, friends, former classmates, and professional colleagues to generate contacts and leads that results in financing, strategic partnerships, sales, etc. must receive additional equity.
Board Role-Founders that have previous experience as a Board Member and plan to play a dynamic role in forming the Startups’ Board should receive additional equity consideration.
Management Role-Founders playing roles in senior management positions must receive additional equity due to the arduous and complicated nature of the CEO, COO, and CTO positions in seed/early stage Startups.
Performance-Founders substantially increases the probability of their Startups’ success when they work diligently to maintain an ownership culture centered on performance.
Founders can not be exempt when it comes to vesting equity based on performance.
Founders that perform well in regard to their day to day contributions and the longevity of their tenures must receive additional equity from an equity pool reserved for rewarding both Founders and Employees for outstanding work.
Duration Of Tenure-Founders should be rewarded for the duration of their tenure.
An Employee Founder {one of the first hires who becomes a Founder by virtue of distinguished work and dedication} becoming part of a Startup during Series A or later funding rounds should not receive equity that makes him/her an equal stakeholder with Founders that have been with the company since inception.
Early Departure Buyout Provisions-It is best to anticipate and prepare for the departure of a Founder.
Founder departures happen often and can be a protracted distraction potentially costing the Startup significant losses in morale, sales, and User sentiment.
Departing Founders should not receive cash settlements of any kind, this would be unnecessarily dilutive to other shareholders and place undue burdens on the company.
When Founders leave they should take a portion of their restricted equity with them as long as they adhere to a set of predetermined specified legal requirements for departed Founders, such as non disclosure agreements, non-competition agreements, gag orders, and the like.
Forced Departure Buyout Provisions-it is necessary to have an agreement to govern the how’s and why’s of firing a Founder {Founder Flip}.
To take the emotional sentiment out of your decision-making it is crucial that Founders establish a Founder Flip protocol to govern the process of compensating a Founder for past contributions.
Founders must decide what percentage of restricted equity is suitable for fired Founders to keep after departure and prolonged adherence to a set of predetermined specified legal requirements for fired Founders, such as non disclosure agreements, non-competition agreements, gag orders, and the like.
Vesting Provisions: Time-Based versus Milestones-Based-Founders must decide what type of vesting policy will govern their Startups.
Usually, vesting is either time-based or milestones-based.
Under a time-based vesting agreement, Founders remaining with the Startup for a period of at least four years would vest all of their stock, usually distributed upon a periodic schedule {monthly or quarterly}.--If the Startup reaches an exit prior to four years then the equity would vest at the close of the M&A or at the end of the restricted period for IPOs.
To the contrary, Founders in a Startup vesting equity under a milestones-based scheme will only vest if the Startup achieves certain predetermined milestones such as sales, market growth rate, cash flow, market positioning, etc.
Gerald,
Thank you. This is an unusually helpful article on the topic of founder agreements and considerations. The rest of the posts on this blog are also unusally conclusive, practical and actionable. I hope you continue writing on the subject of startups.
Posted by: Deena | Tuesday, 19 December 2006 at 03:02 PM