How you apportion equity in the first year of your start-up can come back to bite you later. Marcel Aucar
As a start-up entrepreneur I’ve made lots of mistakes. But one mistake irks me the most – because it can’t be rectified. I fell into it at the beginning when, surrounded by a group of friends at a cafe, I formed my first company, Posse. Five years ago I didn’t know anything about building a technology business. I wasn’t confident the idea would work and, in the interest of spreading the risk, I asked a few friends for help. I wrote a plan and called a breakfast meeting at a local cafe. Over eggs and coffee, I scribbled on the back of a napkin who’d be responsible for what and what percentage we’d each own of the company.
Six months later, my friends had disappeared. Our idea hadn’t exploded as we hoped. They weren’t prepared for years of low-paid hard work. One decided to travel, another became a parent and needed a stable job. But five years on, they still hold significant shareholdings in the business and we’re no longer friends.
This is a common mistake. I often meet enthusiastic new entrepreneurs on the cusp of launching their company. When I ask about their ownership structure they say something like: “I own 50 per cent and the other 50 per cent is split between my friend who’s building the technology, a woman who’s doing the graphic design and a guy who’s going to run operations and raise the money.” Six months later we’ll meet again and at least one person has almost always left the team. The remaining members work hard to launch the business and waste energy and time fighting to get the quitter off the cap table. This destroys friendships and creates animosity that will haunt the life of the company.
Rick Baker of Blackbird Ventures says his firm will not invest in a company where the entrepreneurs have upfront ownership. Instead, they insist on “founder vesting” – founders must earn their shares over time. “Most start-up teams will not survive the first year intact,” says Baker. “As investors, we’re backing the founders to run the business. If we invest $1 million or $2 million and someone leaves after six months but keeps all the equity, then that’s a bad situation for us and for the rest of the team. We need to make sure everyone is committed.”
A founder exiting early creates problems for the life of the company. “It’s a huge distraction early on and even worse when you get 10 years in and the company is worth a lot of money. The last thing you want is a founder who left at the start still owning 20 per cent of the company – that’s just crazy.” Baker says it can be hard to convince founders they need to plan for someone leaving. “Everyone thinks that this isn’t going to happen, but the numbers tell a different story. Even the best entrepreneurs get stuck with problematic exes – just look at Facebook.”
The standard requirement for Silicon Valley and top-tier local VCs (including Blackbird) is for founder shares to vest over four years with a one-year cliff. Team members are allocated a proportion upfront but only gain ownership of their shareholding if they remain with the company. A founder who leaves in the first 12 months gets nothing; they earn 25 per cent at the one-year mark and the rest monthly for the remaining three years. If the CTO in my earlier example was allocated 20 per cent, but left after two years, then she would leave with half her allocation. The team could part ways amicably and without lawyers.
I wish I’d put this structure in place when I started my company. At the time, I was so infatuated with the glorious future of our idea that I couldn’t imagine anyone giving up. No one wants to think about a prenuptial when they’ve just fallen in love. I also didn’t want to haggle about shareholding because it seemed silly. The company hadn’t launched so it was not worth anything. Why argue over 30 per cent of nothing? But a company does have value at the start. It’s worth the years of energy and intellect the founding team is prepared to invest. When I think of the five years of work and perseverance I’ve committed to our business, it’s clear this level of commitment was an asset at the beginning.
Many people have been involved in making our company a success, and some provided far more than their shareholding reflects. As a founder, it’s important to value people who contribute generously. There’s nothing more frustrating than wanting to reward hard-working superstars with shares but being restricted on account of a few who did very little but happened to be around at the right time. Next time I start-up, I’ll ensure everyone (including me) earns shares over time. This is a fair structure which rewards those who build the business.