How to Divide Stock Among Founders
Chapter Nine Excerpt: Startup Muse available from Amazon
Most startups guarantee their failure moments after their birth by making one or both of these mistakes. The most common mistake cofounders make is over-optimizing the division of control and ownership. Less common, but more common than you might suspect, are the cofounders who decide to “trust” each other and delay memorializing their agreements. Cofounders who make either mistake are dooming their companies — period.
In the startup world the most ironic thing you can say to your partners is probably “trust me”. The problem is that when you’re starting a business the realities on the ground change so quickly that relying on the honesty or fairness of your cofounders, partners, investors, or vendors is a big mistake.
The coin of the realm in the startup world is trust — but it is also table stakes — you’re not going to get in the game or invite anyone to the game who you can’t trust in the first place. The most common reason partners, especially when forming new companies, delay documenting their agreements is because they don’t agree. More frequently than you’d imagine founders table important negotiations because negotiations are uncomfortable. The parties trust each other, but what they don’t realize is that what seems “fair” in the present can be very different from what was fair in the past or what will be fair in the future. Don’t start before you agree.
The advantage of negotiating and documenting things before getting started building your company is that the important issues of ownership and control are settled before things get complicated. Pascal, the famous mathematician, observed that “Things are always at their best in the beginning.” What Pascal realized is that time exponentially increases the variables that make solutions harder and harder to calculate. Ironically, when it comes to starting companies, the simplest answer is not only the easiest to calculate it is also almost always the best answer.
During the course of a startup’s life the contribution of each cofounder will be perceived differently over time. If you wait until after you get started the ‘fairest’ division of ownership and control may be very different than what seemed fair when you started. This distortion is bound to create conflicts and more often than you might imagine result in threatened or actual litigation. Setting up the company BEFORE you get started is the safest thing for all involved — failure to do so, IMHO, dooms your company.
STARTUPS ARE BINARY
Startups are typically binary — they either work or they fail — they’re also fragile 90% + end up failing no matter what. Given this fact, spending a lot of time trying to figure out the optimal allocation of ownership and control in an early stage company is a fool’s errand. In my experience finding a way to create circumstances where the parties are equally yoked is the safest way to get started. If cofounders attempt to allocate ownership and control based on their perceived past/ present/ future contribution the company will almost certain fail.
There are a million ways a startup with unequally yoked cofounders can fail. For example, imagine a scenario where a developer/ founder owns 75% of the company because he’s the one building the application. The business/ founder owns 25% of the company because he isn’t really doing that much while the application is getting built. Once the MVP is launched the business/ founder is able to raise $ 5M from a venture capital firm. The partner from the VC knows a great developer from another company he funded and suggests you all bring him on board. The developer brings more and more of his colleagues on board and in short order the developer/ founder is moved into an ‘architect’ role and isn’t really writing much code. The business/ founder is now bringing on customers in rapid succession. The VC realizes that the developer/ founder’s contribution and value to the company is in the past and that the business/ founder’s contribution and value to the company is in the present and future.
The VC courts the business/ founder and foments upset regarding the unequal division of the company. The business/ founder is clearly the one adding all of the value and yet he only has a third of the equity that his cofounder has. The division isn’t fair and the VC has an idea to make things fair — the VC with the cooperation of the business/ founder creates an option pool and issues share to the new developers and the business/ founder. Suddenly the business/ founder has twice as much stock as the developer/ founder. The developer/ founder is upset and hires a lawyer. The lawyer threatens a lawsuit and the company, on the cusp of success, is distracted from their core mission. This is only one possible scenario.
The more common scenario to befall unequal distributions is ‘effort allocation’. Using the previous example, the business/ founder will often limit his effort to 25% of whatever he perceives the effort his developer/ founder is expending. Perversely, the developer/ founder will notice the lack of effort by his cofounder and reduce his effort in response. Their effort allocation is on a slippery slope and it isn’t uncommon for one or both parties to start side projects outside of the company to help equalize their upside. The original business is starved by the cofounders and will most certainly fail.
If you want to give your startup a fighting chance, negotiate control and ownership on Day One AND make sure the division is equal. Realize that there is a reason each cofounder is sitting at the table and that your best chance of success is for all of you to win or fail together. The most likely outcome is failure — don’t select that option from day one. If you don’t feel comfortable sharing in the possible spoils of the business with your cofounders don’t get into business with them in the first place. Also, another pro-tip is entering into a voting agreement with your cofounders — this is a side agreement (not included in the organization documents) that requires that you all vote together or not at all — this will make it hard for third-parties to drive wedges between you in the future. At the end of the day you should design a system where you all succeed or fail together.