Founders and Equity
This question has come up in several conversations I have had lately with folks who have sought my advice on “how to structure” their bright shiny new startup.
How do I allocate equity? Assuming there is more than one of you. If there isn’t, you might rethink your idea. Ask Paul Graham about that (and if you don’t know about Paul and everything he’s up to, time to dig in).
Over my career, both as an operator and an investor, I have been involved in everything from very traditional venture-backed deals to very non-traditional deals to self-funded efforts. While they are all different (and vary by region of the country or even state you are in), some common themes hold true for all of them.
{ This missive also assumes you are seeking outside money }
I can’t say there isn’t a mistake I haven’t made because there is one right around the corner for anyone who is doing this…Some things can only be learned by doing; no amount of education or coaching can teach the needed lesson as precisely as having the experience.
Failure is the best teacher. And the most painful one.
And, hopefully not fatal.
Getting your equity structure right is the first and most important part of setting your company up for success. I have a couple of simple rules for founders:
Titles matter: Founder or co-founder is as real as the value you create with it. If that takes the form of returns to investors (see above), that title is your ticket to the rest of a real entrepreneurial career.
Everyone vests equity, everyone*: I don’t care what you’ve done. Watch their feet, not their mouths — more on that below.
Must be present to win: If you cannot add value (see above) and you are asked to leave, you only carry with you what you were present for against your vesting schedule*. If you go before the end of the first year, you get nothing.
Companies are not democracy’s: Someone has to be able to say, “I hear what you are saying, but we are doing this.” Or, in the words of W, someone needs to be the decider.
Everyone should get paid**: To live a reasonably healthy life, you fortunately or unfortunately need money to live. So as a founder or co-founder, pay yourself. Not an exorbitant amount, but not poorly.
Here is an example of a base structure; we’ll call the company “BobCo” (a Delaware Corp.) for the purposes of this exercise. You can insert your company name and build your own cap table based on your circumstances.
Again, we are assuming you will be raising outside capital, which determines a couple of things:
- You will be diluted.
- There is a different level of pressure inherent in taking outside dollars.
- You have only a couple of endpoints, sale or IPO being the two most likely.
For purposes of this exercise, let’s assume two co-founders, and one of them clearly has the idea. ***
Off the top, you take 20% of the company and stick it on the sidelines; for this exercise, I am going to use shares vs. percentage (either works early) and assumes that 100% of the company is (ten million) 10,000,000 shares. The math is just more straightforward.
Two million shares (20%) are set aside for an employee pool, and from which you can also draw shares for advisory positions, Board compensation, etc., and most importantly, to recruit and retain top talent for your organization as you grow.
Assuming that the co-Founders (or the Founder and his or her co-founder) agree to the split of the balance of the 8,000,000 outstanding shares (80%) — which if you cannot agree on this core piece of the company, perhaps you should not work together.
Founder Bob gets 5,000,000 shares (50%), co-founder Betty gets 3,000,000 (30%) shares — ideally on a version of the above on some version of the suggested notion of vesting above.****
You have a cap table that looks like this:
This is before you take any money or set your value. Clean.
From there, you will set your value, determine how many dollars you will raise (here I used a Seed round of $2M as the example), and post those dollars; your cap table will look something like this:
From there, you will set your value, determine how many dollars you will raise (here I used a Seed round of $2M as the example), and post those dollars; your cap table will look something like this:
Welcome to dilution! The founders went from owning 100% of the company to owning 83% (41.67% for Bob, 25.00% for Betty, and your employee pool is down to 16.67%, respectively), and the investors now control 16.67%. Those investors also now have a Board seat and a voice.
And in this scenario, the company got $2M of working capital.
Many companies don’t make it past this point. Again, another series of posts, or better yet, look here.
But if you are doing it right, things get really complicated from there, and you move this whole mess to Carta:
Ok. We’ll stop there for now.
We didn’t cover off on several essential pieces. Valuation. Preferred stock. Geographic differences in fundraising (including the Valuation), Y Combinator (and everything like it), “Those investors also now have a Board seat and a voice.” which seems like a casual line is an entire discussion unto itself. Lots more to contemplate.
FOOTNOTES:
{* vesting should be a minimum of 1 year, ideally 3, 50% of your total equity at your first anniversary, the balance allocated monthly till full vest at the end of the third year — with a change of control provision}
{** “put your mask on first, then help the person next to you” — even if you are in a position to not get paid, your work has value, and you should be paid. That said, not too much. And if you hit the dreaded ‘end of the runway’ and you have equity, you are the first to stop taking a paycheck.}
{*** There are several related posts (yet unwritten)on why 50–50 is just a bad idea, period, and the difference (if you are doing it right) between your equity ownership and that equity’s role in the companies direction.}
{**** There is another school of thought that all “founders or co-founders” should share the equity equally (less the 20% holdback for the employee pool) — it’s really about what everyone can agree to.}
m
@hellomarko
