During a routine conversation with a client and business owner, I noticed a signed photograph on his desk. Two months earlier he had been invited to speak at the opening of the Global Women’s Network event founded by Laura Bush, the former first lady. The trio of smiles, the business owner, former President George and Laura Bush, testified to his rising profile.
Last year, he presented at the Forbes 400 Summit on Philanthropy in front of the 400 richest people in the US, including Warren Buffet, Bill Gates, and Mark Zuckerberg. He has also been invited to mentor startup founders alongside the executive teams of Pinterest, Air BnB, and Facebook. In addition, he was voted among the most creative people in business by Fast Company magazine in 2015.
As the interim CFO, I function as his strategic thinking partner, I run the numbers, supervise HR, and examine the risk and legal side of the business. It’s my job to make the CEO and the business look great and to free up his time to promote the company.
It’s no surprise that the vast majority of co-founders don’t finish together
I’ve observed firsthand a different 80/20 rule in action. In fact, it’s the 80/20 rule squared. 96% of the glory goes the #1 person and 4% to the rest of the cofounding team.
Many business startups with 2-3 co-founders find themselves in an awkward situation. The founder, who’s been made CEO, has her face on the cover of Entrepreneur magazine. Meanwhile, the other egos on the team get bruised because every month they feel less and less important.
It’s no surprise that the vast majority of co-founders don’t finish together. After about 4 years, 50% of founders have been removed as CEO and of those, 75% were fired. Co-founder ‘prenups’ now exist to protect the company should one of the founders leave still owning a large stake in the company.
As promised in last month’s article, I’ve returned to the equity section of the balance sheet to analyse founder/owner’s equity and employee equity. This will be the first foundational step to understanding equity and raising capital for scaling your company.
Should I Co-found or go it alone?
1 in 7 ventures are solo-founders. They are the supermen and women doing it all alone. Typically, the solo-founder prefers having full control of decisions and doesn’t have a strong need for mental support. Prior to starting her business, she has developed deep financial, social and human capital to tap into as she grows her company. She can effectively communicate with others and can create accountability outside herself.
On the other hand, the founder who wants a team of co-founders, desires to quickly build the biggest, highest impact venture and knows he can’t do it alone. He understands his weaknesses and wants to add to his skills and community around him to support him in his endeavours.
Co-founders should be prepared to open their kimono in front of the team. They should be prepared to share everything, from family history to personal financials. It’s therefore wise to spend time working on side projects together first and see if their styles are compatible.
Wealth Versus Control Dilemma
Noam Wasserstein, a Harvard Business School Professor, wrote the definitive book on this topic. It’s called the “The Founder’s Dilemma: Anticipating and Avoiding the Pitfalls That Can Sink a Startup”.
The basic premise states that there is a direct trade-off between control and the size of your business. If you want to create a larger, higher valuation business you will cede control as you divvy up the equity of the company between your co-founders. On the other hand, if your main desire is more control, you will tend to build your company alone and you’ll end up with a smaller valuation company. You are the king but of a smaller kingdom.
Companies in the technology and life sciences industries, where speed is of the essence, will almost always go with a team of cofounders. Famous co-founders include, Steve Jobs and Steve Wozniak (Apple), Bill Gates and Paul Allen (Microsoft), and also Peter Thiel, Max Levchin, and Elon Musk (PayPal). Naturally, there are exceptions such as Mark Benioff, the founder and CEO of Salesforce.com, who owns €3B worth of Salesforce shares.
When you join a start-up, you expect to receive some level of equity ownership so that when the company is sold or taken public you participate in its financial success. Employees are typically given stock options that convert in the future into common shares.
Why issue equity?
Having your employees be co-owners is core to the startup culture. As the founder and business owner, you want to incentivise your staff in line with the bottom line of your company. You also want them to feel that every euro spent is a euro out of their own pocket. This mindset shift is dramatically different from being a corporate employee.
If they’re at dinner entertaining a new client you want them to stop and think whether the €45 bottle of wine will taste just as good as the €90 bottle, because 3% of that is now their personal money.
It’s up to the business owner to decide whether she wants her employees to participate in the success of the company. Early on, it can sometimes be difficult to not only pay yourself, but also to pay your staff market rates. Adding an equity incentive will allow you to retain their services. Even when you have a healthy net profit and are paying market rates, you may still face the problem that your best people will leave if they see no additional upside coming from their hard work.
Target ownership levels
As you contemplate how much equity you’d like to give key employees, recognise that different factors influence how much equity is expected.
Firstly, founders will have a much higher equity ownership than non-managing staff. Secondly, if you’re located in developed startup cultures like Silicon Valley, Stockholm, Tel Aviv, London, or New York City, you’ll have to give up higher levels of ownership due to the competitiveness to attract and retain key employees. Thirdly, the type of industry you’re in and the role of the employee will also impact the percentage.
Giving equity to the core founding team is more an art than a science
Each founder will tend to have at least 20% ownership in his company to compensate him for the early risk and providing sweat equity. Non-founder employee equity will tend to be around 10%. Once the founders leave that amount will increase to the 20% mark for top executives.
Giving equity to the core founding team is more an art than a science. Once you’re past that stage and are hiring to scale your company, you stop giving equity based on whole numbers such as 5% or 10%. Instead, you start issuing equity based on your company’s valuation and a formulaic system you have chosen to adopt.
Should the equity be equally disbursed among the founders?
Execution has greater value than the idea. You must resist giving a disproportionate amount of equity to the founder that is credited with coming up with the idea for the company.
Typically, a co-founder team is quite well balanced and if everyone is 100% committed, then the allocation should be equal. The whole team is necessary for execution.
There are exceptions. For example, you have a great idea for your first company and you invite a co-founder to come alongside you to build it. You’ve chosen wisely as your new partner has already successfully sold 3 companies for a combined sum of €100 million. In so doing he has developed deep relationships with venture capitalists and when the time is right can quickly access millions of euros of funding. His value to the company far outweighs yours. In this situation it’s likely your co-founder will demand a larger split of the equity and that would be reasonable.
Securities used to issue employee ownership
Although there are many different types of securities that can be issued to founders and employees, I will only mention the two most common:
‘Founder stock’ or ‘restricted stock’ is given to the founder(s) and early team members. It will have vesting provisions typical to options, but triggers immediate taxable income to the recipient. It’s therefore only given early on in the startup’s life when the stock isn’t worth much or a senior executive is hired that can handle the tax burden. When the employee leaves, the company has the right to repurchase the unvested stock.
The reason for the vesting provision is that the company must have control of how founders and staff sell their vested stock. It must be done in an orderly and structured manner. The key is that the company doesn’t want the sale of shares to conflict with any capital raising/share issuance efforts. If they happen simultaneously, the capital raise will be undermined. These special vesting provisions for founder stock can also be applied to early stage investors, such as angel investors.
‘Stock options’ are the most common type of securities issued to staff. This option gives an employee the right to purchase common stock at a time in the future at a set price. Options are issued at “fair market value” and therefore are not taxed. They are a great way to compensate employees. However, beware that when you do exercise your options, you will get taxed. It’s wise to seek professional advice as to the size of your potential tax bill prior to exercising.
A friend of mine who left a medical device startup after 3 years has decided to return his stock options to the company. He has the usual 90 days in which to exercise his options into shares after his final day at the company (this is a typical timeframe that companies mandate for exercising stock options). Even if he exercises the options, he will own shares in a private company he can’t monetise until there’s an exit event such as an IPO. The tax bill he would receive would require him to take out a loan to pay for it. To solve this problem, Pinterest recently decided to allow people to exercise their options for up to 7 years after leaving the company.
Here is the difference between founder stock and stock options: when you’re issued founder stock, you own the entire amount immediately, but are restricted to a repurchase right the company has on the unvested amount. When you’re issued stock options you don’t own any of them initially, but earn them according to a preset schedule over a period of time.
Founder stock has many other rights that are written into the founding documents, in addition to vesting. One of these is having the ability to accelerate the vesting schedule upon a sale of the company. This right should be avoided. Another is having ‘dual class voting’ founder stock, which allows for class A shares to have 10 votes versus only 1 vote for class B shares. Facebook is known for having this as it allows Zuckerberg to fend off activist investor attacks and make decisions with a long-term view. The other rights are beyond the scope of this article.