Rarely does a week go by for me without experiencing yet another conversation with an entrepreneur or cofounder team addressing the question of how to divide up ownership of their startup business. Rather than just spew advice, I begin by probing with a few questions.
How many of you cofounders are there? Whose was the original idea for the business? Did one of you do the preliminary planning or technical creation, thereby serving as the “principle cofounder”? Looking forward, do each of you have clear roles? Have you discussed, and reached preliminary agreement on, the proportion of the business that each of you should own?
Then we talk about some baseline principles.
First, whether your business is formed as an LLC or a corporation, the same constructs can apply. What are called shares in a corporation are called member interest units in an LLC, but you can accomplish the same thing with either legal form.
Second, let’s separate founders’ shares from investment shares. In other words, let’s figure out what proportion of the founder’s equity – that is, what proportional ownership of the startup company – each of you ought to own based on what you bring to the table independent of money. (Investment dollars can be handled separately.)
Then I ask whether the cofounders have considered working out a prenuptial for entrepreneurs. Inevitably, they laugh; but I’m dead serious.
Let me illustrate through the example of an imaginary startup:
Alejandra, Will and Jess are cofounders of a new social networking business – stealth code-name “Spook” (Social Program Only Open on Krypton…. don’t ask) based in Cleveland. Nobody’s quit their day jobs yet, but all three are working diligently evenings and weekends to try to get Spook off the ground. Alejandra is the rainmaker who came up with the concept, sketched out her original vision in a mockup tool so she could express it to others, and talked her longtime friends Will and Jess into tentatively joining. Will’s got an IT background and is applying his tech knowhow to figuring out how to build the product rapidly and at low cost; the trio sees his ongoing role as chief technology officer. Jess just completed her MBA from Michigan’s Ross School of Business and has previously worked in startups, though never in a founding role; the team anticipates Jess serving as the business’s marketing and business development lead.
As I interview Alejandra, I uncover the following thoughts and concerns: a) She feels as if she would have launched Spook with or without Jess and Will, but is tremendously more comfortable doing so with her two cofounders on board. b) There’s a fair argument that she should have more of the founders’ shares than the other two, since she’s the originator of concept. c) On the other hand, she’s very grateful to her friends for joining up, and doesn’t want to offend them or scare them off by demanding a disproportionate share. d) Alejandra knows that if they actually launch Spook, she will be dedicated to seeing the business through. However, in the back of her mind, she’s wondering whether her cofounders might feel the need to jump ship and go find a day-job if their startup hits tough times – leaving her without their support, but still with them owning lots of founder’s stock.
To accommodate this scenario and Alejandra’s concerns, we discuss an entrepreneurs’ prenup, as follows:
1. You cofounders discuss and mutually agree as to what is a fair way to split the founders’ equity. For instance, is one-third / one-third / one-third fair, or would it be more fair to acknowledge Alejandra’s “lead cofounder” role and grant her a larger share? Let’s say the team agrees to Alejandra (40%), Will (30%), Jess (30%).
2. To give us some concrete maths do deal with, let’s say we capitalise the company with 1.2 million founders’ shares. Therefore the founders’ share allocations are Alejandra (40% or 480,000), Will (30% or 360,000), and Jess (30% or 360,000).
3. You all own your founders’ shares up-front, as of the day you legally form the business. However, in order to protect each other from one of you departing early from the venture (or, stated differently, to incentivise each of you to stay with your startup through thick and thin during the early years), you place what we call a reverse vesting schedule on your shares. Let’s say it’s a 3-year, straight-line vesting schedule. The way this works is that each quarter, each of you vests on an additional portion (one-twelfth) of your shares until you’ve vested on all of them. If, for whatever reason, you leave the company prior to full vesting, you keep the shares on which you’ve vested to-date, but the other, unvested shares are recaptured by the company and effectively evaporate. If, for instance, you depart after one year, then the two-thirds of your shares that remain unvested would be cancelled out. (They wouldn’t be distributed to the other cofounders – they’d simply go away.)
4. Alejandra, because you came to the table with the original idea, we’re going to say that one-quarter of your founders’ shares, or 120,000 shares, are vested up-front. Then, just like your two cofounders, you will vest quarterly on the balance, or 360,000 shares, at a rate of 30,000 shares per quarter, for the next 12 quarters or three years, as long as you stay with the company.
5. We agree that for all of you, your unvested shares vest immediately in the event of shareholder liquidity – either sale of the company or an IPO. (If you have the happy option of a lucrative exit before your 3rd anniversary, let’s not have any perverse incentives for one or more of you resist until your vesting is complete.)
Obviously, any given team can establish their own prenup parameters, based on their own agreed-upon rationale. For instance, should the beginning split of shares be different? Should different cofounders have different amounts of shares vested up-front, and if so based on what rationale? Should you have provisions for accelerating vesting of a given person’s shares based on non-time-based considerations? (These could be different targets depending on the cofounder, such as product release-related milestones for the CTO, and successful fund-raising or sales milestones for the business lead.)
But let’s look at what this kind of entrepreneurs’ prenup gives you as a founding team. As with a marital prenup, negotiating such an agreement disciplines you as partners – at the beginning while you’re good friends and enthralled with your startup – to reason through what should happen if the partnership doesn’t hold together as planned. It’s a healthy thing to do. And if you design your prenup intelligently, you don’t have to anticipate every eventuality; you simply need to set up a thoughtful framework.
In our “Spook” example, what if there had been no prenup, and after a year Will fell in love and moved to Fiji to become a surfing instructor, but kept all 360,000 of his founders’ shares? It’s likely that his cofounders Alejandra and Jess would have felt a bit abused, as if Will had left them in the lurch. On the other hand, with the prenup in place, they could feel happy for their old friend Will, and happy for him that he was walking away with 120,000 vested shares – after all, in that first year, he had helped them get their product off the ground and recruited a technical team. At the same time, his cofounders would likely feel relieved that they’d recaptured the other two-thirds or 240,000 of Will’s unvested founders’ shares. Will, meanwhile, could feel at peace: he’s following his heart, while walking away with a well-earned chunk of founder’s shares that’s proportional to his contribution.
With the prenup, because Will’s 240,000 unvested shares would be retired with his premature departure, this would amount to a so-called reverse dilution event for the two remaining cofounders – that is, there would now be fewer outstanding founders’ shares (only 960,000 instead of the original 1,200,000), resulting in the remaining cofounders each owning a larger slice of a smaller pie. So while they may dearly miss Will and his contribution moving forward, Alejandra would now own not 40% but 50% of the founders’ equity, or 480,000/960,000. Jess’s stake would rise from 30% to 37.5%. And Will would walk away not with 30% but with 12.5%. Not bad all around.
Going into a startup, there are so many things that we cofounders can’t anticipate. But negotiating an entrepreneurs’ prenup is a clear-eyed way of building in flexibility so that both our friendships and our business can remain whole regardless of how life plays out.
Jim Price is a serial entrepreneur and Adjunct Lecturer of Entrepreneurial Studies at the Zell Lurie Institute at The University of Michigan Ross School of Business. ©2012, James D. Price.
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