Issues with Equity Misalignment

Q: In our startup we have 4 founders, two of whom are not full time.  We’ve all put in a good sum of cash thus far.  The two founders with the least equity happen to be the two tech founders.  Some of us feel that we made a mistake when allocating shares in the beginning – there is one founder in particular who does not do any work, and he has the second-most equity (the split goes like this: 32%, 26%, 10%, 7.5% with the rest for employees + advisors).  To me, it seems like any outsider would see this as a big disparity and wonder what happened, but one of our guys (Mr. 32%) seems to think that if we can get funding, the VC will correct this wrong.  I’m rather doubtful of that – what VC will want to fund a team that didn’t have the foresight to motivate the biggest contributors and keep them interested?  I’m looking to convince him that we need to fix our own mistakes before pursuing funding.  Am I off base?

A (Brad): You aren’t off base. Furthermore, this is a common problem and one of the reasons I strongly encourage every founding team to have four year vesting on their stock.

While some founders thinks this simply gives future investors a way to claw back equity in the future, it’s much more often the case that this protects the founders from each other, in cases like this or situations where one of the founders simply leaves.

In your case, you feel like the 32% founder doesn’t do any work. If your other two founders believe this also, the three of you should directly confront Mr. 32% right now. Don’t wait, don’t defer, don’t let more time pass. Deal with the issue – up front and directly. It’s an easy thing to solve – if you all agree (including him) that he should only have 15% of the company, then he can simply forgive (or give back – the mechanism will depend on how the company is structured) 17% of his equity. Then, each of you will end up with an increase of your pro-rata percentage of his equity.

If you have equity alignments early in your company, deal with them. Don’t let them fester.

  • AJ Bruno

    Good question and answer. One small correction, the not “doing any work” guy is 26% equity. Is there a preformation period with cliff vesting? Can you vote him down? Is it majority, unanimous, or some other voting method based on equity that can correct this?

    • If the vesting and cliff isn’t defined up front, it doesn’t exist.

      Depending on your charter and articles of incorporation, the majority can make changes to the equity structure. This can be tricky so make sure you have a lawyer involved, but it is a possible approach. You can also do this informally just by agreeing to it (and documenting it) – of course, the “not doing any work” partner has to agree as well.

      • AJ Bruno

        Thanks Brad. Picked up the 2nd edition of Venture Deals yesterday as my team is part of DreamIt Ventures winter cycle. Looking forward to the read.

  • This is an issue that is often overlooked by first time founders. The first two times I was a co-founder we ignored this. The first time it worked as I founded the company with my brother, but the second time it was a mess and we ended up keeping people on board even when the fit was bad because the shares were immediately vested.

    Certainly avoided that mistake with the third company.

    In general I’ve learned that when it comes to the legal framework/documentation of a company things that as a first time founder I considered non-important actually were of great importance.

    It’s not just vesting schedules that are critical but most other documents as well such as NDAs, non-compete (non-solicitation) agreements, contractor/consulting agreements, IP assignment, etc.

    Best to get them done immediately and the right way from the start because the damage that can occur without them grows exponentially as a company gets older and becomes successful.

    • Extremely well said. It’s important to take all of this stuff seriously at the beginning. A good lawyer who knows how to do startups can be very helpful here. If you get it correct at the beginning it wil save you a lot of grief down the road.

      • techbyproducts

        Is it normal when starting a company and dividing up % equity to leave a sizable block (say 20%) that can be used later when hiring on more employees, or is the 100% typically just divided equally among say 3 co-founders, and then when it comes time to hire more employees and offering equity packages to take percentages of equity from the co-founders to give to these new employees?

        • Either works since the unissued options just “disappear” if the company is acquired and they are outstanding. I most often so the equity fully allocated between founders until there is a new investor. Once a new investors shows up, the option pool generally becomes part of the financing.

          • techbyproducts

            Thanks for the insight. I actually started out as an employee and transitioned into a third co-founder as I was given a few percentage points of equity, but I believe all of us would now be diluted equally if/when we take on outside capital. Is this a normal practice, should I be diluted in this case? I was actually given the equity when I was still considered an employee.

          • Yes – you should get diluted when outside capital comes in.

  • At what point is it right to have a lawyer draw up a contract? I’m working through a prototype and have an agreement of understanding with my partner (on email) while we get to version one (with vesting, etc). Should we spend the couple K to get a formal contract written now?

    My hesitation is just that this prototype is an experiment, not yet a company. If I/we like where its headed, then we certainly will go the route of incorporating, etc. Wondering if we should get the legal expertise now anyways.

    • jasonmendelson

      I might be biased given my background, but most of the issues that I see happen exactly at this very beginning, pre lawyers. I don’t think it can ever be too early to consult a lawyer when starting a company

      • I live in Boulder. Anyone in particular you’d recommend?

        • jasonmendelson

          All the small firms are great.
          Stigler Wussow
          Stack McKinney,etc

          This is not an exhaustive list.

  • Brian Maguire

    “At what point is it right to have a lawyer draw up a contract?”

    Day one!

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