While there is no agreement over exactly how, there is widespread agreement over the value of forming some sort of agreement among company founders — sooner rather than later in the life of the company.
The power of these sorts of agreements may be as much a function of the conversations that are had in order to put these conclusions into place as it is a function of the formal agreement/document itself. The goal of the conversation/agreement is to have an open and honest discussion of the attitudes, fears, and aspirations of, as well as the arrangements among the individuals involved with the startup in the hopes of minimizing the likelihood of debilitating surprises later in the life of the company.
This note will focus on four key issues that are common to these agreements: ownership, responsibility, decision-making, and operating procedures. Sometimes, the matters of decision-making and operating procedures are bundled into a single issue. More formal and legally binding versions of these founder agreements will undoubtedly address a range of subjects in addition to the four discussed below.
ROLES AND RESPONSIBILITIES
The matter of roles and responsibility to the venture involves answering the questions of what each individual will do, for what they might be responsible, and to what extent they might be responsible (particularly in terms of time). While it can be common for founders to play broad roles in the early days of a firm, it can still be beneficial to designate the more significant role any individual might play.
Designating Founder X as responsible for managing the finances of the firm will not, necessarily, reduce that person’s role to only the finances of the firm. This designation, however, can help support the condition that when torn between two tasks—one of finance the other of development—this individual should focus on and take responsibility for the finances while another individual should focus on and take responsibility for development.
The roles that founders play may change over time. Therefore, this initial designation of role/responsibility should not prove to be unchangeable. Instead, build into the decision-making procedures the means for redefining roles.
DECISION-MAKING / OPERATING
An important feature of this agreement covers the method through which both simple and substantial decisions should be made. In other words, which sorts of decisions can be made by a single individual and which sorts of decisions should be voted on by the group of founders. If a vote occurs, does everyone have an equal vote (regardless of their proportion of equity) or shall voting procedures align with the distribution of shares. In the case of a split vote (50% on one side of the decision, 50% of the other) will anyone have the deciding vote? If so, how is that person determined and how shall that decision be made?
One truly uncomfortable decision that should not be left uncovered revolves around the “firing” of any of the founders. If three people are involved, the risk always exists that two founders might organize and vote out the third. If possible, consider and define those circumstances under which you would all agree that the ouster of a founder ought to be on the table (e.g., the misappropriation of funds or the failure to meet certain milestones).
Beyond raw voting procedures, founders might desire to explicitly state certain values or other factors that ought be considered when making decisions.
Certain subjects of decision-making, such as hiring/firing employees or buying equipment, may be considered so likely to occur—or likely to occur regularly—that the founders may wish to just explicitly agree to their preferred course of action rather than vote upon each instance of these common issues. Alternativley, the operating procedures in the agreement might be so intertwined with the decision-making components that the two dimensions would be dealt with as if the same.
For example, it might be agreed that all purchases of equipment less than $25 can occur without consulting another founder. Or that all new hires should be interviewed by each founder, with a decision to hire conditional upon a unanimous vote.
Furthermore, it can be helpful from the outset to make clear what happens in the case of certain simple, if not hopeful events—such as making a profit! Do the founders want to distribute any profits equally, or have a vote over whether profits should be further invested in the firm or distributed and how?
The question of ownership is, at the most basic level, a question of who owns how much of the initial equity in the company. That said, this equity-based measure of ownership can also signal—explicitly or implicitly, intentionally or unintentionally—opinions about who’s decision carries the most weight, and who’s actions contribute how much to the value of the venture.
Any attempt to determine the “best” way to divide ownership at the outset of the firm’s existence is most likely futile. A web search on this subject, however, will make it clear that the experience of futility has not prevented many people from believing that some “best way” does or might still exist.
Instead of shooting for the perfect split, consider the question of “Why?” and “Under what conditions?” when determining who gets what. Furthermore, leave some room for your inability to get this slitting challenge perfectly correct. Spare yourself the agony of the optimization attempt. Assume some best split might exist, but that ideal can only be known in a world of perfect foresight or unlimited do overs. Since we don’t live in that world, we might as well act accordingly.
The founders of nonprofit corporations will not likely find themselves daunted by the issue of ownership of the firm, given how the assets (or the value of the assets) of these firms ought be distributed under federal or state laws. The conditions of employment, rewards, and credit will still apply, however.
Rule of N
The most common method for splitting ownership is known as “the rule of N,” or more specifically the rule of 1/N, where N is the number of founders involved. In this method, the founders simply split the equity equally among each other from the start. For example:
Four founders are involved in the birth of ACME Inc.
N = 4
1 ÷ 4 = 0.25
Each founder is granted 25% of the company’s initial shares or units.
An advantage of the rule of N method is the ease of implementation. Only in the case of an odd number of founders will you find yourself not knowing what to do with a few leftover shares/units (e.g., try to divide 1,000,000 by 3 and get an integer as the result).
A disadvantage of the Rule of N method can be its inability to (a) adequately address other issues of “fairness” that will peek out at the edges of the conversation, or (b) account for any changes in the founding team after this initial split it made.
Contributions of effort or capital
Another method for splitting ownership involves a consideration of effort and/or capital (whether financial, intellectual, social, or some other type) that has been or will likely be contributed by the founders. For example:
Founder A brings to the firm the idea, a key design, and $20,000 of initial capital.
Founder B brings their willingness to work hard.
A greater proportion of the initial shares/units might be granted to Founder A, in compensation for the value of their idea, design, and money.
An advantage of the capital/effort contributions method is that it can more directly address the subtle subject of “fairness,” if not the more concrete subject of contributed financial capital.
A limitation to this method can be your capacity to anticipate whether future contributions of ideas, effort, and even capital will conform to the initial designation of equity. Furthermore, the conversation around the value of different types of contributions—like ideas and connections—can, at times, get at least slightly complicated if not very contentious.
Vesting or milestoning
You have more flexibility in the initial ownership decision, however, than some concrete designation of ownership from day one. Vesting simply involves the right of the firm to buyback shares contingent upon certain described conditions.
Conditions that might determine the grant/buyback of shares could include such factors as: the passage of time, the accomplishment of certain tasks, or the occurrence of certain events. In fact, many vesting agreements condition these right upon the passage of time.
For example, a founder’s unrestricted ownership of shares might fully vest over the course of four years, apportioned in monthly increments after the first anniversary of the company. This sort of agreement might sound something like:
All Founders to own stock outright subject to the Company’s right to buyback these shares at initial purchase price. This buyback right applies for 80% of Founders stock for the first 12 months after this Agreement is signed by all parties; thereafter, this right lapses in equal monthly increments, at the end of the month, over the following 48 months.
In this case, the company holds the right to buyback 80% of any founder’s shares during the first year. However, as each month passes during the second, third, fourth, and fifth years of a founder’s affiliation with, or employment by the firm, the proportion of shares the company has the right to buyback would be reduced. That reduction would be by 1/48 the shares the company could buyback starting at the end of year one. In all cases, the company buys the shares back at the initial price the founder paid for their shares.
Another, perhaps simpler way of thinking of the above would be that this founder faces a five year vesting period. The proportion of shares the company can buyback decreases by one-fifth at the end of each calendar year: 4/5 throughout year one, 3/5 at the end of year two, 2/5 at the end of year three, 1/5 at the end of year four, and finally 0/5 after the fifth year finally completes itself (i.e., five years and one minute).
In this example, the company’s right to buyback a founder’s shares would not expire until after five full years, or 60 (12+48) months and one day.
Total number of shares owned by founder: 100,000
Number of shares company can buyback…
Day one = 80,000
Day after sixth month, second year = 80,000 – (6/48 * 80,000) = 70,000
After four years and one day = 80,000 – (36/48 * 80,000) = 20,000
After four years and one day = 100,000 * ((5-4)/5) = 20,000
For tax or other reasons, the buyback approach described above is often preferred over the use of restricted stock unites. Please speak with your favorite lawyers and accountant about these issues.
Departure and dis-ownership
One dimension of ownership that can be but should not be overlooked is the issue of departure — the course of events that unfold if someone decides to leave the venture. Vesting and milestoning features in an agreement address the issue of departure, in part, by conditioning ownership according to time spent with, or things accomplished for the firm. What an individual might do with their shares upon departure, however, is not addressed through vesting/milestoning conditions.
You may chose to restrict whether or how a departed founder can sell their shares. For example, you might include a condition that limits any sale of founder shares such that the firm has the first right to buyback such shares before their sale to any other outside individual or entity.
Frankly, while a small group of founders may not be overly concerned with the vesting of shares, or the sale of those shares by departed founders, professional investors will more than likely be concerned with these issues. As a result, even after you make your initial agreement among the founders subsequent investors may prefer to introduce a new agreement covering these sorts of issues.
LEAVE NO (BIG) STONE UNTURNED
Most importantly, as the founders get together and discuss the issues of an agreement amongst themselves, don’t limit yourself to the confines of some template you found online (like the one you are reading now). Talk openly about whatever issues each individual believes should be on the table. This discussion should lead to a better understanding of not only each other, but also any gaps that exist in skills and aspirations.
Frankly speaking, this discussion can (and likely will at times) get a bit awkward. Pay close attention to how you individually determine and collectively resolve both the seemingly small issues as well as the so-called “deal breaker” issues.
If the shit hits the fan and can’t be easily cleaned up, take a break and take the fan out of the room. Don’t bring the fan back into the room until everyone has had the chance to think on their own and on their own schedule.
For further reading:
Broadwin, D. (2010). Founder Agreements – Vesting, Vesting and more Vesting. High Contrast.
Shah, D. (2006). Top 10 Critical Startup Co-Founder Questions. On Startups.
Simeonov, S. (2010). Startup founder agreements. High Contrast.