The Case of the Deadweight Co-Founder

Episode Summary

Full Transcript

HEIDI: Welcome to The Startup Solution, and “The Case of the Deadweight Co-Founder.”

Hello, I'm Heidi Roizen from Threshold Ventures. The Startup Solution is a podcast where we unpack the “oh shit” moments faced by entrepreneurs, and then find the best ways to get through those moments alive — and, with a little luck, maybe even better off.

Founding a company is an exciting, intense time. You have a burning desire to solve a big problem, and you work day and night to turn your ideas into reality.

For some, you’re not alone on that journey. You may have co-founders — other people you’ve joined up with who also get the problem and who are equally passionate about finding solutions.

Co-founders can become your comrades, your inner circle — your family, even. They often become the most important people in your life.

But sometimes, things don’t work out with co-founders. Sometimes, they opt out and go away.

This is what happened to Claire, an assumed name per the entrepreneur protection program, but a very real situation co-founders may face more often than you’d expect.

Claire was trying to close her first round of outside capital, when she hit a snag and didn’t quite know what to do. So she called me:

CLAIRE: Hi, Heidi. It’s Claire. I’m totally freaking out about this situation with my old co-founder, Paul. It’s impacting closing our round. As I know, I told you, he resigned three months ago to “follow his girlfriend” to Belize and become a divemaster. I know he felt burnt out — it’s hard to imagine after only a single year of doing this, but whatever. It was nothing I could stop. The thing is, now the new investor says it’s crazy to have 20% of our stock sitting on a beach in Belize, and he told me I needed to fix that. Right now, I’m having trouble even reaching Paul. And to be honest, I don’t even know what I’m supposed to ask him to do once I reach him. Have you seen this before? Is there anything I can do? Uh, give me a call when you get this. Thanks.

HEIDI: Claire’s founding story is not that unusual.

She, Paul, and two other co-founders started the company about a year earlier. They were all grad students in a company formation class. They loved their idea so much that they decided to pursue it for real. So, as soon as they graduated, they incorporated their startup, and split the stock 20% a piece, leaving the remaining 20% for an employee pool.

And, as you know from Claire’s call, they were trying to raise money, but one of the co-founders had left. The prospective investor didn’t think it was appropriate to have 20% of the stock tied to what he considered a deadweight.

One thing that will become clear as we go through this case is that founder equity — or really any equity — has two important components. People tend to focus mostly on the first one — that is, that their equity might be worth something someday. However, the other important component to understand is what shareholder rights those shares convey with them — for example, being able to vote on issues, such as authorizing more shares in order to raise money, or even on whether or not to accept an acquisition offer. As you are about to see, voting rights can have huge implications, and can also be structured in many different ways.

. . .

Let’s see if we can help Claire resolve this situation and get her round closed. And while we’re at it, let’s talk about the right way to set up founder stock — and about the ways to fix it if you’ve already done it the wrong way.

Let’s start with Claire and her co-founders’ initial stock grants.

Each of the four co-founders was given their shares at the point of the company’s incorporation when they had little more than an idea and a PowerPoint presentation.

In other words, they each got a big chunk of stock before any of the real work actually started.

When I say things like this, I sometimes get pushback from founders. They argue that the act of creating the original idea and founding the company is where all the value comes from. But any co-founders left to do the work by other co-founders will quickly come to the realization: that’s far from true.

Because, actually building that startup is a shit-ton of hard, hard work!

Having the original idea and being there at the founding is certainly worth something. But it’s a whole lot less than what people should get for actually building the company.

And it’s most certainly not worth 20% to each founder on day 1.

To help solve for this, let’s introduce a concept called “vesting.” Simply put, with vesting, you still know the amount of shares in your grant on day 1. The difference is that you earn it over time — contingent on your continuing to work for the company.

A typical vesting schedule will have some initial period when nothing vests, sort of a trial period. When you hit the end of that period, which is commonly called a “cliff,” some percent of the shares vest, which means they become yours. Then, over time, the rest of the shares also vest, usually in equal monthly increments.

A common construct is a one-year cliff, with a four-year vest, which means that at the end of your first 12 months, you will get 25% of the shares. After that, you’ll get 1/36th of the remaining shares each month until the full four years have passed.

Now, you may argue that the original idea and being there at the founding are not worth zero, and that’s okay with me. If you want to grant some shares to each founder right up front, you can do that.

Or, you could write a different vesting schedule — say, for example, 10% vests on day 1, and then the other 90% follows a 1-year cliff and a 4-year vest. But, I’d still argue that you should keep those initial, fully vested grants low because most of the work is still ahead of you.

Some vesting schedules, especially for grants that occur after the initial founding of the company, may specify vesting conditions beyond simply the passing of time. For example, they may state that you’ll earn your shares only if certain milestones or business objectives are met. Vesting schedules can be creative. But in the end, they should properly and fairly incentivize people to accomplish what the board and management want them to do.

I'm going to explain how Claire might solve her problem, but I want to make one more final point on founder share allocation.

There’s no magic or requirement for splitting shares evenly among founders.

In fact, I’d argue, rarely is everyone exactly equally responsible for the company’s start — or for its ultimate success.

That said, I see this allocation often, particularly among founders who start in a class or incubator program. And, If you don’t want to have those hard conversations now, I kinda get that. Over time, you’ll have more opportunities to issue and grant new shares, including to the people who were co-founders. Eventually, those will likely become differing amounts as people perform different roles, as the company matures, and as you start aligning your compensation more with industry and market standards.

And, of course, as the company grows, hires more people, and raises more money, it will also authorize and issue more shares, which will be needed to compensate those additional employees, or sell to those new investors. Those new shares will also cause dilution — that is, there will be lots more shares than there were at the time of the original founder grants, so each share now represents a smaller percentage of the company than it did in the beginning.

So, yes, you will have the opportunity to course-correct relative ownership over time. But if you can, I’d still suggest you have those conversations up front, if something other than even Steven seems more fair to you. You’re going to go through many difficult times with your co-founders, and you need to learn how to have hard conversations together. So, you may as well start now!

. . .

Let’s get back to Claire now, to see what options she has for solving the Paul problem and getting this round done.

Funding rounds often provide the motivation — and frankly, the necessity — for cleaning up badly structured founder equity.

In this case, I suggested Claire ask her new lead investor if resetting all four founder grants to an industry-standard four-year vest would solve his problem and allow him to issue a term sheet. I suggested that she also ask to have 25% of their shares deemed vested, in order to give them credit for the time they've already worked — which also seemed fair and reasonable. The investor agreed to both of these things and included them in his term sheet.

As for Paul, because he was no longer working, the vesting reset meant that he would vest 25% of his original grant for the year he worked, but the remaining unvested shares would return to the company to be used for other employees in the future.

Of course, next, Claire needed to talk with Paul and the other co-founders to explain why this was a reasonable approach and necessary for clearing the funding roadblock. She hoped that everyone would feel okay about their equity being brought to the same industry-standard terms.

And as for Paul, she hoped he would see this as a reasonable outcome for him, too. After all, she hoped he would rather have a smaller piece of something that may become valuable, instead of 20% of a sure zero. Without funding, the company would not be able to continue.

Of course, some Pauls don’t agree, and then a lot will depend on the legal constructs of control and voting that had been put into place beforehand.

So before I tell you what happened when Claire talked to Paul and the other founders, let’s talk about a few other ways Claire might have been able to solve the problem, depending on the control and voting rights in place.

In some cases, the remaining three founders may have the control to make these changes whether Paul likes it or not. Some companies have voting restrictions that company equity financing agreements can only be voted on by those common shareholders who are still providing services to the company — with certain exceptions under the law. Some companies also have voting proxies that delegate the right to vote shares to particular individuals.

These are some of the constructs I’ve seen — and again, it is best to talk to an experienced attorney about what you should consider when you found and fund your own company. But remember, these should be put in place at the time when the shares are issued and when the company goes through its first equity financing. You can’t just go back and remove rights you gave out in the past with no process.

There is yet another way to potentially solve this problem, though again, it depends on the voting rights that would have already been in place.

If Claire can’t “un-vest” Paul’s stock, she could instead authorize a bunch more shares. By doing so, each founder’s prior grant would go down percentage-wise, as all those new shares flood the denominator of all shares outstanding. This would solve the new investor’s issue by reducing Paul’s percentage ownership. Then, Claire could provide new grants to herself and the other two remaining co-founders with some of those shares and put those on the vesting schedule the new investor wants to have in place for the three of them — which is, again, pretty industry-standard.

As with everything else we’ve already talked about, this type of action may have its own legal and business risks. The ability to do this is subject to both who controls the board and stockholder voting power. And even if you have the voting power to do it, it might not be the right move, for cultural and other people-related reasons. I bring it up because this is a potentially viable option — but I recommend that if you are considering this move, you should weigh the pros and cons and potential collateral effects, very carefully.

Back to Claire: As I said earlier, her new investor was okay with simply resetting the existing grants onto an industry-standard vesting schedule. He was also okay with giving everyone a year of vesting for the work they already did, and then canceling the remainder of Paul’s grant, since he no longer worked for the company.

Luckily, Claire was able to reach Paul. He got on a call with her and company counsel and asked for a thorough explanation of the rationale. He thought about it for a day and then agreed to the changes. He agreed that how he was being treated seemed fair to him in relation to how the other three founders were being treated. And, while he now has less stock, the stock has a much higher chance of being worth something someday, with the new capital this change enabled.

As for Claire and the other two founders, they didn’t love what felt like a give back of shares. But they also understood the rationale, and talking to other founders they knew, they learned that this was actually a pretty common thing to do in the course of a funding round. The experience with Paul helped them understand that these large allocations needed to be earned over time, and since they were all being treated equally — and as it was also a requirement for getting new capital — they agreed to reset their vesting as well. The financing moved forward, and, should they all continue to work together, there will likely be more grants in their futures as well.

. . .

So, what can you learn from “The Case of the Deadweight Co-Founder”?

First, starting and growing a company is hard work over years of time. While being there and contributing to the original idea does have some value, the bulk of the value will be contributed over time. So, it’s best not to give away all the founder stock upfront.

Second, using industry-standard stock vesting provides a way for founders to continue to earn stock at a steady pace, as they continue to contribute to the company’s growth and success. And if they leave, it naturally stops.

Third, while everyone focuses on stock because of wealth creation, stock can also carry voting rights that can be very important, especially when the company faces critical decisions like fundraises or M&A. Understanding voting rights and how to best design them to suit your goals is critical to do up front at company formation and funding times.

Which leads me to my final point, which is: It is really worth it to work with an attorney experienced in startup equity plans and voting and governance issues to sort all this stuff out.

. . .

And that concludes “The Case of the Deadweight Co-Founder.” For the record, this situation is real, but Claire and Paul are composites. And I want to thank the very real attorney Alex Kassai at Cooley for helping me sort through these complicated issues.

Thanks for listening to this episode of “The Startup Solution,” a podcast from the venture capital firm Threshold Ventures. We hope you have enjoyed this episode, and if you have, please leave a rating or review in your favorite podcast app. I’m Heidi Roizen.

Further Reading

Good article on co-founder departure/firing

Personal story of cofounder split with his learnings from Brett Fox 

 Forbes article on founder departures  

Previous Episode