Many entrepreneurs start their business without ever discussing roles, shares, and, much less, specific terms like vesting and cliff. This common mistake can end up limiting an investment or leading a business to failure when founders do not come to an agreement on these terms.
According to Noam Wasserman, a Harvard Business School professor and author of The Founder’s Dilemmas, 65% of startups fail due to conflicts between co-founders. He states that one of the main sources for dispute among founders is the division of equity at the inception of a company, which only demonstrates the importance of creating and signing a Founders Agreement where the division of shares is reasonably justified.
During their first steps, founders tend to take the legal aspects of their company lightly, but as they start to grow, these issues need to be addressed. Before joining a company or seeking investment, I highly suggest that founders create an agreement that will provide clarity among them when faced with any situation.
Why is a Founders Agreement important?
It is a preventive measure for conflicts and misunderstandings, as well as a way to give clarity on each member’s responsibilities in guaranteeing the company’s success– including what that success means. The Founders Agreement anticipates possible situations that the company may experience in the future along with the corresponding course of action. This not only helps founders deal with the difficulties that may arise but also minimizes the risk of damaging a company and its chances of success. The agreement is also a way to reassure investors and provide transparency of the risks they are undertaking.
Where do we start?
Start by talking about the expectations each founder has for the company. It does not have to be a difficult or uncomfortable conversation, it can be a relaxed discussion among partners so that their interests can align. The sooner founders address these topics, the less risk of fallout in later stages.
To start a Founders Agreement, founders should review the answers to the following questions to create a unified vision and establish the startup’s priorities:
- What does your startup do?
- Who is it for?
- Where do you see the startup in the future?
- What are the startup’s priorities?
- What are your expectations for this startup?
- How do you measure each founder’s success in the company?
What should a Founders Agreement include?
Once the previous aspects have been settled, it’s time to put it down on paper, divide roles, and walk through the different scenarios founders may face.
Whether it be simple or complex, a written agreement is important for future reference. There’s no specific form this agreement should have as it is not a formal document, but here are some recommendations on what it should contain:
- Overall objective and vision for the startup
- Founders’ roles and responsibilities
- Under what circumstances can a founder be fired?
- How are key decisions made? (Unanimous vote, CEO has veto power, majority vote)
- What happens if a founder is not meeting the responsibilities set in the FA? How is that resolved?
- Startup dissolution
- What happens if a founder wants to leave the startup? Does the company or another founder have the right to buy their shares? At what price?
- How will the founders sell the company?
- What happens if a founder dies or becomes disabled?
- Confidentiality and non-competition agreement
- Split Equity and vesting
One of the most complicated topics to discuss is how many shares each founder will get. Of course, there is divided opinion on the best way to approach this decision.
On one hand, experts and accelerators like Y Combinator consider that equally dividing shares will ensure the same level and duration of commitment from all founders. A common mistake founders tend to make is splitting equity based on early work. Building a successful startup is a long term process, therefore, the small variations in responsibilities among founders in the first year do not justify unequal splits in what will be a long-term relationship.
On the other hand, there are those that divide according to what each founder contributes. This stance has many schools of thought. Harvard Business School, along with other renowned institutions, recommends creating different shareholdings considering that each member’s contribution is different. Additionally, in the eyes of an investor, an equal division of equity could be seen as a lack of negotiation skills.
Equal equity splits among founders
When it comes to teams where founders are at the same level of commitment in terms of time and responsibilities, there is no point in overthinking the right approach. It seems fair and logical to equally divide shares since the founders are committing to the same amount of time and effort in the long run.
Equity Split and Considering Contributions
Deborah Petersen suggests the equity should be split putting value on the roles of company partners, the founders should consider each position and the value each person will add to the company. Unequal splits usually consider a premium, taking a lower salary, and/or taking the CEO or CTO position or any member they consider deserves a special share. Wojtek Skalski proposes a slight variation to this approach which is assigning percentages by responsibilities. According to Skalski, the share should be equal to the partner’s contribution to the startup. In other words, the percentage positively correlates with the number of roles a founder plays in the startup.
Top recommendations for a Founders Agreement
In my experience, the way founders decide to split equity depends on each team. Some teams may find an equal distribution approach to better suit their situation, whereas others may opt for a division that is proportional to a founder’s contribution to the company. Regardless of the decision, here are some suggestions that will help maintain an attractive cap table for future investments and to create a successful company:
- Try to split as equally and fair as possible
- The maximum number of co-founders should be 4. If you think you need more, carefully consider the role of each member and how they add value to the company
- Always use vesting! All of the founders must have vesting (typically for 4 years with 1 year for cliff) that will help solve future discussions and claims
- Vesting should be tied to the continued participation of founders in the company, including fulfilling their roles, responsibilities, and objectives
- Keep 10% of the company for the most important employees (stock options pool)
- At least 10% is required to be considered a co-founder, less than that is a “first employee” and salaries should be contemplated
- Determine the Founder that will take on the Manager role until one is incorporated into the company
- Rights of Founders, establish if there will be a difference of rights between founders
- Consider the transfer of rights to the company in cases of intellectual property
This article is not meant to provide legal advice. It should be understood as a simplified overview for readers to consult with their legal advisors as every situation is unique.