If you’re thinking about starting a company with someone you know, this is a must-read. I will help you to avoid some of the very common startup pitfalls and guide you as to how to split equity among cofounders. This page details the goals, risks, and structure of what I’m calling The Fairest Founder Collaboration Agreement™. You can download the agreement for free at the bottom.
Or, you could just make up numbers or split up shares evenly, right? But that’s a very carefree way to start something so serious.
Don’t Read this If…
…you have already distributed equity among your cofounders. This will just make you sad.
Why You Should Listen to Me
I’ve used this agreement in two instances and seen it used in two more (as of February 2014). At least two of the companies created under this operated to the point of receiving investment.
(What’s more significant is the list of companies that didn’t get started. When negotiating this agreement caused heartburn, I knew that was the wrong team to co-found a business with.)
Before tackling this founder collaboration agreement, you should already understand the following principles:
- Relative ownership of a startup is split among cofounders at time of incorporation. If this is fuzzy, and you’re in Boston, go to a Capital Network meeting, or Google “founder’s stock” until you get it.
- Dilution of ownership occurs when capital is raised, when stock options or warrants are granted, or when stock subject to vesting is vested. If this is fuzzy, google “dilution.” Bottom line: whatever percentage you assign in the FFCA is only going to get smaller.
Do you Want to Be Rich or King?
Noam Wasserman at Harvard Business School wrote a book that you should read, The Founder’s Dilemmas. He talks about a host of issues relevant to pre-incorporation startups. The most important of these, I think, is the decision you have to make between wealth and power.
Entrepreneurs who seek to become rich have to create value beyond what their own effort can produce. They must therefore give huge responsibilities to a great many skillful people, and they must offer real value to those people, in terms of stock ownership, to incent them to work hard. Ultimately, this transfer of responsibility to others may result in the entrepreneurs being fired from the companies they helped to create. They walk into that with open eyes. But because their aim is to create a real business, with real profitability, they take such actions knowing that their vastly diluted founder’s stock will become worth a great deal.
Entrepreneurs who don’t consciously choose wealth, by contrast, probably default to what drove them out of the corporate world in the first place: the desire to be masters of their own destiny. They take actions to tightly control the activities of their company and those around them. These policies endure many years after incorporation. The founders may be extraordinarily capable people who create companies of extraordinary value. There are such entrepreneurs out there. More probably, however, their companies are held back by their own growth rate as individual managers. The value of their business idea never realizes its full potential. But they remain in control.
That’s the fundamental choice here. The FFCA sets you up for wealth only.
Read No Further if you Want to be King
Just go be king and don’t worry about how you treat your cofounders.
Goals of a Founder Collaboration Agreement
An agreement between potential cofounders should accomplish three things:
- 1. Define the scope of the business idea
- 2. Put a point on whether the founder’s are motivated to be rich or to be king
- 3. Define a method by which equity will be granted
Why Scope the Idea?
Because probably you’re thinking of starting other companies, too. Those should be covered by separate agreements.
Why Point out Motivations?
You can’t all be king. If control is a primary motivation for two or more on the team, don’t co-found together.
The negotiation over the agreement will trigger some difficult conversations. It’s far better to have these earlier than later. The added advantage is that you can practice disagreeing before you get into a serious situation, like, when people’s jobs will be on the line.
Additionally, there’s a fourth goal at this early stage:
- 4. Avoid uncertainty about business valuation.
The FFCA splits equity without knowing how much the company (or the idea) is worth.
How to Split Equity
Step One: Define Contributions as Dollars and Time
Companies are built because people work at them. Some people work without compensation. Others are paid.
Founders often contribute their time without compensation. But they could have a paying job, so their time has an opportunity cost. What else could they be doing? This opportunity cost is accounted for as “sweat equity” or contributed labor.
Money is also valuable when starting a company. An investor with capital may not do any work him or herself, yet their capital can be used to hire others for pay to build the business. This capital is accounted for as “contributed cash”.
Step Two: Recognize that not all founders are created equal
Some founders could get a job in the corporate world making $50/hr. Others could get different jobs paying $20/hr. Their opportunity cost varies. The FFCA asks the founders to define it for each cofounder.
Step Three: Recognize past work
Sometimes a cofounder has been working on the idea off and on for many years. Maybe they’ve already put some money into getting a patent, or building a website, or otherwise fronting some money to get started. All of that counts. The FFCA asks the founders to estimate their past capital contributions.
Step Four: Forecast and commit to future contributions
This is certainly the hardest and most beneficial part. Startups usually begin without enough capital or revenue to sustain the founding team as paid employees. This means that cofounders need to meet living expenses through savings or other means. Some will have more time to work on the startup than others. The FFCA asks the cofounders to think about what’s realistic and to set out mutual promises on paper.
Another problem with startups is how difficult they can be to sustain past the “honeymoon” period of business plans and upwelling financial forecasts. Some founders will end up losing interest, being unable to perform, or deciding to outright drop out. This leaves the remaining founders to do the work, in which case it’s only fair that the remaining founders should get a larger share. The FFCA contemplates this and subjects founders to vesting.
Nothing here is intended to replace the advice of an attorney. The agreement itself has highlighted yellow regions where you need to think about what you want and add your own text. If you’re not sure what the agreement says, especially if you cannot understand certain sections, consult an attorney.