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How Should Cofounders Split Equity? A Cofounder Vesting Riddle

Here’s a cofounder riddle:

Cofounders A and B start a company around A’s idea. There are 10 million shares authorized. A gets 2 million unrestricted for the “idea.” A and B each get 4 million subject to vesting.

Due to unforeseen circumstances, A immediately quits. A’s unvested shares return to the company. B presses forward alone and vests all 4 million shares. The company succeeds without further investment.

At liquidation, A has 2 million of the 6 million outstanding. B has 4 million. A gets 2 million divided by 6 million = 33% of the proceeds. A’s idea premium was lofted from the 20% agreed-upon to 33%. B feels snookered.

What could A and B have agreed to on “day one” so that A would have ended up with just the 20% idea premium?

I posted this to the MIT Venture Mentoring Services forum. Here’s a summary of what was proposed by others:

  • A, the departing founder, could be
    • subjected to steeper vesting
    • given a contractual claim or special class of shares, instead of common, that convert to 20% of the liquidation proceeds
  • B, the remaining founder, could be
    • granted additional stock or options
    • signed onto a “bear hug” right of first refusal to purchase cofounder shares
    • given a loan from the company to purchase cofounder shares
  • Or we could do one of the following:
    • forget idea premiums;
    • accept ownership changes as a risk in starting up;
    • forget the whole “riddle” as an impossible problem.

The type of solution we’re looking for is:

  • Not predictive: we shouldn’t have to know whether A will actually quit;
  • Prescriptive: if A does quit, or participates less fully than B desired, there is no disagreement on how A or B should be penalized/compensated;
  • Smooth: the spectrum of A’s non-participation and B’s compensation, from “A quit” to “A is fully engaged,” should have no step changes;
  • Tax-free: founders can still declare an 83(b) election to pay relatively zero tax on their founder stock; and
  • Cash-free: founders should not have to come up with lots of money to maintain an agreement made early.

Many of the ideas above have either tax or cash consequences, or are not smooth, or are predictive.

The “bear hug” concept combined with an idea sent to me privately, issuing warrants that expire as the co-founder’s stock vests, seems to me to be an implementable solution with few tax or cashflow consequences. So that’s what I’ve been working on this week.

I will report back and/or blog about it if we produce anything interesting. Certainly the name of this scheme would be, “a completely warranted bear hug.” Stay tuned.

Pixaby "bear hug" graphic to accompany "cofounder riddle"

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