Although entrepreneurs are motivated by things in addition to money, money’s important to everyone I’ve ever met trying to start a company. Monetary rewards in a startup, as everyone knows, ultimately derive from ownership of stock (not salaries or bonuses). Since there can never be more than 100% of the founders’ stock available for allocation, every co-founder should focus on ensuring that the allocation best matches the realistic, expected contributions of each founder to the success of the Company.
In Silicon Valley (assume it’s the same in other startup regions), “founders” have a bunch of iconic attributes, some good, some bad.
Although we don’t, we should have a statue dedicated to “The Startup Founder” prominently displayed somewhere in Silicon Valley. Founders are passionate about their businesses, and will run through brick walls to make them succeed. In large part, Silicon Valley’s success is attributable to this passion and “never-say-die” attitude.
That’s the good part.
Founders are also “expensive” in terms of equity (usually, and sometimes even rightfully, to reward them for taking the risk in joining a startup). Founders are harder than normal employees to transition out of the Company (not legally, just emotionally: “How can we fire Fred? He’s a founder.) Just like most people (including VC’s), founders usually have skills and experiences that are narrower than they, themselves, believe (even sincerely). And finally, founders don’t always pick their co-founders with a beady, cold-eyed, highly calculating gaze with a tough-minded focus on who can actually make the biggest contribution to the Company. Often, co-founders are picked because they are friends, or like-minded, or “great people, the kind you’d pick if you were in a foxhole under fire”.
That’s the bad part.
Let me illustrate the problem with a hypothetical (though not uncommon) four-person startup.
Four friends decide to start a new company. After some jockeying (since they’re “peers” at their current company), they finally settle on the following titles, roles and percentages of the equity: (1) President and CEO (35%), (2) VP Marketing (25%), (3) VP Engineering (25%) and (4) VP Finance/CFO (15%).
To them, it seems logical to have these four (eventually) important business functions covered by the founding team. Moreover, these responsibilities roughly match (perceived) skills and experiences, although none of them has ever had a title higher than Director, and none has ever had general management experience (i.e., responsibility for a complete P&L).
They work hard on their business plan and actually come up with a very interesting idea.
Because the idea’s interesting, they quickly arrange several first meetings at top-tier VC firms, but receive no call-backs. They know that the odds of getting VC financing are low, but can’t figure out why they are having no success at all. Without exception, their first meetings have been energetic and enthusiastic – and no one has pointed out any blind spots in their planning or preparation.
As it turns out, the VC’s actually liked their idea a lot. The VC’s also actually liked two of the four founders (marketing and engineering) a lot, although no VC they met believed that either of them was ready for a “real” VP role. Unfortunately, when asked, the marketing founder and the engineering founder were defensive about deserving “their chance to step up to the VP level”. That paled, however, in comparison to the defensiveness of the CEO when questioned about his future role in the Company. Finally, the CFO couldn’t really describe what kinds of CFO-like duties he would perform for the first two years. Every duty he did describe could be done by a competent, high-level office manager.
Spotted the problem….?
Actually, there are several: (1) the CEO and CFO, who owned 50% of the founders’ stock, were not appropriate for their roles, (2) neither of the “continuing” founders was really ready for a VP role (and was defensive about the issue) and, though less importantly, (3) no startup needs a VP Finance/CFO.
From the VC’s perspective, this is a deeply “broken” situation, despite the interesting business idea. And since the “broken-ness” involves founders (with all the iconic complexity that entails), “fixing” the situation involves some really hard work and tough decisions. Given the tensions (and lurid myths) that surround VC’s replacing founders, any VC with decent deal flow will simply move on to some other interesting startup that doesn’t have these problems.
What’s the big deal?
First, it is extremely difficult to transition a founder out of “their” company. Moreover, as hard as it is for the Board of Directors to make such a transition, it’s virtually impossible for the other, continuing co-founders to do it. After all, they were friends and “peers” who took a huge risk together, as well as a blood oath: “All for One and One for All!”.
Second, even if it can be done, it’s usually “expensive” in terms of founders’ equity. Frequently, all founders have some form of accelerated vesting (or full vesting) of their founder’s stock if they leave the Company otherwise than by voluntary resignation. In our example, if some VC had loved the business idea enough to undertake the tough job of reorganizing the founding team, the departing founders would have taken as much as 50% of the founders’ stock with them.
It’s important to note that it is NOT the VC or angel investor who gets screwed here – it IS the continuing co-founders. How so? Think about it for a second…
When considering an investment, any investor, whether VC, angel or otherwise, will place a pre-money valuation on the Company when they offer to invest. That’s what they think the Company’s worth, regardless of who owns the founders’ stock (a slight oversimplification). If a good chunk of the founders’ equity is in the hands of co-founders no longer with the Company (and therefore who won’t contribute to its success), it doesn’t alter the investors valuation calculation. So, the continuing founders will end up with substantially less equity than they “deserve” – but not because the VC’s were unfair.
In fact, it can actually be worse than this for the continuing founders. If enough stock has left the Company in the hands of the departed co-founders (in our hypothetical, up to 50%), an investor may simply decide that there isn’t enough equity left to properly motivate the continuing founders (calculating what additional stock must be reserved for future hires). In this case, the top-tier VC simply moves on to an equally interesting, but less troublesome, situation.
What would have been a better strategy for this startup? Like everything else important in life, it depends……
In my next post, I’m going to suggest some things for entrepreneurs to consider as they put their founding teams together.
Hopefully, they'll help.
In the meantime, however, before you prick your fingers and take the startup company blood oath, do the tough part and carefully evaluate who is on the founding team – you owe it to each other.