Finding the Right Co-Founder, Allocating Equity and Key Founder Protections You Need
How do you successfully found a technology-based company in tech, life sciences or the consumer space? A good place to start is to make your first sale – to a co-founder. If your idea for a product or service and a new company is a good one, your first test is whether you can convince someone to join you as a co-founder of the company. This article is about – finding that co-founder, finding the right co-founder, and then putting in place key protections for the founders and the company you are building.
FINDING THE RIGHT FOUNDER
How do you find a co-founder? It is often among your own network, among people you already know. Often your co-founder may be a person that you’ve worked with in the past at a current or past company or a class mate from high school or college that you’ve kept up with over the years. But friendship does not automatically translate into the prerequisites for a good co-founder with whom you can succeed.
For the right co-founder, you want a person whose knowledge, smarts, achievements and judgment have you respect. You want a co-founder who is capable of making an intellectual contribution to the business enterprise on the same or comparable level to what you are making. A key benefit of having a co-partner is to have someone you can vet your plans with – someone who will offer ideas and constructive suggestions, not a “yes man” to all you propose. Founding a business is generally not a straight course. There are frequent bends, detours and turns in the road. Founders need to be nimble – able to learn from mistakes and pivot quickly to regain course and direction. You want a co-founder who will be a constructive contributor to that process.
Complimentary knowledge, background and skillset is also a big plus among the founders, whether you have two, three or four founders. If you are more tech-savvy look for someone who is business oriented. In a nutshell, clearly you need the founder who has knowledge of the product or service – often the technical founder – the founder who can or can oversee making the product work for the purpose intended. But that is only part of the battle if you are to succeed. Will they buy it? What will they pay? Can you be profitable? The ability to test and understand marketing and sales is just as critical to success and generally a very different skill set and experience from that of the technical founder. Successful founding teams usually have both.
Even with bright and complimentary founders, there is still more to look for if this is to be a successful founding team. Ultimately, choosing a co-founder is like choosing a spouse. A business partnership is like a marriage. You will have to make compromises when it comes to money, ideas, scheduling and so much more. And if you are to succeed, the founders will be spending an awful lot of time with each other, often under trying circumstances as you stretch your meager resources in your battle to eventually sell product or services or achieve clinical success. So, don’t jump the gun to enter into a partnership. Get to know who your potential candidate to assure they are trustworthy, loyal and accountable, and more … to see too how he or she reacts to the pressures, setbacks and emotions of founding a startup company. This is so even with old friends and work buddies. If you have never been founders together in a start-up company, see how you both react to that situation and how you work together as a team. After a few months or other sufficient “shakeout” period, then take the next step to formally found your company and also provide protections to each other and the company.
FORMING THE COMPANY & ALLOCATING SHARES
To formally found your company, you need to form an LLC or Corporation. My recommendation for two or more co-founders is a corporation. It involves standard charter, by-laws and agreements without the tax and business complexities of an operating agreement, that you don’t need as a startup company.
With a corporation, your focus will be where it should be on allocating the equity among the founders and providing the key protections needed.
How do you allocate equity among the founders? Allocation based on fairness when there is two co-founders can be as easy as splitting 50/50. However, when dealing with a core team which makes varying contributions to the company, the allocation of equity can be more complex. If one founder is going to contribute more to the startup than the other, then the allocation of equity should reflect that. Picture a pie, take a look at how much each founder, or member of the core team contributes to that pie and allocate the equity that way. Contributions can take many forms – cash, technology and inventions, connections, equipment, office space or overhead. One of the most important contributions is “sweat equity” – giving up the day job to work full time for the enterprise and thus giving up a pay check to build the company. When laying out the value each founder in this sense, splitting equity 70/30 may be the more realistic decision, one that can still be respected amongst the co-founders or core team. Honesty is crucial in this process, it is important to vocalize the actual value of each founder to realistically and fairly allocate equity.
VESTING EQUITY TO ASSURE PERFORMANCE
After a fair allocation has been determined, there remain key protections need for the co-founders and business. The most important protection is “vesting”. In allocating equity it is wise to generally view the company over a 4 or 5 year period, and to allocate equity based on what the founders are expected to contribute over that 4 or 5 year period. The vesting arrangement verifies that the contributions expected or each founder over that period are actually made – so that each partner truly earns his full share and that none of the partners is allowed to slough off and profit from the hard work of others while the laggard partner does little or nothing.
Thus, for example if partner A was awarded 40% of the equity because A was going to do the marketing for the company for 4 years, working without pay but working for that equity, and then after six months, A accomplished little and was “let go”. Then under the vesting arrangement, A only vested 1/8 for 6 months of the 48 month vesting period and would forfeit 35% (7/8) retaining only 5% – the 1/8 A had earned. Under some vesting documents, it could provide a “sweat equity” partner vests nothing if they leave the enterprise within the first year.
The same approach can be applied to other contributions. In a second example, if partner B was to receive 30% for contributing herself or raising $200,000 in seed investment the first year to fund operations, and only $100,000 was raised within the required time, she might vest 15% and forfeit the other 15%.
IMPORTANCE OF SECTION 83(B) TAX ELECTION
Vesting is very important to assure the company receives the performance promised for which shares were issued. Also very important is a tax election that needed to be made within 30 days of when the stock is issued to the founders. This Section 83(b) election takes into income the value of stock granted to the founders which would be subject to forfeiture if the conditions for vesting are not met. If this tax election is not made at the time of founding, when tax costs are minimal, this could result in a large tax bill later if the company succeeds.
For example, at the time of formation, the 30% interest to Founder A might be worth just $300. If A paid $300, there would be no tax or if he got the shares for nothing he would pay tax on $300. He leaves after 6 months and vests 5%. Taking the example further, if B had achieved at least some success and the company had in month 5 received a seed investment based on a post-money company valuation of $200,000, then A’s 5% interest is now worth $10,000. With no 83(b) election filed, A would have to pay tax on $10,000 of income, even though he has not sold the shares and perhaps cannot sell them. If the 83(b) election is not made with the 30-day window at time shares are issued, then, at each stage of vesting, tax is due from the founder on any appreciated value of shares. This can be quite devastating later on.
OTHER IMPORTANT FOUNDER PROTECTIONS
Beyond, allocation of shares vesting, there are other important protections beyond the scope of this article. These include:
- Stock Restrictions – prevent transfer of shares to non-founders
- Buy-sell agreement – to provide protections against death, disability or if a founder wishes to sell to a third party
- IP ownership – to assure that IP is owned by the company and that no claims of third parties may be made against company
- Minority protections – protections for minority shareholders including “drag along”, ” tag along” and financial information
- Employment termination – protections to founders for differing treatment in the event of termination of employment with or without cause and for severance in the event of termination
- Restrictive covenants – protections to the business enterprise including non-solicititation of customers and employees and a limited non-compete in the event of a founder’s termination
In close, it is lonely at the top, and thus startup companies often do better with two or three co-founders. However, as this article states, it is important that you have the right co-founders and when you do take the plunge to launch your company, put the key protections in place.