Founder Series Part III: How to Structure and Document Your Founder Agreement

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You should never start a venture without thinking about how to end it.  Many founders make the mistake at the company's formation of slicing up the founders pie, serving everybody a piece, and treating that as the end.  In this case, it needs to be the beginning.  Here's why and what you need to do to protect yourself. Now that you have carved up the equity, you need to decide what to do with it.  Even though on day one your team is in place, your roles are assigned, and you are ready to develop your company, remember that the only constant is that the situation will change.  You will hit some roadblocks with your business plan and have to evolve your concept.  You will have to prepare for those events that you don't expect.  And you may even have to adjust your founder team by adding or removing members.  Keeping your structure flexible will prevent headaches (and money!) down the road.

First, you should have a agreement among the founders (and write it down!) to deal with these issues.  Use the structure up front to prevent disputes later.  And, as I have noted before, you have to deal with both the economic issues and the management matters.

  1. Equity Split and Ownership.  The discussion in the previous posts should give you a sense of why this is important to make clear up front, so I won't rehash that discussion.  But an important point in the Founder Agreement is to avoid using percentages to describe a founder's ownership.  Even though we often speak of percentages (as I am doing here for the most part) as a type of shorthand, the agreement should use specific numbers of shares of stock to avoid both legal and financial impacts down the line.  For example, if each of three founders has one-third of the company in the agreement, what happens when an investor is brought in or an employee is granted equity?  They need to be diluted to a certain extent to allow for the new stockholder.  This becomes even more important when someone leaves the company.  I once saw an owner claim an absolute right to keep 10% of a company because that was how it was stated in the agreement.  That will become unsustainable as your company grows.
  2. Vesting and Restricted Stock.  Remember that once you issue stock to a founder, it belongs to them and your options become limited if you want it back.  So vesting of the stock (giving the founders full ownership rights to their shares over time) becomes a valuable tool.  If three founders split the company in thirds and then, after six months, one of them leaves the company, their ongoing ownership should reflect that.  This is often done through "restricted stock", by which the company issues stock to the founders in accordance with the splits they devised, but that stock includes a right for the company to repurchase some or all of it at a very low price should that founder leave the company (for whatever reason) - a right that will slowly lapse over time.  Typically, that is done over a three- to four-year period (anything more does not really make sense for a startup), and can also include some acceleration up front or upon certain events.  Now if that founder leaves the company, she can keep what she earned in the time she was there, but the company can buy back whatever has not vested.  This leaves the other founders with a stake in the company that will better reflect their ongoing contributions. PLEASE NOTE: A discussion on restricted stock is never complete without mentioning 83(b) elections.  I will leave the details to another post, but don't even think about taking restricted stock without considering the 83(b) election because 30 days after the stock grant, you lose the option and it may cost you thousands of dollars in taxes in the future.
  3. Limits on Stock Transfers.  Founders choose to start a venture together because they bring unique qualities or because they have other relationship ties.  So you will likely want to have place some restrictions on when the founders can sell their shares (and thereby giving some or all of their rights to someone else) and to whom.  You could do it with an absolute ban on transfers without the consent of the other founders. But you can achieve more flexibility by adding a "right of first refusal" for the company or the other founders to buy the shares on the same terms, or a "tag along right" to give the other founders the right to sell some of their shares on the same terms.  A sticker situation develops when a founder dies or develops a disability that prevents participation in the company.  Since stock in a company is a personal asset, those shares will pass on death through a founder's estate.  So you may now be in business with that founder's spouse, kids, or someone else.  Consider including a buy-back provision at some predetermined price or calculation, or some other mechanism for transferring the shares.  Also, if you have a repurchase provision upon a "disability", you must take great care in determining exactly when that provision is triggered.  But in either a death or disability, it is wise to consider how you will fund the repurchase by the company or the cross-purchase by the other founders, which is typically done with proceeds from life insurance policies on the lives of the founders.
  4. Management.  Generally, the ultimate control of the company rests with the stockholders through the Board of Directors and is tied to their ownership percentages.  However, a company with founders shares split up evenly is ripe for deadlock and disputes.  Founder agreements often address this with provisions dealing with how to elect directors, who should sit on the Board, and how will voting happen.  Do each of the founders get Board seats?  If not, then who?  What about independent directors?  Beyond the Board, agreements will also often include overriding provisions for certain events and decisions.  Even if the Board has the power to determine most of the daily issues of the company, all of the stockholders together may want to retain control if the company is issuing new stock, taking on debt, making capital purchases, and other major events.  These issues may be particularly relevant to founders with less equity than the others.  These "minority interests" may need extra protection because they will have little control on their own.
  5. Intellectual Property.  Many startups have few assets more valuable than their intellectual property - whether it's comprised of software, patents, trademarks, designs, formulas, etc.  Having each founder contribute to the company any intellectual property she may have developed prior to formation is critical, but keeping control of the intellectual property that is developed over time can also prevent problems in the future.  I once saw a company's public offering fall apart when they determined that the intellectual property that served as the basis for the company's value was not properly owned by the company.  So sloppiness in this area can have profound effects.  The founders can also decide in this agreement what should happen with the intellectual property if the company is dissolved.  Even though the business may have failed, the intellectual property can be very valuable going forward.

The bottom line is that founders need to spend some quality time working through these issues.  As I mentioned in the previous post, the process can be quite uncomfortable with founders focusing on what happens when things go wrong.  However, nothing will ever go as originally planned, and it will be much easier and less costly to deal with these issues up front than when the dispute arises later.

Read more about founders in my Founders Series Part I and Part II.

Founder Series Part II: How do you slice your startup's founder equity pie?

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In Part II of my Founder Series, it is time to structure the organization and issue ownership interests to your founder.  I have worked with companies who think that this is an easy step.  It isnt'.  And it can be very uncomfortable.  Embrace that. The first thing you should do is resist the urge to just check the box on this by splitting the equity equally among the owners and moving on.  It may seem like a purely academic exercise because you are just "dividing up zeros" of a company with almost no value (which, in fact, you pretty much are).  But your decisions here will have significant ramifications for the company - and your relationships with your co-founders - in the future.  Treat it as the beginning of a negotiation, not an endgame.  Future investors may also look skeptically on a hasty resolution for a major decision.   It may be that you ultimately decide to do a straight equal split, but that decision should not be made without going through this analysis.  

Separate the Roles: Managers and Owners are Different

Remember that there are two sides to equity ownership: economic rights and management rights.  You can consider each separately.  An equal split between co-founders may sound fair on the economic side, but the management of the company may be stymied by impasse.  A Founders Agreement or Voting Agreement can then give you additional flexibility by reallocating some of the responsibility on the management side.

Valuing Contributions: a Co-Founder's Value is Not Necessarily Static

Don't overvalue pre-formation contributions.  Many founders look at what they have on day one and issue equity based on the perceived value of that contribution means to the company at that moment. But each is contributing some asset to the company, whether it is cash or time and opportunity cost.  Cash is easy to quantify, but what about technology, or future services? Start by determining how much the company would pay for that contribution and use that as a baseline.  Then any differences would add or subtract from that total for each co-founder.

Also, future value can be just as important as past contributions. You may want to give a founder's share to someone who will be doing development work for the company in the future, which could mean just as much as the $10,000 cash contribution. But again, make sure you look at the bigger picture when doing this.  Here is an example of how this can cause trouble:

There was a company that had two co-founders, but they split the equity of their company into three equal interests - the third interest going to one co-founder's mother for use of her basement to start the company.  On day one, this may make sense because the value of the space is just as important as the contributions of the other owners.  But a few years later - long after the company had moved out of that space into a new location - investors questioned the credibility of the co-founders. Aside from the logistical hassle of getting the mom to sign some of the documents, it made little sense.  While the co-founders continued to build value for the business, a third of the company was tied up with someone who now had nothing to do with it.

This same scenario could play out when a founder leaves a company early, particularly where there are three or more founders.  The goal is to put together an equity arrangement that makes sense at formation, but also is relevant as the company evolves.

In Part III of this series, I will talk about Founder Agreements and some ways to structure equity splits that can help with some of these issues.

Read more about founders in my Founders Series Part I and Part III.

Founder Series Part I: How to Choose Your Founders

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How can you sink your startup before you ever start?  Choose the wrong founders.  It sounds obvious, but in practice is remarkably challenging for many startups.  In this first post in my founder series based on a class I taught at MIT Sloan recently, I am going to focus on what you need in a team and what you should do without. Companies have taken a variety of methods in putting together founding teams.  Some ventures are started by a few old friends.  Others are placed together by serendipity.  Some go it alone.  Companies at one time of another may have found success with each of these.  But that does not mean each will work for yours.  Before you start, answer these three questions: (1) how many founders do you need? (2) What skills should a founder have? (3) Do the founders share a vision?'

How many founders should a startup have?

First, there is no one right answer to how many founders should be involved.  Facebook's Mark Zuckerberg went solo (at least officially), and seems to be doing o.k.  Others took a collaborative approach with four or five.  To figure out your answer keep it simple - use rules that know from a bar.  My favorite analogy for founders is the "martini rule": one is unusually not quite enough, but four of five is likely too many.

The more I work with startups, the more I see that two seems to be about the right number.  Three can work, but human nature says that you are inviting trouble.  Think about successful companies and inevitably you will associate them with two founding members.  Apple, Google, Microsoft, HP, and even newer startups like Foursquare, HubSpot, and Twitter all started with a pair of entrepreneurs.

I have had clients tell me that they "need" this person or that person on the founding team because of a long-standing friendship, or because they want a diversity of views, or even because they just happened to be involved in the early conversations and offered some suggestions.  A founding team is more than just payment for past actions (more on that in my next post) and friendships can change very quickly when money and business is involved.  Over time, the company will require contributions from many people to be successful, including advisors, but they don't all have to be founders.

What Skills Should a Founder Have?

The one thing that founders should have in common and that is that they are different.  Often, two people with similar skills make poor co-founders.  The best teams bring contrasting (but complementary) skills to the venture - a yin to your yang.

Keep in mind that you don't have it all.  A solid co-founder can be a very valuable partner in your new venture by helping you to stay focused, being a sounding board for ideas, and, simply put, as another set of hands to help manage the workload.

The key to a good co-founder is balance.  Each of you will bring different skills to the table that together will help propel the company.  If you like to code or tinker with products, another technie might not be the best fit.  Perhaps your co-founder should be a businessperson who can help sell your ideas (think Steve Jobs and Steve Wozniak).  Again, the complementary skills are key.

Vision

Finally, you need to share a vision with you co-founder.  I am not talking about on day one - everyone is excited and in alignment at the beginning.  But what about when things change?  Do you share a philosophy on dealing with the things you did not intend to deal with?

Many founding teams start to fall apart as things change.  They start to argue about what to do when the original plan is not working.  Or even worse, refuse to adjust when it is clear that you are headed in the wrong direction.

I saw a promising startup fall apart because they just could not agree on how to deal with an employee (who happened to be a friend of one of the founders).  This is when having history with your co-founder becomes important.  You will have a better idea about not only what skills they can bring, but also how those skills will help you evolve the company you will create together.

So what has your experience been?  What have you found works best when choosing your co-founders?

Read more about founders in my Founders Series Part Two and Part Three.

How to work with your startup lawyer: Why entrepreneurs should not wait

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When I was guest lecturing at an Designing Entrepreneurial Organizations class at MIT Sloan School of Management recently, I was asked by a student who was working on developing a startup, 'when should I consult with a lawyer?'  The answer: yesterday. I often hear from entrepreneurs that they don't consult with a lawyer early on because they don't have much cash at startup and the lawyer will be too expensive - I need to put my cash into other things, they say.  Sometimes, this is true: some law firms deal with startups the way they deal with larger clients.  By involving too many people at high billing rates with inefficient processes.  This often comes from law firm structures themselves, which are not designed for representing startups.

Another misconception is that people often assume that any lawyer can advise a startup company, which is why entrepreneurs will often select a relative or friend who practices in a different area of law altogether.  That lawyer will probably spend more time researching than advising and the advice may not even be relevant to the company's particular situation.

So here are some things to consider when you are starting up:

1.  Choose a lawyer yesterday.  Your lawyer can be one of your most important advisors, and a true startup lawyer can be invaluable.  Lawyers have the perspective of working with many different companies and seeing first-hand the avoidable mistakes that early companies make.  I start with entrepreneurs before they organize, because some of those foundational issues become critical to the long-term success of the company.  Setting up the organization, protecting intellectual property, determining the proper equity splits (worthy of its own subsequent post), and vesting schedules are just a few of the important decisions that need to be made up front.  Too often entrepreneurs jump into the work without properly considering the ramifications.

2. Don't just go for a brand name.  The problem with big name firms (having worked for them) is that the person you sign up with is not always the person you end up working with.  Many large firm partners have great reputations of working with successful companies, but that often means they will not have time to work with you, particularly because you won't have the money to spend.  Don't get me wrong, I don't mean to say that associates are not capable and energetic attorneys, but the system they work under values time instead of results, and as a result of the billing rates that large firms are charging, you will have trouble getting any of that.  There are many terrific lawyers who work with small firms or who have left larger firms to start new ones.  You can do some research and find out who they are.  There is a tremendous amount of information out there - particularly due to social media - and never underestimate the value of advice from other entrepreneurs and companies that have already been established.

3.  Be honest with your attorney and be ready to hear some honesty in return.  Working with an advisor requires give and take in order to make the right decisions moving forward.  There is no one right way to set up a company, and the decisions you will be making are dependent on the people involved.  You should hire a lawyer to advise, not just to be a cheerleader.  And remember that you should never start a company unless you have thought about how to end it.  Be prepared for some uncomfortable discussions, and know where you want to go before you start.  Your lawyer will help apply his or her experience to your company, but needs to understand all of the details to do it right.

Remember above all that your lawyer and other advisors will be a valuable part of your team.  Work closely with them early and often and don't be afraid to move on if it doesn't work out.

REMINDER: Massachusetts Privacy Regulations Launch March 1st. Here is what you need to know.

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There are only two weeks left to comply with the new Massachusetts privacy regulations.  And before you think that they won't apply to you, think again. I have written before about the new privacy regulations, which will be the toughest and most aggressive privacy rules in the country.  Even though the process has been long and included delays and adjustments, the regs are finally going into effect on March 1st.  And you don't have to be in Massachusetts to worry about them; the new rules will apply to anyone - whether based in Massachusetts or not - that holds certain information about Massachusetts residents.  As a review, here is what you need to know:

Who is covered?

The new law covers any individual, corporation, association, partnership, or other legal entity that handles a Massachusetts resident's personal information in connection with employment or with the provision of goods or services, as long as that information is not otherwise publicly available.  The personal information described here means a Massachusetts resident's name (first name and last name or first initial and last name) in combination with that resident's Social Security number, a driver's license or state ID number, or a financial account or credit card number.

What is required?

Those who are covered must create a comprehensive written information security program (a "WISP") to safeguard the information.  The WISP need only be appropriate to the size, scope, and type of operation the person or business is engaging in, the amount of resources available, the amount of the stored data, and the need for security and confidentiality, but that still means that most people will need to make some adjustments. Your WISP must cover:

  1. Designation of a someone to maintain the WISP.
  2. Identifying and assessing reasonably foreseeable risks (both internal and external) to the confidentiality of the information whether on paper or electronic, and continually evaluating and improving the effectiveness of the safeguards through employee training and means of detecting and preventing security system failures.
  3. Developing security policies for the way the information is stored, accessed, and transported outside of business premises, and especially for the way the information is stored or transmitted on computers or wireless systems, including email.
  4. Imposing disciplinary measures for violations of the WISP rules.
  5. Taking reasonable steps to ensure that third-party service providers are capable of maintaining similar protections and requiring them by contract to implement and maintain appropriate security measures.

What kind of protection is necessary?

For paper records, you must provide for secure storage of materials containing personal information, such as physical restrictions (e.g storage in locked storage facilities or containers) and limiting access.

For electronic records, the WISP must include, to the extent technically feasible, a system to secure control of user IDs, password selection and control, and restricting access to active users.  In addition, all electronic personal information transmitted wirelessly or across a public network, and all personal information stored on a laptop or other portable device must be encrypted.  It is important to note that encryption for this purpose does not mean password protection; the regulation requires the information to be transformed into a "form in which meaning cannot be assigned".  In other words, the information must be unreadable.  Password protection alone does not satisfy the requirement.

Are there standard procedures to follow?

The quick answer is no - each person or company needs to come up with unique procedures and safeguards that are both reasonable and feasible for its specific operation.  A large company will necessarily have more detailed procedures than a smaller company, and one industry may be held to a different standard another on a case-by-case basis.  Your current procedures may be a good starting point and may, in some cases, already comply with the new requirements.  There is ambiguity in the law's use of the terms "technically feasible" and "reasonable" that leave latitude for the specific terms of compliance.  Some of these will be clarified over time through lawsuits and enforcement actions, which simply reinforces the need to re-evaluate your program over time.

However, that ambiguity should not be confused with making compliance optional.  There are real consequences including lawsuits for breaches and in some cases civil penalties and fines imposed for each violation.

The bottom line is that you need to take this new Massachusetts law seriously, even if you are not in Massachusetts.  But you can mitigate the risk by establishing these minimum standards to safeguard the personal information and prevent unauthorized access.

Here are some additional resources for information on the regulations: