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

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

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

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.

What Are the Essential Components of a Business Plan?

As I prepare to mentor teams from MIT Sloan as part of the Business Plan Contest of its 100k Competition this month, I was thinking about what companies need to produce.  Business plans out there vary from a single page summary to an excruciatingly long dissertation.  The key to a good business plan is to only have the information you need and forget the rest.  Easier said than done though. However, here are some thoughts for companies as they are preparing their plans.  You can see an overview from some very recognizable entrepreneurs in this video.  The entrepreneurs here stress that the market itself, due primarily to the growth of the Internet, is different today than it was in the past, so the model for preparing a business plan is different.  The key is to know the market and have a good idea.  As Marc Andreessen, founder of Netscape turned venture capitalist, notes:

The process of planning ... is very valuable, but the actual plan that results from it is probably worthless.

And as summed up by Kevin Ryan, CEO of DoubleClick, the questions you have to ask to create a good business plan are (1) is this market big enough, (2) do we have a good idea, and (3) do we have good people.

So what should be included?

HubSpot founders Brian Halligan and Dharmesh Shah also have abandoned the large, detailed business plan because once you start showing it to investors, it won't last.  If you have put all of this effort into a 50-page business plan, you either have to throw much of it out as it evolves, or you will be so invested in it that you won't want to change the plan.  Neither result is a happy one for an entrepreneur.  They prefer to think of the "business plan" as a set of three items:

1. a PowerPoint deck describing the business and team
2. An executive summary of the target market and business (see more below)
3. A three-year pro forma profit & loss document

In the early stages of development and the first round of financing, investors are mostly looking at the team and what they are going to do.  It is only when you get into the later stages of financing that detailed financial data become important.  So focus on the market and the concept rather than getting lost in a complicated document.

For the summary, investors will be looking for the following:

1. The Team.  The people who will be running the business and developing the product are key.  The best startup teams will feature a mix of strengths working together.
2. The Market.  You need to describe the size of the target market and the environment to show that you will have customers and they are currently being underserved.  However, no business plan should say that the market is unlimited and there no competitors.  Be realistic.
3. Your Product.  What is unique about the product or service you are providing.  If you have trouble describing it, you will have trouble with Item #2.
4. Money and Forecasts.  Give a reasonable view of what you expect your financials to look like for the next few years (again, understanding that this estimate will change) and provide guidelines of what you see as development and customer relationship milestones to meet along the way.

See my previous post for another perspective.

The key to all of this to show that you have thought through your plan realistically but are ready to adjust when it inevitably changes.

What has been your experience with preparing business plans?  What have you found works or does not work?

Can a Court Rewrite Your LLC Agreement? You Might Be Surprised.

What do you do if you never put a limited liability company operating agreement on paper?  In some cases, the answer may be decided against your wishes by a court. I was recently speaking with a small business owner who ran into trouble with the other member of his limited liability company.  The two had formed the LLC six years ago by filing with the Commonwealth but never put an operating agreement on paper.  However, he indicated that they had an oral agreement on a variety of things that would normally be in an operating agreement - how the LLC is managed, how the profits and losses are divided, how to buyout a member who leaves, etc.  Now he wanted to use some of those agreements to resolve the conflict.

In Massachusetts (as well as many other states), a written operating agreement is not required; members can have an oral agreement on how their company is structured and operated.  But that flexibility can bring risk.  Here's why.

States have a common law concept called the "statute of frauds".  (For those of you who eyes are immediately starting to glaze over at the sight of technical legal talk, you can skip to the paragraph that begins "So what does this mean for your company?" to understand the practical implications.) State laws vary, but generally the statute of frauds states that certain contracts must be in writing and signed if you are going to enforce them.  In addition to other things, this common law principal includes any contract that cannot by its terms be performed within a year.  Note that an agreement that happens to take more than a year is not automatically subject unless the agreement specifically states that it will take more than a year.  If so, the contract is not automatically void, but one party can raise the statute of frauds in order to have the contract voided.  Remember that this is a complex topic because there are some exceptions, but as a general principal, long-term unwritten agreements carry some uncertainty.

This issue became much more relevant to LLCs last year when the Delaware Chancery Court ruled that an oral LLC agreement was subject to the statute of frauds.  In Olson v. Halvorsen, C.A. No. 1884-VCL (Del. Ch. Dec. 22, 2008), a hedge fund founder who was removed by the other members demanded that the court enforce a multi-year earnout agreement that was included in their unsigned draft of an LLC agreement - an earnout worth well over $100 million!  The court held that because the earnout was to be paid over the course of six years, it falls within the statute of frauds and was therefore unenforceable.  The former hedge fund manager's claim for the payout was rejected.

The applicability of this case in Delaware adds some uncertainty to the operating agreements of LLCs formed there.  Other states, including Massachusetts, have yet to decide this issue definitively, but the Delaware courts often serve as a model for other courts when they are facing corporate and LLC issues.  So this decision may eventually have implications for your agreement.

So what does this mean for your company? If your LLC is operating under an oral operating agreement, many of the provisions with respect to management and such may be enforceable because they can be performed within a year.  However, as the court decided in Delaware, if you have an oral agreement with the other members that entitles you to some benefit that extends beyond one year, you may lose that right in a dispute.  For example, if the members agree that if you were to be hit by a bus tomorrow, the other members would buy back your membership interest with installment payments over five years, the other members might be able to successfully void that provision upon your untimely demise under the statute of frauds.

So here are some tips with respect to operating agreements in light of this case law:

1. Put your LLC operating agreement in writing.  Operating Agreements do not have to be fancy.  You can write the provisions of your agreement in any way that expresses the true intent of the parties.  Working with a lawyer may help save a tremendous amount of agony since they have experience in drafting agreements that will be enforceable.  But don't get caught up in the formalities - just get it in writing.
2. Make sure everyone signs the agreement.  A critical element of the statute of frauds is that the agreement must be signed by the person against whom it will be enforced.  As in the Olson case described above, the members wrote out the provisions of an agreement, but the courts did not enforce it because the parties never signed it.  I have dealt with other situations where clients "forget" to sign a document.  It may be easily overlooked a the end of a negotiation, a critical issue to protecting your rights.
3. Revisit your agreement periodically.  Companies that have been operating for several years might be surprised by what is in their operating agreements because the needs of the members and the company may change over time.  This is even more important if you are operating with an oral agreement.  After a few years, the members may have very different recollections of your agreement, which may lead to messy disputes down the road.  I would recommend that you take a fresh look at your agreement annually when you have an annual meeting.