“It never makes sense to give anyone equity without vesting.” says the Tough Love Angel.
This is part of my Nokia Startups Mistakes series. For a backgrounder, please read the introduction. My previous post discussed the free rider issue partly amplified by the Nokia Bridge program itself. The ownership problem results from the combination of inexperienced CEO, more than one founder, and the Nokia Bridge incentives.
What is the ownership problem?
The ownership structure illustrated in the cap table of a company is about fairness and control.
- Fairness. The sense of fairness is a crucial factor to startup’s culture. The cap table should reflect the relative contributions and risk taken of each shareholder over time.
- Control. Startups are not a democracy. There are many tough choices in a startup. It will increase the probability of success if there is a single party that can quickly call the shots when needed.
A cap table that shows a fair allocation of equity with someone clearly in charge is a good one. If the equity is not allocated fairly – you have a problem, if no one is in charge you have a different problem. Who then calls the shots in difficult situations? Having said this, perceived fairness is much more important than having someone in charge.
How to divide the founders’ pie?
It is always an interesting and mind-boggling exercise. First a few guiding principles summarized from Fred Wilson’s post on the topic:
- Fairness, and the perception of fairness, is much more valuable than owning a large stake.
- It never makes sense to give anyone equity without vesting.
- Ideas are pretty much worthless.
- Only people working full time count as founders.
I would like to add one more:
- A co-founder’s opportunity cost or how much money he needs to feed his family are his problems.
If each co-founder invested an equal amount of time, this would lead to a social democratic split of the pie, each co-founder having a 25% share of the pie, right? The social democratic pie makes only sense and is actually fair if each co-founder delivers exactly the same value to the company – which is practically a fairy tale. So, we are looking at this pie thing through the company’s eyes, not from a co-founder’s perspective. This is the key thing to understand.
It is typically the CEO’s job to get the co-founders around the same table, and then have more or less intellectual discussion about who contributes and what (Frank Demmler explains here in more detail the philosophy behind.) To get this discussion going, here’s a rough idea how it works:
- You first define a few most relevant factors (attributes) that create value to your company.
- Then you add weight to these factors to indicate their relative importance in value creation.
- And finally you specify the relative contributions of each co-founder against these factors.
After this exercise, you read the resulting ownership figure from the bottom line to get the ball park.
Let me explain the process through two different simplified yet practical examples.
Case A assumptions: “A high performance team built around the product guy”
- A CEO with a strong capability to sell and lead the product, credible in the eyes of other co-founders and investors, knows how to raise funding, can lead the team
- A credible CTO who can code hands-on, and can recruit top-notch talent form US and Finland
- A world-class UX designer
- A bunch of top-notch coders
- A bunch of top-notch business developers
|Attributes||Weight||Parties / Relative Contributions|
|Idea & IPR||5 %||60 %||30 %||10 %||0 %|
|Product Contribution||35 %||50 %||10 %||30 %||10 %|
|Domain Expertise||10 %||80 %||20 %||0 %||0 %|
|Time||20 %||25 %||25 %||25 %||25 %|
|Responsibilities & Risk||30 %||50 %||30 %||15 %||5 %|
|Idea & IPR||3 %||2 %||1 %||0 %|
|Product Contribution||18 %||4 %||11 %||4 %|
|Domain Expertise||8 %||2 %||0 %||0 %|
|Time||5 %||5 %||5 %||5 %|
|Responsibilities & Risk||15 %||9 %||5 %||2 %|
|Targeted Ownerships||48,50 %||21,00 %||20,50 %||10,00 %|
The CEO is clearly in charge here, though doesn’t own a controlling stake. The CEO and the CTO jointly own close to 70%.
Case B assumptions: “A less high performance team with free riders”
- A CEO with no startup experience, may have been even General Manager at Nokia, no clue how to design a (killer) product, can lead a large division, nice guy
- A CTO who doesn’t code, can define great architectures and evaluate top-notch tech guys, may, however, not be able to recruit killer hackers
- A business development person who develops business
- An excel guy, with either a degree in law or financial administration, doesn’t sell or contribute to the product, works full time but there are no daily tasks to match his skills
|Attributes||Weight||Parties / Relative Contributions|
|Idea & IPR||5 %||15 %||70 %||15 %||0 %|
|Product Contribution||30 %||40 %||60 %||10 %||0 %|
|Domain Expertise||10 %||70 %||10 %||10 %||10 %|
|Time||30 %||25 %||25 %||25 %||25 %|
|Responsibilities & Risk||25 %||40 %||35 %||20 %||5 %|
|Idea & IPR||1 %||4 %||1 %||0 %|
|Product Contribution||12 %||18 %||3 %||0 %|
|Domain Expertise||7 %||1 %||1 %||1 %|
|Time||8 %||8 %||8 %||8 %|
|Responsibilities & Risk||10 %||9 %||5 %||1 %|
|Targeted Ownerships||37,25 %||38,75 %||17,25 %||9,75 %|
In this case, the CTO is the product guy, and the excel guy is an adviser disguised into a founder, and gets most of his stake through contributing time while his real contribution to the company remains unclear.
Remarks & Recommendations
Here are a few remarks:
- The number of co-founders is the biggest driver of how many shares you get in the beginning.
- Each case is different and have to be worked in detail.
- You can start with yourself or take at most one or two co-founders, define the business you are in, and recruit the rest of the gang with much higher valuation later on (here is a related article from Venture Hacks).
- Work out first how to split the equity among the co-founders, when done with that you can simulate what happens to your equity share through dilution because of new equity issued for investors and future employees.
I would like to recommend the following:
- Start with less co-founders. Don’t take additional co-founders if you really don’t need them.
- Do the founders’ pie discussion openly before incorporating with your co-founders.
- Always sign a Shareholders’ Agreement with stock vesting before incorporation. If you don’t do this, you are an idiot.
A collection of related links can be found from Kippt here. if you know a relevant link that you would like to share with others, please feel free to send it via email to mika (at) marjalaakso (dot) com.
I hope you will enjoy this series, the thoughts it provokes, and the discussion it triggers. Please do participate to the discussion by sharing your own angle and experiences on this topic, or commenting on something, anything on this post. The preferred place for discussion is the Facebook page at https://www.facebook.com/ToughLoveAngel.