equity

Some rights reserved by quapan

I was reading an excerpt from Noah Wasserman’s The Founder’s Dilemmas: Anticipating and Avoiding the Pitfalls That Can Sink a Startup (Kauffman Foundation Series on Innovation and Entrepreneurship) about Founder Dilemmas: Equity Splits and it struck home. Equity splits and distribution are often the key issues related to power imbalances, perceived injustice and tension amongst cofounders.

In Noam’s dataset, 73% of founding teams split equity within a month of founding, a striking number given the big uncertainties early in the life of any startup. The majority of those teams set the equity in stone by failing to allow for future adjustments to equity stakes if there are major changes within the team or the startup…

Setting the early equity split in stone is one of the biggest mistakes founders can make. With their confidence in their startup and themselves, their passion for their work and their mission, and their desire not to harm the fragile dynamic within the nascent founding team, cofounders tend to plan for the best that can happen. They assume that their early, high levels of commitment will last long into the future, rather than waning as the challenges of founding begin to sap their passion for the idea and for each other. They assume that no adverse events will change the composition of the team.They also tend to take a very short-term view of the factors that should affect equity splits.

Sometimes it just doesn’t work out, and a founder will choose to leave the company or have the choice made for them. The question is how do you create a set of agreements that is fair to all of the cofounders. Often we think that standard employment and shareholder agreements cover much of the difficult situations that we can encounter with cofounders. But as cofounders it starts by really understand what you each are looking for, and then making sure your agreements cover the specifics of your situation.

10 Critical Cofounder Questions

How should we divide the shares?
How will decisions get made?
What happens if one of us leaves the company?
Can any of us be fired? By whom? For what reasons?
What are our personal goals for the startup?
Will this be the primary activity for each of us?
What part of our plan are we unwilling to change?
What contractual terms will each of us sign with the company?
Will any of us be investing cash in the company? If so, how will this be treated?
What will we pay ourselves? Who gets to change this in the future?

A couple of things. I think all founders stock should vest. I like it when founders purchase their initial shares with a one-time acceleration clause for a small percentage at purchase (3-5%). I like when founders’ stock reverse vests with a traditional one year cliff. The initial vesting acceleration is because things can change at 6 months and it seems fair to value the capital risk that each founder has taken at purchase. And the one year cliff because it is standard. What I’ve seen a lot is founders that don’t do the small initial accelerated vesting clause.

The other thing I like to see is an Employment Agreement with Termination clauses, in particular, an acceleration on vesting regarding “Termination by the Corporation without Cause”. I like to see a single trigger acceleration with 6-12 months of stock vesting on termination without cause (I’m not alone). The goal is to be fair and to protect each cofounder and the corporation if things don’t workout.

What tips do others have for equity splits? acceleration clauses? terms? That as cofounders we should put in our agreements.

Other Resources

Compensation can be a tough thing. It is particularly difficult in startups. How much should you pay founders? How much should you pay early employees? There are legal, tax, financial, retention, and emotional issues tied up in paying your employees. Given that founders/early employees are a critical factor in the success of an emerging company, it is important to understand that attracting and retaining rockstars can help make or break the early success of a startup.

“As a founder, set your pay to mirror what the company can afford. It is not about what you need, what you want, what is market, what is fair, etc. It is about the company.

Don’t work for nothing, don’t give away your equity and do the right thing for the company are the three pillars that you should based the discussions around.” – Rick Segal

Dharmesh argues that founder compensation is usually part of 1 of 2 schools of thought:

Founders get no pay. (“Salaries, we can’t afford no stinkin’ salaries…”)

Founders get paid close to fair market value. (“We raised outside capital so we could reduce our risk, might as well pay ourselves…”)

He provides a great summary of why it is important to pay founders and early employees. And that there are a number of factors that influence how much these critical employees should be paid. Cash flow and the ability to pay salaries is a critical first step, whether this is through founder loans, early customers, or outside investment. Without money in the bank, it is all deferred compensation. Other critical factors include:

available cash,
tax optimization (within the law)
fair market value (FMV)

But it still doesn’t answer the question of what should I pay myself, my co-founders or my developers?

“All of this distracts from the core question of paying value for value. It doesn’t matter what somebody made at their last job. It doesn’t matter what their expectation is now. What matters is the value a firm places on the productive capability of an employee.” – Bradford Cross On Wages

I’ve talked about founders and early employees and their equity stakes in the past. I like the model that Paul Graham provides a model for calculating the amount of equity that can be used for equity grants for key hires (early employees, executives, etc.). The model calculates the value of company with the new employee.

n = (i – 1)/i where
n = percentage of the company
i = average percentage increase in startup value

The example provided states, that if you add a hacker to the company and you feel they will increase the value of the company by 20%, then you will break even offering them approximately 16.67% of the company. n = 16.7% = (1.2-1)/1.2. However, this calculation does not include salary and overhead costs. There is some discussion about converting salary and overhead into stock, but the number used is 1.5. The formula uses the Net Present Value of the company, plus the proposed salary, and the expected impact the potential employee will have on value. In the examples provided, Graham uses a recent post money valuation of $2M and a cash compensation of $60,000, and builds in a 50% profit on employee activities in favor of the company. The logic behind the calculation is, if an employee will add 20% value to the company the maximum amount of equity you should provide is 16.67%. However, this number is discounted n = ((1.2-1)/1.2)/(1+0.5)) = 11.13% against the employer generating 50% profit on the efforts of the employee. And is again further discounted against the cash compensation (FMV) and overhead costs (50% of cash compensation), calculated against their equity percentage using the NPV at time of hire, ($60,000*1.5)/$2.000,000 = 4.5%. The total compensation is a mix of cash and equity, i.e., a total compensation of 11.13% of the NPV of the company split into 6.63% equity plus $60,000 in salary.

n = percentage equity
i = average percentage increase in corporate value of new employee
p = profit percentage
NPV = Net Present Value of the company
FMV = Fair Market Value of employee compensation
EOC = Employee Overhead Costs

n = ((i-1)/(i+p)) - (FMV*(1+EOC)/NPV)

Yikes, this is getting complicated. The good news is that we can fix some of the parameters.

i = 20% (if every employee adds 20% value to the company, you’re should see fantastic growth, adjust this as necessary)
p = 50% (assuming you want to make approximately 50% profit on the efforts of every employee)
EOC = 50% (approximately 50% overhead on salary costs)

Hopefully as the early founders, you can figure out NPV but this can be difficult for companies that haven’t closed funding rounds. We’ll assume that this data is available or that the funding round was recently.

Fair Market Value

The open parameter is Fair Market Value. How much should you pay a developer? a designer? a senior executive?

Monster.ca and Salary.com have put together the Salary Wizard. It includes job descriptions and salary ranges based on local geographies. The data is a great starting point for assembling an overview of the fair market value for salaries and cash compensation. Here is a spreadsheet of Toronto Developer salaries (no bonuses). I’ve included job descriptions ranging from entry level programmers to CIOs.

Plugging in the 5oth percentile salary for a entry-level program into our equation above we get:

n = ((i-1)/(i+p)) - (FMV*EOC/NPV) = (1.2-1)/(1.2 + 0.5)-((49,830+24,915)/(2,000,000)) = ~8%

This should not be considered gospel, but it’s a good starting point for figuring out either the rough compensation for early employees including both equity and salary. It also provides a model for helping employees understand why it is so important to take as much of their compensation as equity, i.e., not cash. This provides a starting model for understanding potential compensation discussions. Both Rick & Dharmesh suggest that FMV for early employees may not be the right compensation metric, and that “creating value in ownership” is a much more important number. At HubSpot early employees salaries are 25-50% FMV based on cashflows and the rest is deferred. There are very real taxation issues with deferred comnpensation, and I am not an expert.

Before you decide on a compensation plan, it’s best to talk to your accountant, your lawyer and your board.