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

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?

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.

Franchising works, but does it work for you?

We have all been to a McDonald's, Taco Bell, or other franchised restaurant.  No matter where you go, a reliable menu is waiting in familiar surroundings.  These systems are examples of an established business model where independent business owners buy the rights to operate their restaurant with the look and feel of any other restaurant in the system. But franchising is not just for fast food.  Franchised businesses are responsible for $2.31 trillion which represents 11.4% of the total private sector output in this country and up to 40% of all retail sales!  Franchises come in all sizes and flavors - I have personally represented casual dining restaurants, a dog training business, an educational learning center, health club, and other systems.  You can find franchises is just about every industry operating in the U.S. today.  So franchising clearly works.  But will it work for you?

A franchise is born whenever a business relationship meets three criteria:

1. The right to use a trademark or trade name,
2. Some type of marketing plan or system created by the franchisor, and
3. A fee paid by the franchisee.

The parties cannot opt out of the franchise regulation; if you meet the three-part definition, you have a franchise and must comply.  Failure to follow the rules can result in fines and other penalties.

Here is an example:  I was speaking with a business owner who has been operating for several years and has established two successful locations.  He was interested in expanding, but couldn't find financing.  He was approached by entrepreneur who was interested in opening a few other locations based on the established name and concept.  The store owner was willing to grant the entrepreneur the right to use the name of the business, but he expected some type of payment for that right and he wanted to make sure that the new stores would be run in a similar fashion to his since he spent years developing good will with his customers.  It sounds like a win-win situation: the business is expanding, but the business owner does not have to put out the capital to open the additional locations, and the entrepreneur is leveraging the proven model into starting his own business.

However, it is not without concerns.  Franchise regulation is neither a simple nor inexpensive process.  And while many successful businesses have enjoyed rapid growth through franchising, you must have an understanding of the definitional requirements, particularly if you are trying to avoid falling under the regulatory umbrella.  The franchise laws and regulations control the process of selling franchises - everything from the initial meetings, to signing the paperwork, to operating.  And the rules were rewritten last year, making the current state of the law even more complicated.

But before you launch into franchising, consider the following:

• Is the business franchisable? Many businesses are prime candidates for the franchise model, but others are not.  Franchises exist in almost every industry from food and retail to auto parts to education to professional services.  But a business built around a person's unique personality, for example, may not be reproducible elsewhere.
• Is there a need and is the business scalable? You may be able to keep up with current demand by producing your product in-house with a solid team.  But will the need grow with the increased availability of your product or service?  A healthy franchise system will require an exponential growth in the delivery of raw materials or other services underlying your business.
• Are you ready to give up "your day job"? Whatever business you were in before you decided to franchise, you are now in the business of selling franchises.  Creating and maintaining a franchise system requires a full-time effort and attention to business and legal issues surrounding your own company and the needs of your franchisees.
• Are your finances in order? Franchising is a great way to develop a system using other people's capital.  However, there is still a significant capital requirement to get up and running and to provide continuing support services to your franchisees.
• Where will you franchise? State laws will require that you have a franchise plan before you start talking with prospective franchisees.  Failure to comply with state requirements could result in fees and other penalties.  Many franchise systems start in one state or a region and gradually increase their presence to avoid the financial and legal burdens of nationwide compliance all at once.

And of course, there are many more.  Franchising is a proven business development method that has helped thousands of businesses employ millions of workers.  Whether it is right for you will depend on many factors.  By consulting with experienced professionals like franchise lawyers, accountants, and financial experts, you can determine whether you are ready to take the next step for your business.