Founders, Ownership and Prenuptials

Posted on Aug 18, 2009 | 27 comments


Yesterday I wrote a blog post in which I urged people to not have too many founders.prenup

Best case scenario in my mind is just 1, but at most I recommend 2.

I knew this topic would be controversial because when I tell people this in person it always elicits shock.   To be clear – it is not about being stingy with or hoarding equity – it is about having a prenuptial agreement.

Let me give you some scenarios that do happen in real life:

You start a company 50/50 with a good friend.  If it becomes the next YouTube you always stay friends.  99.99% of companies do not become the next YouTube.  In fact, most go through tough times at some point.  Or maybe it’s not a good friend but you’re a business guy and hooked up with a technical guy you know through the network and you think you’ll work well together or vice-versa.

If you’re not an overnight success or if you do struggle what happens?

– What if one guy needs to pay bills and takes a full time job somewhere.  Should he/she keep 50%?

– What if you have to make really tough calls on cutting costs, biz dev deals, fund raising and you violently disagree on direction? Who prevails?

– What if the person performs OK, but not great and you need to hire above him?

These situations are only compounded if you have 3 or more founders.  I know that many people reading this will be in companies with 3+ founders and aren’t having any friction.  That’s great.  I have even invested in companies like this.  I know that conflict doesn’t always happen.  It’s just that when it does it usually comes after much time and expense.

A friend of mine used to work at Google.  He started a company with others.  They agreed to all be co-founders.  Now nearly 2 years of hard work have been put into the company (not to mention a lot of their savings) and they have had to have the discussion about who should be CEO.  There is no mechanism for deciding.  They agreed to let the VC’s decide once an investment comes in.  That sucks because VCs will want to know that you have all the difficult stuff worked out before you come to them. You’re just giving the VC one more reason to potentially so “no.”

Do you want to risk not finding an agreement AFTER you’ve sunk in years and hard-earned $$$?

Why does someone need to be CEO?  In many businesses you end up needing to make tough decisions.  Consensus does not always build.

In yesterday’s post; however, I did not advocate being greedy.  To the contrary.  I believe that it very important to spread the equity.  I believe that you should have a “partner” or 2 in the company.  I believe you should treat them as partners.  They should have access to all the same information.  They should be involved deciding in all the difficult issues.  They should have huge upside in the economic potential of your business.

But if you set up a company by yourself and give a large % in restricted stock or stock options to a partner and for some reason you fall out of love, you have a pre-nuptial agreement in place.  If they stay 2 years and then leave – great.  They only walk with half of their position.  I know that this could be achieved with simple vesting schemes, but there is a rub.  What if you decide that they need to leave?  It’s far better than you have some leverage that doesn’t end up torpedoing the company. 50/50 partnerships sometimes end with a bang.

There, I’ve said it.  I know it’s controversial.  But I still think it’s right for many a founder / entrepreneur.  Yes, there are exceptions.  No, it’s not the end of the world if you’re 50/50 or 33/33/33.

A friend and respected colleague, Bryce Benjamin (of TechCoast Angels)  wrote to me after my last post.  He was concerned that I had set the impression that founders should hoard their equity or that there were prescribed numbers to hand out.  He authorized me to post his comments:

“We’re in sync on so many start-up/entrepreneur issues that I may have knee-jerked a bit too harshly on this one.  But it is the “founding team” size and “percentage ownership” advice in this post that I feel you’re being too prescriptive about.  After re-reading, I see you have qualified your comments, but one of the things readers really like about your blog is that you give specific, actionable advice in it and your qualifiers will be ignored just as I read right past them last night.

One of the mistakes I see entrepreneurs commonly making is too much focus on their ownership % and not enough recognition of the various core competencies and expertise they’ll actually need to create a successful biz.  Generally a founder (or founding team) has strong core competencies in “a” discipline, but lacks the breadth needed to build the business.  First time entrepreneurs, especially, tend to need more than one other “key” team member/partner to help them be successful.  And to be able to attract the expertise/experience they require, they should be willing to give up pretty sizable chunks of the company.  Experienced entrepreneurs who know the ropes won’t need the same kind of support and will be able to build a team by giving up less of the ownership.

In terms of %’s, my advice to entrepreneurs is to focus on value and fairness.  I agree that “fairness” doesn’t always mean equal, but sometimes it does.  Again, though, the key for the entrepreneur is to focus on what individual(s) is(are) essential to expanding the size of the pie and getting the right people, not specifically on the size of his or her piece.”

I agree 100%.  I hope that this post clears that up a bit.  I don’t advocate being stingy.  I advocate, to steal Bryce’s words, “fairness and value.”  Many solo founders who have spent time with me would confirm that I often tell them, “you need to find a “co-founder” to work with if you want this to be successful.  And you need to be prepared to part with 10, 20, 30% of your company or more to make this happen.”

  • Don

    Fully agree with this, it’s business, and it’s hard. It’s about having clarity in those tough situations and taking ego out of the equation. Mike Jones delivered a nice presentation on the subject at Startonomics in February, worth checking out. Speaks about his experiences, founding teams and the prenuptial / buy-sell agreement. TechZulu vid at http://bit.ly/pQ2HM, slides at http://bit.ly/kXPyh

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  • jkfy

    Very good post! Friendship mix money -This is a never end topic, money issues between friends easyily leadto tension and resentment……

    Recommend a movie to all friends here- The YES Movie,
    Louis Lautman created it, about Successful young entrepreneurs of today, very informative.

    http://www.TheYESmovie.com

  • http://www.pockettales.com Brennan

    Any examples or templates of good “pre-nuptials”? This has been weighing on my heavily since I started my business. My partner and I decided to split 50-50, and I’ll put myself in the category of I can’t foresee us having problems. We get along perfect but…what if?

    Vesting can handle if one of us wants to leave, but what if we need to hire “above” as you say? Or one of us just isn’t performing altogether and should go? What mechanisms can we put in place now to make that easier, even if we’re already 50-50?

    You’re giving us the “Built to Last” advice and I’m asking for the “Good to Great.”

  • http://www.jobsbyref.com Ravi K

    Excellent post. The point you make about a being a CEO is right on the money. I see entrepreneurs focusing on the titles and positions and not the real essence of why they started the business in the first place. Sometimes title manifests our ego, and it becomes worse when it is demonstrated inside the team, especially in the early stages of the company. Being the founder of a company in itself, is a great responsibility.

    True founders should always focus on doing whatever it takes to make the business successful. Remove “I” from the equation and replace it with “We”, it makes a huge difference in sorting out issues and misconceptions that arise. If this is what each of the founder truly believes in then decision making becomes a non-issue, the focus will automatically shift to what is the right thing to do for the business to succeed.

  • http://www.totalbeauty.com Emrah

    I’ve only started one venture backed company but I have started several other companies where there were 2 or 3 “founders” who were friends in the deal. I always heard that friends weren’t good partners but I disagree. In my experience it’s the expectations that are flawed. I find that people do a better job of setting expectations and documenting their decisions and potential future scenarios when the co-founder is not a friend. They tend to be a lot more loose with the partnership when it’s with friends.

  • marksuster

    Starting with the easier answer – if you’re starting a new business the best prenuptial is that future members have stock options (or restricted stock) that vests and that you have the ability to fire them if need be. Hopefully it never comes to that. If you’re already 50/50 it is obviously trickier. You can have a mechanism which allows one person to buy the stock of the other at a pre-determined price. But the bigger problem isn’t the share buy-back but rather decision making if you don’t agree on a topic. I learned this lesson at a very young age. My mom opened a bakery and split it 50/50 with a close friend. After a couple of years they disagreed on how to run the business. There was no mechanism for resolving the conflict and they ended up in court. Not fun. So when you see a loved one go through something like that you don’t wish it on anybody. Nobody wants to have the difficult discussions about what to do if there’s a fundamental disagreement in the future, but I think it’s a topic that is always best discussed up front. Down the line you may find out you wasted years and $$$ and you’re at an impasse. Good luck.

  • marksuster

    In your scenario I agreed. The only problem is that what sometimes happens is that multiple people think that they know what is right for the company and don’t trust the other person to be the ultimate arbiter on an issue that they disagree on. You can’t get around this in many circumstance. The buck has to stop with somebody.

  • marksuster

    Emrah, thanks for the comments. I agree 100%. I never tell people not to work with friends. I think it is all about agreeing expectations up front AND knowing what will happen when people disagree.

  • http://www.jobsbyref.com Ravi K

    Correct Mark. To make this possible, the founders needs to keep some of these things in mind:

    1. There is no need for every founder to have an opinion about every decision that is made earlier on. Being prudent about this goes a long way in making it easy for the business to move forward.

    2. Even if two people have opposing views about a particular decision, in the interest of the core objective towards which one started the venture in the first place, try the one which has more pros than cons and if it does not work, then try the other option.

    3. Sometimes having 3 founders helps. It they agree among themselves that if 2 of them vehemently disagree with a course of action then you don’t go forward with the idea. Figure out an alternative. This alleviates some of the potential disasters that can save the business.

  • David Smuts

    Hi Mark

    You’ve been busy on this blog of late. Always enjoy reading your insights.

    I have a start up in the UK which I have co-founded with my business partner on a 50/50 split. I don’t think the problems you highlight are that difficult to counter.

    We have a board with 2 NEDs and a Chairman with a casting vote so deadlock is not an issue. Also with UK company law shareholders can dismiss any Director at any time. This is difficult of course when there are 50,000 shareholders but when it is a close company and there are one or a few investors on board, getting rid of an underforming partner is not difficult.

    The equity is dealt with vesting rights and good leaver/bad leaver provisions.

    The point I would add to your advice is that Inevestors and Founders should choose their board very carefully. They truly need “Independents” on board who can adjudicate in the case of differences among co-founders.

    as ever, enjoy your postings very much!

    David

  • marksuster

    Thanks, David. I lived in the UK for a decade and will tell you that the UK is ahead of the US in board structures and procedures. For example, in the US you still see people how are “Chairman & CEO” rather than recognizing the important role that the Chairman in a company is supposed to play. The role of the Board of Directors is to represent the interests of the shareholders (not management) and to provide strategic counsel to the management team. How can a Chairman & CEO as one person be independent? Also, I have not year of many US companies even discuss “good leaver / bad leaver”. We tend to focus on people who are fired for “good cause” which basically means you did something illegal.

    So while I accept that the UK is more advanced in board structure and function, there are many inherent problems with an early stage board. I do not believe that they really function as well as many people may believe. Independents are still beholden to investors because without the next round of capital the company doesn’t exist. Independents often want to sit on multiple boards so are reluctant to piss off the largest investors for fear of not being asked to participate on other opportunities. And independents often don’t have any skin in the game so can lack the resolve to make difficult changes in a company when required.

    I know that this is a controversial subject that I can’t do justice to in a reply so I think I’ll write a post on it in the future. But thank you for your comments and pointing out the way that some people are able to address the prenuptial issues.

  • David Smuts

    Mark,

    I AM SO IMPRESSED!!!! A reply on a Saturday! Are you crazy? My God, is this more than just a business for you!? I suspect a passion behind this blog rather than just a promo effort. Kudos to you my friend….,

    YES- UK corporate governance in my view is miles ahead of the US in regards to providing a clear divide between the roles of CEO and Chairman. I worked top level for a US Fortune 16 company, who as typical US fashion had their CEO also act act as Chairman. This was not to the benefit of shareholders. And a Chairman MUST be “independent”.

    But you are also too right to point out the deficiencies in having a board with “independant” NED’s. Are they REALLY “independant”? My advice is to pay them nothing, just an attendance fee. This helps to preserve their “independance”.

    We have yet to identify an ideal model between the US Chairman/CEO with an Independant BoD and the UK Independant Chairman with a Mixed Operational/Independant BoD. By the way…, are you a member of the IOD?

    In my experience you should NEVER have a Chairman and CEO in one person. The Chairman must be the custodian of the shareholder. The CEO is simply the Executor (deliveror) of the strategic plan (albeit paid considerably more than the Chairman).

    Didn’t know we had such international insight from VC’s from LA!

    all the best

    David

  • marksuster

    Thanks, David. Good for a Sunday morning laugh for me. Yes, I am passionate about many of these issues. When I started the blog I was already having many of these conversations daily with people in coffee shops across LA and I had hoped to be able to have a 1:Many conversation that would broaden the discussion. Only reason I have some insight into international issues is that I worked in Europe for 11 years and had to deal not only with things like BOD composition but also with employment law in Germany, France and the UK. I had to deal with import/export laws in India. I had to deal with cross-border taxation, software development domicility and many other complicated topics. Not to mention then having to deal with cross-border “over lay” laws introduced by European-wide legislation like TUPE employment laws. Maybe some day I’ll cover some of these topics but for the average American reader they would have no idea the complexities of cross-border business.

    WRT, independent directors, I take a controversial view. I believe that they should be paid zero. I believe that an independent director you bring on board should invest in your company – even a modest amount. That way they have their skin in the game and will start to truly act like the shareholders that they are supposed to represent.

  • David Smuts

    Hi Mark

    I agree 100% with you about not paying indie NEDs. Most FTSE 100 Companies don’t pay them here. (Well, they do actually pay a small stipend around £10-25k p.a. for their time, smaller companies pay zero to a much smaller stipend). Neither do they receive equity.

    Unfortunately you pointed out a real issue in BoD governance in regards to indie NEDs. The issue being that like you say; 1) they are all looking to have multiple directorships so they can earn a decent sum (in addition to whatever other income they’re getting) and therefore are disincentivised to do anything which may risk their stipend. 2) they seldom “rock the boat” and are more often than not inclined to say what the Exec. Board members want them to hear rather than challenge management. This fully nulifies what the Higgs Report set out to do.

    In Germany it is common for employees to appoint 1 NED. These employee appointed NEDs provide a much better “indie” service in my view than an NED appointed by the CEO because they go to the same golf course!

    In respect of VC funded companies this is where an investor appointed NED can indeed provide a good and reliable “indie” service on the BoD. Of course they are looking after their own interests, but at least it’s an “independent” interest from that of management and as they usually represent the largest independent shareholder it makes absolute sense for them to be on board. VC NEDs can bring real value when they actually have been in business themselves. And I’m afraid to say this Mark, but this is where many if not most VCs have a deficiency.

    You should then have an industry expert on the board as an indie NED alongside the investor NED. Someone both the management and the investors feel confident in.

    Lastly comes the Chairman and this is where you really do need an indie father figure and not a VC appointed one. Someone who is going to help mentor the CEO, chair the board meetings and ensure shareholders’ interests are protected. Chairmen do receive a salary unlike the other Directors. You are paying him to do a job and his job is to govern the board and protect shareholder interests.

    This is where I think the US model suffers from CEOs who are also Chairman. Too much power in 1 man’s hands. I like your suggestion that the NEDs should have skin in the game. Pity though this is usually not the case. There is an argument against this saying their indie status may be compromised if they are representing their own shareholder interests and not that of all shareholders. But I disagree with that viewpoint myself.

    With all that being said and in light of what you, Brad and Fred are saying/doing about standardised term sheets it should be pointed out that there are also opportunities to look at how VC models, governance issues etc.., are dealt with internationally. We can all learn from each other then! In terms of VC leaders it is certainly the US that is miles ahead, with the UK next and then I would say Israel. And individuals such as yourself are helping to lead this debate. We anxiously await to see if words and good thoughts become actioned. And for that, the VC voices calling for change must be supported by their employers. Watching with interest….,

    By the way, where did you live? If ever you’re in London I’ll treat you to real beer and curry!

    all the best

    David

  • http://www.pockettales.com Brennan

    David – You offer some helpful ideas for a partnership with a 50/50 split. Thanks for sharing.

  • Babette

    Great post! As a single founder, I may be partial to going it alone to keep the company’s focus clear. However, if the other founder can double up on another job function like developer, lawyer, designer… You may save a ton of cash by not having to hire anyone in those positions as you start to grow. Regardless, it is refreshing to read it’s ok to have one founder. Your company’s traction should be enough to prove you can make it. IMHO

  • Mark Suster

    Thanks for the comments, Babette. I think everybody needs a co-founder – I just have a different definition for it than most people. My definition is … you set up your own business, register it, get the concept going and then shop for people with complementary skills. Invite them to be a co-founder. Given them a very large stock option plan with a 4-year vesting. Treat them like a true partner. Give them 100% information and get them involved in all decisions. But … if you fall out of love you’re protected AND a partner does not = 50% of the company. Congrats on doing the more difficult route – on your own. I know it will pay off for you.

  • http://twitter.com/eranshir eran shir

    Mark, you shouldn't be shy about this point, it's very important and in fact critical to a start-up's success. A founding team should be small (I'd say ideally and at most 2). The pre-nup is one side of it, but there is another reason, potentially even more important. When you have a large founding team, in the early days the founders are a huge percentage of the workforce. In an 18 months old company with 15 employees, a founding team of 4 is more than 25%. The problem with that is that even if one of them is the CEO, typically he will have much less management leverage on them than he has on other employees. They might be his buddies, or he feels one of them could've just as easily turn out to be the CEO. It's hard not to look at them as peers. And then it's much harder to hold them accountable and force an objective metrics driven management process.

    So I would say, get a partner to bounce ideas and build together in the garage (it's hard not to get mad alone), but keep it at that. And when you choose one, remember the other side of the pre-nup metaphore – choosing a co-founder is the closest thing to choosing a spouse. Don't be Brittney Spears.

  • http://twitter.com/eranshir eran shir

    PS, just found your blog (through Fred) and love it. Nice work.

  • http://twitter.com/eranshir eran shir

    Mark, you shouldn't be shy about this point, it's very important and in fact critical to a start-up's success. A founding team should be small (I'd say ideally and at most 2). The pre-nup is one side of it, but there is another reason, potentially even more important. When you have a large founding team, in the early days the founders are a huge percentage of the workforce. In an 18 months old company with 15 employees, a founding team of 4 is more than 25%. The problem with that is that even if one of them is the CEO, typically he will have much less management leverage on them than he has on other employees. They might be his buddies, or he feels one of them could've just as easily turn out to be the CEO. It's hard not to look at them as peers. And then it's much harder to hold them accountable and force an objective metrics driven management process.

    So I would say, get a partner to bounce ideas and build together in the garage (it's hard not to get mad alone), but keep it at that. And when you choose one, remember the other side of the pre-nup metaphore – choosing a co-founder is the closest thing to choosing a spouse. Don't be Brittney Spears.

  • http://twitter.com/eranshir eran shir

    PS, just found your blog (through Fred) and love it. Nice work.

  • http://bothsidesofthetable.com msuster

    Ha, excellent visual. Yes, I believe in smaller founding teams. It's controversial and most companies have 2 founders if not 3,4 so I try to be sensitive by not shouting louder. But I usually tell these people privately to start their next company by themselves and add “co-founders” later. Thanks for your input.

  • http://bothsidesofthetable.com msuster

    Ha, excellent visual. Yes, I believe in smaller founding teams. It's controversial and most companies have 2 founders if not 3,4 so I try to be sensitive by not shouting louder. But I usually tell these people privately to start their next company by themselves and add “co-founders” later. Thanks for your input.

  • http://bothsidesofthetable.com msuster

    Ha, excellent visual. Yes, I believe in smaller founding teams. It's controversial and most companies have 2 founders if not 3,4 so I try to be sensitive by not shouting louder. But I usually tell these people privately to start their next company by themselves and add “co-founders” later. Thanks for your input.

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  • http://www.recake.com Berry

    Mark
    We really need some advice. We have 2 cofounders. There is a guy we want to bring on- right connections, experience, etc. The two of us have a decade long friendship, have worked on several projects, etc. We met the new guy at an industry trade show where we were exhibitors (btw- we won't be conference ho's- but trade show ho's- that is a possibility!)

    So two questions:
    1. How can we phase him in as an equity partner? What is typical in terms of earning trust, performance targets, and vesting?
    2. Who owns the IP– the new guy is not a programmer. What is a typical scenario for “who gets the code” if the company dissolves?

    Thanks.

  • http://twitter.com/halebrewco Timothy Golden

    I'm in the same situation. Would love some advice.

  • http://www.kirillzubovsky.com Kirill Zubovsky

    “…a friend of mine used to work at Google. He started a company with 2 others. They agreed to all be co-founders..” – redbeacon?