Hey Founders: The Big Equity Structuring Mistake to Avoid
This is tenth in a series of blogs on launching, growing and ultimately selling a technology company, with a corporate finance focus. Topics include cap structures, equity plans, financing, corporate partnering, board matters and how to achieve a successful exit.
The last in my series on vesting (I hear much cheering) on the prickly issue of vesting applied to founders.
Probably the single biggest mistake I see entrepreneurs make in setting up their initial share structure is mishandling the allocation and vesting of the founders’ shares. Interestingly, this happens even though most entrepreneurs are aware of the need to vest the stock options they grant to their employees (which comes later in the life of the company).
Since situations can change with your founding partners, you should make sure that if things don’t work out with one of them a year or two down the road your company isn’t in a compromised position. How you handle and vest the founders’ shares can have a profound impact in this situation.
A decision that seems counter-intuitive
Why is this a common problem? The reason is that there is often no check and balance on the founders’ decision process on this issue. When the company is just being formed there’s usually no board to review share structure and no investor to insist on vesting provisions. Typically the main advisor is your new lawyer, who’s focused on the here and now of incorporation.
And the founders themselves? Well they are each motivated to be fully vested so it is pretty easy to let this pass. Simply put, there’s no one to insist on vesting.
Taking the long view
So why should founders vest their founders’ shares? The simple answer is you do it because it’s in the company’s long term interests, and you do it for each other.
Founders leave companies for all kinds of reasons, not always performance related. There is no shame in stepping down from being a start-up founder after a year or so, it happens all the time. What would be a shame, though, is if the departing founder retained all of his or her equity and left holding an equal, or worse yet, greater stake than the co-founders who remained with the company to continue pursuing the dream. That scenario could cause serious friction, discontent and might even represent a serious threat to the company.
If, instead, the departing founder only keeps what they have vested (fair reward for their contribution), this problem can be avoided. It is all about alignment, fairness and a sincere commitment to set the company up for future success.
A TIP FROM THE FRONT LINE
I have seen professional investors refuse to invest in a company because a long since departed founder still retains too much founders’ equity. And I’ve seen continuing founders become unmotivated, resentful and in some cases quit over the same issue, or struggle to attract new talent who see this former founder getting a significant “carry”.
Volunteering to vest your founders’ shares when there is no one at the table to demand it of you takes integrity, discipline and a forward-thinking mindset. You do it for yourself and for each of your co-founders to ensure that the company can dodge a bullet should one of you leave, regardless of the reason.
And self-imposed vesting means that, down the road, some VC is less likely to layer further vesting obligations on top of yours. It does happen.
Next up, dog biscuits for the sled dogs. How are we going to get anyone to work for us?
David practiced corporate finance law for 20 years representing numerous technology companies before retiring to co-find a venture capital fund where he was a partner and portfolio manager for ten years. He now provides corporate finance/M&A advice to a portfolio of early stage companies with a view to growing them to the point they are ready to exit, and then leading that process.
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