The Founder's Dilemmas: Anticipating and Avoiding the Pitfalls That Can Sink a Startup

by Noam Wasserman

tend to take a very short-term view of the factors that should affect equity splits. They assume that the tasks that they are performing during the early stage of startup development are the same tasks that will be performed during the next and very different stages. They assume that their skills will remain as valuable to the startup as they are right now. They overestimate the amount of value that they will build in the first months compared to the value they hope to build over the subsequent years, and thus overweight their past contributions compared to the future contributions that will be required of them.

adjustments can cause major changes in the obstacles that the startup faces, the skills needed to address those obstacles, and thus the roles that each founder (or perhaps a new founder or a nonfounder) will have to play in building the startup.

come to understand each other’s abilities and commitment at a far deeper level than was possible at the beginning.

team believed it had avoided destructive tension over the equity split and could now focus on building the startup.

who knows what skill sets and what milestones and what achievements are going to be valuable as you move ahead. That first handshake caused a huge amount of angst over the next year and a half.”

half of the teams had neglected to include any dynamic elements (vesting, buyout terms, and the like) in their equity agreements, sentencing themselves to the same risks faced by the Zipcar and govWorks.com teams.

As important as it is to get the initial equity split right—by matching it as closely as possible the founders’ past contributions, opportunity costs, future contributions, and motivations—it is equally important to keep it right; that is, to be able to adjust the split as circumstances change.

It breaks down the qualitatively different stages of startup development into separate phases, provides a structured way to discuss and weight the importance of each phase for building the startup’s value, and provides an opportunity to plan and evaluate the various tasks that are being or will be performed by each founder.

A structured approach can also serve as a check on the natural tendency to overemphasize tangible factors at the expense of intangible factors which may have more impact on team dynamics and the success of the startup.

For founders—and for researchers!—past contributions are usually easier to assess than future contributions, cash contributions are easier to assess than contributions to honing the idea, and skills are usually easier to assess than commitment and motivation, but teams should seek mechanisms that enable them to discuss and balance this wide variety of factors.

shift its focus away from wrangling over specific numbers and toward a more productive process for agreeing on criteria, arriving at weightings, an...

negotiated its equity split twice in order to account for the varying contributions of each founder over time and also used the template to do some forward-looking planning, but even that wasn’t enough.

Terms, Contingencies, and Trust Dynamic equity agreements can make use of a number of approaches, such as buyout terms (in which a founder’s stake might be bought on prenegotiated terms by the startup or by other founders) and vesting schedules.

different types of uncertainty involved in contracts as “knowns” (whose outcomes are already known or are ensured), “known-unknowns” (scenarios for which one can anticipate the occurrence but not the outcome), and “unknown-unknowns” (whatever complete surprises the future holds in store).22 These three types of uncertainty can be addressed by terms, contingencies, and trust, respectively.

Founders’ equity splits involve knowns, such as how much capital each founder has contributed and who owns the patents, which can be addressed using standard contractual terms.

Known-unknowns can be addressed by using contingent provisions that outline how the equity split should change for various worst-case, expected-case, and best-case scenarios.

dealt with this known-unknown by crafting a buyout agreement that carefully laid out the rules and price for buying back founder shares should a founder cease to participate in the startup.

“In the event Burows is not a full-time employee of the Company by April 19, 2000, the other Founding Shareholders shall have the right . . . to purchase fifty percent (50%) of the Shares owned by Burows.”

an awful lot can fall into the category of unknown-unknowns. The first step in dealing with them is to work hard to identify as many as possible and discuss how things should change if such an event occurs; that is, turn the unknown-unknowns into known-unknowns.

any founding team can plan for the possibility that one of its members is suddenly forced to cut back or leave for medical or personal reasons. Teams who are willing to surface and discuss such scenarios will be able to transform some unknown-unknowns into known-unknowns and to work out contingent agreements to deal with them.

the tension-filled, high-stakes equity-split negotiation is itself a double-edged sword, an experience that can leave the team wiser, stronger, and more unified, or can undermine the trust within the team.

the equity-split negotiation is one in a series of negotiations that will determine the founders’ individual and collective success.

arriving at an agreement that they all felt was fair gave them valuable insights into each other’s motivations and goals,

Vesting is the most common type of dynamic equity agreement. Vesting terms require founders to earn their equity stakes, either over a specified time or when they accomplish specific milestones, rather than owning the equity from the start, as is the case with static equity splits.

Founders who leave a startup before their equity has fully vested must relinquish the unvested portion to the startup or to their cofounders, thus either shifting it to the cofounders who will continue to build the value of the startup or allowing them to reallocate it to someone who will replace the drop-out founder. Vesting terms thus help serve as “golden handcuffs” that either give each founder financial incentives to continue contributing to the startup, rather than dropping out while keeping the full equity stake, or help protect the remaining founders when one founder leaves.

enables core founders to test whether their potential cofounders intend to stay with the startup for the long term and to set expe...

Founders often worry that proposing vesting terms will be seen as a lack of trust in their cofounders’ dedication, or resent the idea that their own equity will have to vest, or even fear how they might be treated down the road before their equity has vested—without considering how vesting protects them.

time-based vesting and milestone-based vesting.

time-based vesting, each founder who is actively involved in the startup earns predetermined portions of his or her equity stake as each month, quarter, or year passes.* This type of vesting assumes that the passage of time approximates the addition of value to the startup, a valid assumption as long as work proceeds according to plan.

time-based vesting that is too short releases the “golden handcuffs” and increases the risk of losing a founder while the startup is still being built.

Team members earn a specific amount of equity for each of a well-defined set of milestones that, if accomplished, would add concrete value to the startup.

While this approach aligns each additional award of equity with the addition of value to the startup, it is effective only when the team can (a) define objectively when each milestone has been achieved and (b) clearly link the achievement of each milestone to the founder(s) responsible for achieving it. If the milestones are more subjective, milestone-based vesting can increase the tension and conflict as the founders disagree over which milestones have been achieved.

buy-back system whereby if Ken, the idea person, cut back to half time, his equity would be cut accordingly, and, if he had not joined by the end of the first year, his equity could be completely bought out.

non-idea founder would vest while the founder who had had the idea would not, a flexible arrangement that fit that team’s needs.

We saw how splitting equity early can help attract cofounders but can undermine the founders’ motivation and foster free riding, while late splits can bolster the founders’ motivation but interfere with attracting cofounders. Dynamic agreements offer a way to avoid this trade-off.

Defining the equity split (both its core terms and its contingent terms) early in the life of the startup allows the core founders to attract cofounders with concrete equity terms. Making the split dynamic—changeable in accordance with each founder’s continuing contributions—helps keep cofounders motivated to build the startup’s value.

early equity split, for example, allowed Mike and Jim to be fully attracted and committed to the startup (by receiving equity early), while its equity-buyback clause encouraged them to continue to work diligently for success because they wo...

In beginning a startup, founders incorporate their startups into their self-identities to the point where their own self-esteem becomes deeply tied to the startup’s success or failure.

severely limit a founder’s bargaining power for compensation, resulting in the founder discount.

startups grow to 100 employees, there is no significant difference between founder and nonfounder compensation.

Splitting the equity too early is a recipe for continual renegotiation.

the business is still amorphous and the team composition is in flux, the founders should hold off negotiating the equity split.

As the founders begin to agree on particular terms, they should document those agreements in writing to avoid later misunderstandings or miscommunication. Investor Jeff Bussgang observes, “I find that the most common source of tension is the ‘he said/she said’ disagreements down the road, which can be avoided by having well-documented, clear agreements or contracts.”

working together is a long-term proposition and that the equity-split negotiation can make or break the team’s relationship.

Founders who treat the negotiation as a “transaction” and try to maximize their own short-term deals may poison the relationship and lose in the long term, securing a larger slice of a smaller pie or increasing the chances that there will be no pie at all.

quick handshake splits are associated with lower valuations than negotiated splits (even negotiated equal splits).

founders should structure their equity split on the assumption that some aspects of the startup (such as its business model or strategy) and their founding team (such as the founders’ roles or levels of commitment) will change. They should (a) define how foreseeable scenarios should affect the equity split and (b) “plan for the unforeseeable” by including buyout terms or similar means by which an underperforming cofounder’s equity can be reclaimed by the other founders. Such terms encourage each founder to continue contributing and, failing that, let the remaining cofounders redeploy the under-performing cofounder’s equity in order to replace him or her. Each founder is protected and so is the startup overall.

inherent conflict in the fact that founders’ contributions (relative or absolute) can never be precisely defined or measured while their equity stakes and cash compensation can be specified down to the decimal point.

Founding teams who want to avoid the potentially disastrous consequences of an early and static equity split should do their best to devise a compensation plan (including the equity split) that (a) reflects each member’s past and expected contributions as accurately as possible and (b) motivates each cofounder without seeming unfair to the others. Teams should also keep in mind that the deal is never completely done. Circumstances will change, and the equity split and compensation may need to change, too, in order to accomplish what these essential tools are meant to accomplish—an issue we will examine in Chapter 7.

the closer the prior social relationship, the more likely the team is to adopt an egalitarian approach to decision making.