Prenups for Startups: How to Structure Founding Teams

September 17, 2013

11:00 am

One of the people in my networking group in Chicago posed this question: How do your teams structure yourselves so that people are compensated fairly and encouraged to do their best work?

The ensuing online discussion inevitably turned toward how to create a working relationship so that everyone is happy, motivated, and feels appropriately rewarded.

There are no silver bullets for how to do this, and we are all products of our own experience. The perspective here is mine, and I have no doubt you can find plenty of people who have a different take on what follows.

Early in my career I worked at IBM. While people there made good incomes and had great benefits, no one was awarded stock options and very few employees owned any IBM stock. People acted and behaved like employees. A few years later I went to work for Microsoft where stock options were a part of everyone’s compensation. I was astounded at the cultural difference between the companies. At Microsoft you would see people look for ways to be efficient, to save money while traveling on company business, actively pursuing new ideas, and so forth. People behaved as owners of the business. This contrast has indelibly colored my thinking about how to motivate teams and manage people.

I have a couple of important principles that almost always enter the picture when forming new companies:

  • It’s vital in a tech startup to create a culture whereby everyone thinks and behaves like an owner of the business. Everyone at every level, therefore, gets some equity (or stock options as a proxy for equity).
  • Everyone except cash investors gets the same type of security…common stock. The amounts can differ, but you do not want to create a layered structure or have different classes of stock among the founders. If you have a layered structure, you’ll create the potential that some employees see cash from their equity before others do.  My philosophy is that everyone is in the boat together even if the amounts differ.
  • Everyone should be on the same vesting schedule. I like a four-year vesting schedule with a 25 percent cliff after the first year and monthly vesting thereafter. With this structure, poor performers who don’t last a year don’t get anything. And since the vesting is very smooth thereafter, there aren’t any big dates that people are motivated to hit in order to reach their next slug of vesting.
  • In an LLC, you’ll have an operating agreement. In a corporation, you’ll need a shareholder’s agreement. It is these documents, in my experience, that really create the relationship among the founders/shareholders. This document is your prenuptial agreement, and it spells out the following:
    • When someone leaves the company, what happens to their vested stock? Do they get to keep it? Do they have to sell it back to the company? If they want to sell it, do the other investors get a right of first refusal? Can they sell it to a competitor? Or are they limited to whom they can sell it? If they sell it, how is the price determined?
    • Can they start a competing company? Employment agreements may have non-compete clauses, but what if someone has founder’s stock in the company but is not an employee? How are the other founders and shareholders protected?
    • I once had a business partner in a consulting firm we started together. Since the “equity” in the company only really had value to each of us, he put a Texas Draw clause into the partnership agreement. In a Texas Draw, each party is subject to a reciprocal matching offer. The agreement said that if one of us wanted out of the partnership, then we could name the price we were willing to pay to buy the other person out. But the other person could then, instead of selling, choose to buy the person out at that same price. That meant that if you tried to low ball your partner, he could stick it to you. This is identical to the game where someone cuts the pie and then the other person gets to choose which piece they want. We had no difficulty whatsoever dissolving our agreement when it came time to go our separate ways, and I credit the agreement we had struck in advance as helping a lot.
    • If you raise money from a traditional VC, chances are your prenup will get rewritten.
    • People don’t obsess about what happens if the business fails. If it does, no one gets anything, and that’s a risk that everyone understands. People obsess over what happens if the business succeeds…they want to know how they’ll make out. The worst case scenario for everyone is that despite the odds, the business succeeds but they don’t get what they think they’re owed. That really creates some misery. Managing this can help to create the right kind of culture that has everyone working together.

Where people go astray, I think, is to assume that the stock you get at the beginning is the only stock you’ll ever get. This may be true of the founders, but in all of the companies that I’ve led, I’ve taken the approach that additional stock option grants can be awarded as part of merit compensation. That is, if you do a great job, you can get additional stock options awarded to you. If you only meet the expectations of your position, you probably won’t get more stock. If you fail to meet expectations, you’ll get terminated which means you lose all of your unvested stock.

Inherent in this philosophy is an obligation to communicate expectations and manage people. This is not something that startups traditionally do well, especially among founders who consider themselves peers. For an organization to thrive, people need to be managed. A company cannot be run by a committee. You can have a flat hierarchy, and people can be equal in terms of pay and/or equity, but at the end of the day someone has to be in charge.

It goes without saying that a young organization cannot tolerate any prima donnas. Titles don’t matter much either. There should be an agreement about who does what (i.e., “I handle sales, you handle technical development”), but everyone wears multiple hats.

Some people today advocate for milestone-based vesting. While this sounds equitable and sensible on the face of it, I’m not a fan. I’d rather make periodic additional awards to people to reflect their contributions while relying on time-based vesting to allow the management team to handle weak performers. A shareholder’s agreement can also mandate that employees who leave have to sell their stock back to the company. This is a mechanism for ensuring that people who leave too early don’t get to participate in the run up of the stock price although it can be an unwelcome surprise to people who didn’t know it was in there.

From management’s perspective, by making periodic additional stock awards, any employee at any level is always leaving something on the table in the form of unvested stock when they leave the company. What you don’t want to happen is have founder’s stock suddenly vest and then people leave taking the spoils with them. You want to make sure there’s a cost to their decision to leave.

Here’s my final point: Be a founder. This is sort of like saying, “It’s good to be king.” It’s a lot easier to hire people into your company than it is to choose a co-founder. If you start the company and later bring in people by hiring them, the dynamic is very different than five people getting together at the outset to form a company where each gets 20 percent. The biggest dilution you will suffer is with a co-founder(s).

This is a very complex topic, and I’ve only scratched the surface. Are there any other aspects of this subject that you’d like to me address in future posts? And if you disagree with my perspective, please let me know.

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Neil Kane, the Director of Undergraduate Entrepreneurship at Michigan State University, is a leading authority on technology commercialization and innovation and has the battle scars to prove it. He was named a Technology Pioneer by the World Economic Forum in 2007. His Twitter handle is @neildkane. He’s also on Google+ and LinkedIn.

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