Forming a Business Team (Overview)
The business team either refers to the business managers or, in the case of most startups, everyone working on or in the business. In the early stages of a startup, the business team is generally a close-knit environment. Individuals are working diligently together, usually for little or no salary, to carry out the business operations. This environment requires a special type of bond between the startup members. As such, forming a strong, compatible business team is the single most important aspect of successful startup ventures.
Forming a team is about “fit”. I define fit as the complimentary abilities and personalities of individuals involved in the business. Fit is particularly important in early stages when the business consists of founders and early employees. As the business grows larger the sense of camaraderie among all team members may decrease. Startup firms must work diligently to maintain the entrepreneurial spirit or personality of the business as the team members grow.
Considerations for Formation of a Business Team
The startup team forms continuously throughout the lifecycle of the business. Below is an overview of the stages of team growth that a business undergoes.
- Culture and Fit
- Founders & New Owners
- Early Employees and Contractors
- Ownership and Control of Founders
- Rights of Owners
- Organizational Documents and Ownership Agreements
- Duties of Owners
Entrepreneurs & Inventors
As discussed in the previous chapter, the entrepreneur assembles resources around a source of value. More common than not, the entrepreneur is not the person who came up with the idea or invention. This separation is the most common genesis of entrepreneurial teams. For example, an engineer develops a state of the art baby stroller. It has functionality that is far superior to all of the strollers on the market. The inventor may not have the knowledge, time, or ability to work on the product and build a business around it. In steps the entrepreneur who undertakes the process of assembling value around the product. While the engineer undertakes the role of continued product development, the entrepreneur plans for bringing the stroller to market in a way that will provide a sustainable transfer for value that benefits the business.
Do you love your product or service?
Now is a good time to raise another point. As an entrepreneur, do you love your product or service? In the case of most successful serial entrepreneurs, the answer is generally “no”. You should be passionate about the process of building a business, but not necessarily about the idea itself. The role of the entrepreneur is to remain objective in evaluating the business opportunity. He or she knows that many good ideas exist. If the present idea, no matter how cool or innovative, does not product the desired value, then it is not worth pursing. Inventors, on the other hand, tend to become consumed by their product. Their dedication to their work product makes it difficult to look objectively at the product when determining the feasibility of creating the desired value around the venture. The entrepreneur looks at the product through the lens of the intended customer segment, rather than through the lens of the devoted inventor.
Now that you understand the concept of what type of ideas constitute potential business opportunities, let’s turn to how individuals identify or form these ideas. The next chapter will focus on evaluating these ideas to determine whether they are indeed feasible entrepreneurial opportunities.
Founders with Complementary Skill Sets
The business team begins with the entrepreneur(s). Earlier lectures in this library introduced the genesis and evaluation of the business idea. In many cases the founding entrepreneurs consist of an inventor or the person generating the idea and another entrepreneur. As we previously explained, the original entrepreneur is generally not the inventor. The inventor spends so much time working on and developing the product or idea that he or she has little time or ability to work on the business. The startup entrepreneur enters the picture as a cofounder and begins to build value (a business) around the product or idea through assembling resources. So, it is quite common for the startup team to consist of the inventor (or sometimes multiple inventors) and a business-minded entrepreneur. A common theme among successful startups is the presence of two individuals as founders who match the entrepreneur-inventor (developer) dichotomy.
The reason that this entrepreneur – inventor relationship among founders is successful is because each member has a unique skillset and distinct purpose within the business. This is a very important situation. For a startup team member to be of value to the business, he or she should have skills that are complimentary of other members (rather than duplicative). This does not dismiss the fact that founders often have similar skills. Just look at Steve Jobs and Steve Wozniak or Bill Gates and Paul Allen. In both cases these individuals had a great deal of common skills. However, in each relationship, one individual assumed a greater role in product development while the other focused more heavily on the entrepreneurial tasks of developing the business. In many cases the founding team will consist of multiple individuals, all with complimentary skills
Early Employees as Owners
Early employees are critical to the business. Generally, the founders will have to make strategic hires to proceed along the intended growth path. As a founder, you should exercise considerable diligence in evaluating potential employees. You will look for the same type of personal and professional fit as described in our previous lecture. The early employees often have skills that are far more valuable than you are able to pay them in salary. With this in mind, early employees are often incentivized with a combination of salary and ownership interest. For example, a new software designer may receive a low salary, but have a vesting plan for ownership interest. This serves two purposes. The new employee is incentivized to make the business a success (because it raises the value of their ownership interest) and the startup does not use up as much cash by paying a higher salary to the employee.
The concluding point to this introduction is that early members of the entrepreneurial team should have both personal fit and complimentary skill sets. These are individuals with whom you will have to work and collaborate extensively. Personalities that strongly conflict or duplicative skills can cause conflicts or voids that hinder the startup’s progress. Remember, the startup depends almost exclusively on high growth and productivity. Without a strong fit among team members achieving this objective is very difficult.
Later stage employees of the business generally assume the role of salaried employees. At this point, the business produces sufficient revenue (along with equity investment) to pay personnel a salary. The downside to this relationship is that the startup leadership has to develop ways of incentivizing and motivating employees to accept and continue the entrepreneurial spirit of the business. That is, these employees will be asked to work long hours on a variety of tasks to fulfill any random need of the business. The startup work environment can be stressful and more demanding that equivalent salaried positions. The characteristics of the job make it extremely important to focus on acquiring workers who have the same personal and professional fit as described above. Employees must have that same entrepreneurial spirit and drive that is motivated by achieving the growth-based goals of the startup. Generally, the startup employee must be self-motivated and able to work and perform under conditions of little to no supervision. These are the employees that will form the backbone of the business, as they become managers of their own teams as the business grows.
- Note: One important point is that the entrepreneurial nature of a firm necessarily changes as it grows. The startup leadership should constantly be aware of the necessary changes in operations structure, benefits, authority, compensation, etc., that is necessary to motive the later stage startup employee.
At various stages of a startup’s growth, contractors will play an important role in the development of the business. That is, contractors can provide temporary or outsourced services that provide a high value proposition for the startup. For example, early on starting the business may require accounting, legal, or other business consulting services. Rather than hire employees to handle specific functions, it may be advantageous to outsource these functions to third parties who specialize in these functions. Generally, the temporary nature of these outside workers produces high quality work without having to invest significant time and effort in hiring a full-time employee with a particular skill set that may or may not fit within the startup culture.
The most common form of contracting in startup ventures is the outsourcing of product development. Manufacturing is an expensive process given the high cost of equipment and personnel to operate the equipment. As we discussed in the chapter on strategic planning, outsourcing the manufacturing of products is a primary method of reducing the cost associated with producing a product. Many people lament the trend of sending manufacturing work to lower-wage overseas locations. In reality, this may be the only manner in which a startup can produce a product at a cost point that allows the business to be feasible. I certainly don’t advocate the outsourcing of manufacturing to places that fail to adhere to decent standards for the employee work environment. However, outsourcing the production of goods at the early stage of business growth can allow the business to grow and create value within the local market that previously did not exist.
Control of Founders
Two of the most difficult decisions in the early life of business are the splits in the level of authority (control) and ownership rights of owners. Control is a much easier matter than ownership. Control involves having say-so or authority over an area of the startup process. A business is wise to allocate control to the individual whose incentives are correctly aligned with the business’ objectives and who has the potential for best performance in role. It is advisable to develop a plan for the chain of authority early on. A team environment without an individual decision-maker or person in charge can be inefficient and unproductive.
We address the legal considerations for control by members of the business in the context of business entity selection and agency liability (tort and contract) in other articles.
Ownership of Founders
Ownership interest in the business is a much more challenging situation. Among founders it is difficult to attribute value to one person over another. Each team member believes (usually correctly) that his or her skills and effort are critical to the success of the startup. This will cause each member to desire or develop a sense of entitlement to a great percentage of ownership. These subconscious power struggles can tear apart a team. I cannot tell you how to divide up ownership, but I can give you some tips for doing so. Much of the information is relevant to business entity selection and observing appropriate legal entity formalities.
Considerations for Dividing Ownership Among Founders
Below are some general tips when dividing ownership interest among founders. These tips apply as well to early employees who acquire an equity interest in exchange for their services.
- Intellectual Property: The individual who developed the idea or owns the patent (who also assumes a primary work load) should start out with a higher ownership percentage.
- Contributed Capital: Given a similar amount of responsibility, an individual who contributes a greater amount of early stage (startup) capital will have a higher percentage of ownership. While the skills of each member of the team are valuable, the business could not get started without the initial risk incurred by the capital investor. Founders who invest a greater amount in the business and share nearly equally in the workload should have a higher percentage of ownership.
- Obvious Discrepancies in Responsibility: If the value added of one individual obviously exceeds that of another, then that individual should have a higher share of ownership by comparison. Generally, the lead inventor (designer) will have a greater percentage of ownership than other members of the team. In contrast to larger corporations, the member who manages the finances will generally have a lower share than the individual in charge of sales and marketing. Remember, sales and marketing is the lifeblood of the business.
- Other Value Added: Acquiring a prominent individual to the startup team could demand a higher percentage of ownership. Remember, investors will evaluate the business largely based upon the ability or expertise of the team members. Having an accomplished person with a strong reputation on the team can be invaluable when seeking investment. Further, an individual that has the ability to bring necessary resources to the table will command a higher ownership percentage. For example, bringing on an individual to manage the finances who has extensive connections that will allow the business to obtain financing is extremely important. This is why startups are generally willing to bring in members who have connection to lots of angel investors or venture capitalists. These connections can make or break the success of the business at any given point in the business lifecycle.
- Dilution: Team members should address the issue of dilution up front. This means that, as the business distributes additional percentages of ownership, the ownership interest of each team member decreases. For example, two founders own an equal 50% ownership stake in the business. Now they need money from an angel investor. They offer the investor 20% of the business in exchange for equity capital. In an even split, the two founders now own 40% each. Their ownership percentage has been diluted. There are methods of diluting total ownership percentage, but not diluting authority. One example is the issuance of a preferred class of stock (if the business is a corporation) to the angel investor. Another example is limiting the voting rights of the angel investor in the LLC agreement (if the business is an LLC).
- Calculate Ownership Based Upon the Exit Valuation: As we previously discussed, most startup ventures have a planned exit event. That is, a time in which the startup will either sell the business ownership or offer ownership to the public. This allows the owners (all equity holders) to sell their entrance and exit the business, if they so desire. We will discuss in the next chapter how the financial performance of the firm determines the value of the business at an exit event. In any event, the business plan will contain an anticipated exit valuation. This valuation is used to estimate the ownership percentage offered to equity investors in exchange for invested funds. Likewise, the exit valuation should be used to determine the amount of ownership interest awarded to team members. For example, a business plan shows a business value of $10 million in year 5. The business plan calls for dilution of the owner’s equity by 50% as outside equity investors acquire interest by funding the business various stages. An individual who was awarded 10% equity interest now has a 5% stake of $10 million = $500,000. You will have to evaluate whether the risk taken by the individual and the amount of work required over a 5 year period is worth the present value of $500,000. Of course, you will add in the value of any salary that the business was able to pay (which is generally quite low if any salary is paid at all).
- Vest New Ownership Over Time: New team members (founders) should not be given ownership interest up front. That is, they should be vested with an ownership interest over time. For example, a new team member who will be in charge of sales and marketing may receive 10% of the business. However, that ownership interest vests over a 3-year period (1% up front, 4% at the end of year 2, and 5% at the end of year 3). If the individual is not performing, then they may exit or be fired before a considerable amount of ownership is awarded them.
- Form a Decision-making Body or Board: Form a board (even if you are not corporation) that has authority to make decisions about hiring/firing, distributing ownership interest, and other key decisions. You will want to establish a democratic process that allows co-owners to take part in the decision-making process. Voting authority should be directly commensurate with the ownership interest of the individuals on the board. In this way a single individual generally does not have sole decision-making authority.
- Buy-Sell Agreement: Have a plan for the business to acquire or reacquire a founder’s ownership interest if the individual wants to leave or is fired by the other team members. This is often known as a buy-sell agreement among owners. The provisions vary, but it allows for a member who wishes to leave the business to either sell their interest back to the business or purchase the ownership interest of other members.
Rights of Owners
As discussed in the previous lecture, control and ownership are separate concepts in a business ventures. Control, itself, is a right that may be bestowed unto owners. Control is generally determined by the type of entity and the position held in that entity. For example, a partner is assumed to have extensive control in a partnership, while a shareholder in a corporation is presumed to have little or no control over the organization.
Ownership in a business entity generally entails two rights:
- entitlement to profits of the business, and
- voting rights for business decision-makers.
Entitlement to Profits
In a startup venture, any potential profits are generally reinvested in the business in order to obtain a higher level of growth. The reinvested profits ultimately produce a higher return on investment at the point of sale (exit). Equity investors understand this principle and expect the business to lose money during the initial period of growth (generally 3-5 years). Owners and new employees must be made aware of this aspect of the startup venture. Perhaps a co-founder who is less familiar with the principles of growth-based entrepreneurship or a new employee who acquires an equity interest in the business may not understand why the business reinvests every penny of potential profit and, generally, reports a significant loss during the early years. These team members should me made to understand early on the nature of the business and the fact that there should be no expectation of distribution of profits during the business’ growth phase.
Equity owners of a business generally have a right to vote for the board or members of the business who will be in charge of decision-making. In a corporation, the shareholders vote for the board of directors that is vested with the major decision-making of the business. In an LLC or Partnership, each member has the ability to vote in accordance with the terms of the LLC or partnership agreement. This situation primarily becomes an issue when outside equity investors (angel investors or venture capitalists) wish to exercise control over the business. This is an understandable position for the equity investor, who wishes to protect his or her investment. For this reason, it is important to establish early on the voting and decision-making authority of equity owners. One way of limiting the voting rights of equity investors is to assume a corporate entity status and to issue outside investors alternative types of ownership interests. For example, the business may provide equity investors with preferred stock that has no voting rights, but has some other preferential treatment (such as priority in the payment of dividends or the ability to convert the ownership interest to debt). In any event, co-owners may have varying degrees of understanding of their ability to control business decision-making through their voting rights. Planning accordingly, through the issuance of ownership and detailed ownership agreements, will prevent issues of voting rights from becoming a point of contention in the business.
The organizational documents of a business generally include the documents used to form or organize the business (registration documents) and the operational documents used to control activity within the business (operational documents).
The organizational documents are known as the declaration of partnership for partnership; the articles of organization for LLCs; and the articles of incorporation for the corporation.
This lecture focuses on identifying the operational documents that control the internal operations of the business.
Operational Documents contains provisions regarding the percentage of ownership of each owner, the role of each owner in the business operations, and the authority of each owner to make decision and bind the business. Whenever a business has more than one owner and no ownership agreement in place, then state law controls. In most situations, the default rules call for equal ownership, equal control, and equal profit/loss sharing between owners. While this may be the owners’ intent, it is still advisable to have a thorough ownership agreement to address the litany of issues that can arise during the life cycle of the business.
Ownership and Control Rights
The ownership and control of a business generally begins with an agreement between the owners – founders and managers. Ownership agreements generally outline:
- Control of the entity (or authority to act on behalf of the entity in carrying on business),
- Percentage of entity ownership,
- Entitlement to profits and responsibility for losses.
Each type of business entity has a different operating, management, and ownership structure. The business ownership agreement that you employ depends on the entity you choose to operate your business or venture. After selecting a business entity, each of the above consideration arise in drafting the ownership agreements.
Sole Proprietorship (No Formal Document)
A sole proprietorship is a company with only one owner. Therefor there is generally no issue of control or ownership of the business operations. Starting the sole proprietorship requires no paperwork. It is not registered with the state, unlike a limited liability companies (LLC) or corporations. As such, there is no legal requirement to file any formal document in place. All you do to create a sole proprietorship is simply go into business. No ownership agreement is required, so the business plan often serves as a guide for planning operations.
Partnership Agreement (PA)
The PA should outline the control of each partner of the business, the partner’s ownership interest, and the duties and responsibilities of the partners. Below are the important aspects to address within the PA.
- Governance – Outlines rules governing the business
- Relationships – Establishes an understanding of the business relationship that exists between the partners.
- Duties and Responsibilities – The regards the position that each partner will assume in the business operations
- Profits – Rights to or allocation of benefits or profits.
- Dispute Resolution – It serves as a base to deal with problems that arise in carrying on business.
- Leaving the Partnership – Determines the procedures and rights for when a partner leaves the business.
Without a PA, the default state law rules for Partnership operations apply. With this in mind, It is always better to have a planned, customized partnership agreement in place that meets the needs of the individual partnership.
LLC Operating Agreements (OA)
Individual state law determines whether an LLC is required to write out an operating agreement. (See your state Code of Laws).
The purpose and elements of an OA are as follows:
- Ownership – Lays out ownership percentage and the profit and loss sharing between between the members.
- Authority – Duties, obligations, voting rights, etc.
- Managerial structures & Governance – (i.e., Member-managed or manager-managed. Rules for meetings and voting.
- Decision making – Procedures for decision-making about the business
- Exiting the Business – What will happen in the event that one of the owners decides to leave the business.
- Disputes – Avoid or alleviate misunderstandings between members.
- Default Rules – State laws control by default without an OA in place.
A corporation must file articles of incorporation (formation) and ByLaws (Operations). It may but is not required to file a shareholder’s agreement (Ownership). The purpose of the corporate bylaws is to lay out the operating procedures that the corporation. At a minimum, a corporation’s bylaws will cover:
- Name, address, and principal place of business
- Directors and corporate officers
- Election or appointment procedure
- Terms of Service
- Stock (number of shares and classes) that the corporation is authorized to issue.
- Governance Procedures:
- Director and shareholder (s/h) meetings
- Shareholder, director, executive actions
- Corporate record-keeping
- Amending articles of incorporation and bylaws.
Corporate Shareholders’ Agreement (SA)
The SA is an agreement among the shareholders (owners) of the company regarding their ownership interest. These are consensual and are usually formed to serve a particular purpose or settle an issue. The SA is not generally publicly filed (unless the terms or content mandate disclosure to investors). Elements: A SA will vary depending on the purpose, but common provisions in a SA are:
- Who can be a shareholder;
- Procedure if the shareholders leaves, dies, or is fired;
- Who can serve on the board of directors;
- Management of the company;
- How the company should be operated
- Shareholders’ rights and obligations;
- Information on the regulation of the s/h’s relationship.
- Ownership of Shares – privileges and rights of shareholders;
- Valuation of the stock for internal purposes;
- Entitlement or obligation to repurchase shares;
- Procedure for the repurchase of shares.
Regardless of the type of entity you choose for your business, it is advisable to have an ownership agreement in place. We cover ownership agreements in greater detail in the Startup Legal Resources Library
Fiduciary Duties in a Business Entity
A fiduciary is a person of trust and confidence. Members (owners and employees) incur duties of trust, loyalty, disclosure and confidentiality to the business. That is, members of a business are fiduciaries. The extent and nature of the fiduciary duty varies greatly with the nature of the business and the individual expectations of the member.
Co-owners of a business, regardless of the entity type, owe a fiduciary duty to other owners. This is a duty to act reasonably in all undertakings that affect the business. Partners in a general or limited partnership are required to discharge his or her duties in a fiduciary manner.
There are several obligations that fall under the aegis of fiduciary duty:
- Duty of Care – This is the duty to act as a prudent person in that position would act (i.e., as a reasonably prudent business owner would act. This standard is similar to the standard for negligence in a tort action.)
- Duty of Loyalty – This is the duty to act in the best interest of the business. This includes the obligation to not act in one’s own self-interest at the expense of the business. This means avoiding conflicts of interest in business affairs.
- Duty to Disclosure Important Information – Business owners have an implied duty to inform other owners of important information or material changes that come about in the operation of the business.
- Duty of Confidentiality – This is the duty to preserve and protect business information from inadvertent or purposeful disclosure.