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Control of Founders
Two of the most difficult decisions in the early life of a 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 the 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) within our Startup Legal Resources Library.
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 workload) 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 a 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.
We cover this topic in greater detail in the Startup Financing Resources Library