New York Tech Blog

A pretty basic question that entrepreneurial team faces early on is how equity should be divided among founders to ensure “fairness”.  There are tons of unforseen problems that might come up over time such as some partners needing to leave the company, wanting to sell some of their shares, or simply not contributing equally to a venture.  It is a worthwhile exercise to think about all of the potential problems that your founding team may face. If you think these problems won’t come up because your team is all besties of friends, think again. Every entrepreneur should watch Startup.com to see the brutal reality of how badly teams can break up. Here is a trailer:

There is a myriad of actions that teams can take when issuing stock to prevent some problems, but here are a couple of common practices that I’d recommend:

1. Vesting.  Vesting refers to the concept of acquiring ownership of an asset (such as owning stock in a company) over a specified period of time.  For startups, this is a valuable provision that helps recalibrate ownership of the company based on whether the founders continue to remain involved in the company.  It prevents the problem of “free-riding”, where a founder may decide to leave the company, but retains an unfair amount of ownership while others are putting in the hard work.  Take this example:

   
   “Sally, Bob, and James decide to found a company called ‘Widgets Inc.’.  They believe they will contribute equally to the venture and therefore each want to own one third of the company.  They incorporate their company and issue 12,000 shares (they just picked an arbitrary number) with each founder owning 4,000 shares.  Two years into the company, James wants to leave the company for personal reasons.  Based on their initial share distribution, James still continues to own one third of the company even though he is no longer contributing to the company!  James thinks that his ownership is justifies because he had put a lot of work into the company, but Sally and Bob argue that there is still a lot of work that needs to be done to grow the company!  This sucks for Sally and Bob because they are working their butt off and still have to give James one third of any profits that they create!” 

   What the founders should have done is to create a vesting schedule, where they could have agreed to distribute their shares over a period of time contingent upon their continued involvement.  For example, they could have agreed that each founder will be granted 4,000 shares with 25% of their shares to vest at the end of their first year, and the remaining 75% of shares to vest monthly over the next three years.  As a result, James would get 2,000 shares after working at Widgets Inc. for two years.  After 4 years, James’ ownership would thus be diluted to 20% rather than 33% in the first scenario.  The 20% ownership is due to the fact that James has 2,000 shares from 2 years of work, and Sally and Bob each have 4,000 shares from 4 years of work.  Problem solved! 

   If you want to take this ‘fairness’ concept even further, you can come up with ways to grant options and stock over time based on performance of each founder.

2. Rights of first refusal and co-sale.  Rights of first refusal and co-sale is actually two provisions that are often clumped together.  It is a provision that prevents a shareholder from selling their shares without allowing the company or other shareholders to either purchase the shares themselves (right of first refusal)or participate in the sale (right of co-sale).  Let’s first talk about the right of first refusal with the example above and see how this helps the founders:

   
   “James leaves after 2 years and rather than holding onto his 2,000 shares, his friend, Omarosa, wants to buy his shares for $100,000.  Sally and Bob hate Omarosa, and they would prefer to buy the shares from James themselves.  However, James already promised the shares to Omarosa (maybe he even intentionally does that to piss off Sally).  Sally and Bob are therefore upset!”

   With the right of first refusal, Sally and Bob would have an option to buy the shares from James before he can sell it to Omarosa.  Now let’s see an example of how the right of co-sale works:

   “James and Bob have both been working at the company for 2 years and they both need some cash to pay their rents.  They hear that Omarosa may be interested in buying 2,000 shares for $100,000.  As a result, both of them try contacting Omarosa to sell their shares.  However, James gets to Omarosa first and sells her all of his 2,000 shares for $100,000.  Bob is now screwed and now has to live in the streets.”

   The right of co-sale would have allowed Bob to equally participate in the sale of shares to Omarosa.  If Omarosa wanted to buy 2,000 shares, both Bob and James would have been able to equally sell 1,000 shares each and get $50,000 each.