Much of the fundraising advice entrepreneurs get is extremely tactical, e.g., say the following thing on this slide or don’t say “platform”, etc. This may make a first meeting with investors go better but usually leads to disillusionment and a pass later on in the process. It’s a lose-lose proposition. Both sides spend precious time and go nowhere.

I prefer a more fundamental approach, one that attempts to help build a business with fundraising simply an artifact of that broader goal. A founding team must discover its core strength and the reason why they, as opposed to the other dozen smart teams going after similar ideas, are going to win. This requires intellectual honesty and emotional maturity. It’s hard work. It may point out significant holes in a team’s capabilities or issues with the company’s business model. Then the work gets harder. Companies that face these challenges come out stronger and much better prepared to raise money and grow.

Here are a few of my posts I tend to refer founders to over and over. I hope you find them helpful.

• Agile ideology
• How to raise money without lying to investors
• When to fire your co-founders
• Ten rules for better founding teams

Back by request, a post on repurchase rights and related concepts.  These concepts pertain more to companies that are not venture financed than to companies that are venture financed.  Why?  Because when VCs invest, they cover off all these concepts in their basic investment docs.

The issue sets up like this:  You and three friends (Mark, Luke and John) decide to form a company to found a new social network.  You have checked out what Sim Simeonov has to say about vesting, so you figure you have it knocked – until you go talk to your lawyer.

The first words out of his mouth are, “Well Matthew, what if Mark, Luke or John leaves the company and goes to the dark side?  What if one of them becomes disabled or dies or gets a divorce or goes bankrupt?  You might find yourself with a partner you don’t want.”

There are a number of ways of dealing with these issues.  They begin with transfer restrictions, move on to repurchase rights and obligations, go through a process for determining the purchase price and end up with an agreement around payment terms.  So let’s take the tour.

The tour is all about how to anticipate and prepare for the situation in which one of your co-founders leaves the business.  The far more common situation is that the founders come to a parting of the ways or they need to reallocate equity for reasons of nonperformance or noninvolvement and there is no agreement in place.  So, first a few words about that.

Equity Reallocation Without an Agreement

In my last guest post, I suggested that perhaps you would need a prescription for Nexium in these circumstances.  I repeat my suggestion.

In the absence of an agreement, you are going to have either a negotiation or you are going to have to dilute the departing or non-performing founder (or consultant or whatever).  It is hard to imagine a circumstance in which a negotiated result is not going to serve you best over time.  So, unless something about the situation or your lawyer’s advice dictates otherwise, your best course of action may be to have a come-to-Jesus meeting with the other person and explain what you want (i.e. a give up of equity either in the form of a simple contribution back to the company or a sale at some low price) and why it makes sense for the company as a whole and, therefore, for the other person as a shareholder.  If that works, go for a release while you are at it.  Your lawyer can help you with that too.

If the negotiated route does not work, you are going to be looking for ways to dilute the former founder.  Anything you might do here is fraught with potential corporate law and tax law consequences.  You should not start issuing shares or options without legal advice.  Just to make the point, if you issue yourself a bunch of shares, that could be taxable income.  Also, issuing shares at less than fair market value could be a breach of the fiduciary duty of directors and could expose them to a lawsuit from the disgruntled party.

All this, of course, argues that you should be prepared lest you end up in founder Purgatory or worse founder Hell.  So, now at long last, the tour:

Transfer Restrictions

Most stockholder agreements begin with the same basic commandment, thou shalt not “sell, assign, gift, loan, pledge, mortgage, hypothecate (that one sounds ominous), distribute, encumber, or otherwise transfer or dispose of “ thy shares, unless … There are really two points here.  First, you really can’t sell (etc.) your shares to anybody under any circumstances.  Second, is the stuff that follows the word “unless.”

“Unless” is usually followed by a variety of exceptions to the principle of no sale.  These exceptions include some, or all, of the following:  (1) pursuant to a bona fide purchase offer from an arms-length third party after first providing the company and/or the other stockholders a right of first refusal, (2) pursuant to bona fide estate planning (with the proviso that the recipients remain subject to the basic transfer restriction), (3) upon death or disability, (4) pursuant to a divorce decree or (5) upon bankruptcy.

Think about it this way:

Mark can sell his shares to Satan, but only after giving the company and the other Apostles a chance to buy them (usually on the same terms and conditions as offered by Satan).  Sometimes you see flat out prohibitions on sales to competitors.

Luke can put his shares in a trust for anyone he begets, but if he does that, the begotten can’t make further transfers unless they comply with the basic transfer restrictions.  Same result if Luke dies or becomes disabled and the shares go to some trust or other.

If John gets a divorce, then the shares can be transferred by court order in the divorce.  There is not much you can do about that, except get the spouse so sign something beforehand or provide for repurchase by the company and the other stockholders pursuant to some fair valuation.  Similar issue if John goes bankrupt (only the bankruptcy court has even more control than a divorce court).

Repurchase Rights and Repurchase Obligations

A departing stockholder may be required to sell and/or the surviving stockholders may be required to buy the stock of the departing stockholder.  This type of arrangement has the following results:

• It may provide liquidity to the departed, depending on the price per share
• It permits the surviving to retain 100% of the ownership
• It prevents undesirables from becoming stockholders

You can also mix and match.  Under some circumstances you may want repurchases to be mandatory and not under others.  For example, stockholders often want repurchases to be mandatory upon death or disability because they foresee the need for liquidity.  Sometimes they want the right to be optional in the case of a sale to a third party because they don’t want the company (or themselves) to be obliged to make a payment they can’t afford but they need the security that they can prevent a sale to a competitor.  You want to consider the needs of the company and the stockholders to decide what works for you.

What is the Purchase Price?

There are probably as many ways of setting a price as there are people wanting to set one.  However, there are some that can be described as typical or usual.  In any event, they are more common than others.  These are (1) in the case of rights of first refusal, the price set by a bona fide third party offeror, (2) formula pricing, (3) appraisal, and (4) the mutual option method.  Sim has pointed out to me that he sometimes sees 409(A) valuations used to determine fair market value in shareholder agreements that apply to many shareholders.  While I can’t say that I have seen this done, I can see that it could have great appeal.  You will have an objective third party valuation.  However, these valuations sometimes seem low.  So, representing a senior exec, I might go for something else.

In the case of rights of first refusal, the right is always (almost always) the right to preempt the proposed purchase by a third party.  It seems inherently unfair to set the price at a number different from that which a bona fide willing third party has offered.  Enough said on this one.

Formula pricing offers the illusion of objectivity in the guise of ease of calculation.  Typical formulas are things like multiples of revenue or EBITDA or even, sometimes, book value.  Formulas can, and do, work well in situations where the company is well-established in an industry where companies typically sell on some established basis such as a multiple of EBITDA.  Having said that, this approach may not (almost certainly won’t) work for early stage companies or technology companies where there is real value in the technology.  If a company has no revenue, it will not have positive EBITDA or, frankly, any other balance sheet number that can be used in a formulaic way to set value.  But, this is not to say that the company has no value.  For example, the exclusive right to sell indulgences may not have achieved revenue, but it sure could have value.

Once you give up on formulas, the typical fall back is appraisal.  In my experience, clients like to go with a neutral knowledgeable outsider such as an investment banker to do the appraisal.  There are various methods of choosing the banker such as the parties agreeing or if they can’t agree after some amount of time, each picks one banker and the two so chosen pick a third banker who does the valuation.  This method can, of course, be expensive since the banker has to be paid.  Another possibility is that the independent directors (if there are any) pick.  I have even seen baseball arbitration used in this context.

A final method that I mention because it is used more often than I ever expect (which is not to say that it is used all that often) is the mutual option.  The way this works is that, at a stated time, either party may set a valuation and the other party may then elect to either sell at that valuation or buy at that valuation.  For example, in a simple case where there are only two founders, Luke and John, one founder, Luke, sets the valuation and the other founder, John, elects whether to be a buyer or a seller at that valuation.  If Luke sets the valuation too low, John will buy out Luke but if Luke sets the valuation too high, John will sell out to Luke.   This method pushes people to pick reasonable valuations because the risk giving away the store if they don’t.  It has other drawbacks, however, for one, it is difficult to make work if there are more than two parties.  For another, it favors the financially stronger party.  If one party can’t come up with the money to be a buyer, then they are likely to end up selling at a low valuation either because they themselves are constrained to pick low valuations or because the counter party figures it out and is artful about how they set the valuation.

In the End: Payment

In the case of rights of first refusal, usually payment must be made in the same manner as that which the third party buyer has proposed.  On occasion, however, thoughtful entrepreneurs take into account the possibility that a large sum could have to be paid in a short time frame and provide some sort of payout mechanism in the stockholder agreement.

Unlike the situation with a right of first refusal, in the case of appraisal and other valuation methods, the payment method should be set forth in the stockholders’ agreement.  Usually the stockholders agree on some portion to be paid at a closing and the rest to be paid over time.  Often the timed payment is in the form of a note that bears interest and may, or may not, be secured.

Dealing with Disputes

Needless to say, when these situations come into play, there are many opportunities for disputes.  It is hard to say anything good about disputes and how to resolve them.  Disputes among founders are almost always fraught with emotion.  This makes them very intractable.  Many people have tried to find cheap and easy ways to resolve disputes.  These ideas sometimes make it into shareholder agreements.  The typical approach is some form of non-binding mediation for some period of time followed by binding arbitration.  A lot of clients are of the view that this process will be less costly and less time consuming than a court proceeding.  They may be right, but it is really hard to know.  Also, there is the belief, which may not be correct, that arbitrators tend to compromise, compared to courts that just decide who is right and who is wrong, thereby reducing risk to all parties.  Again, this may or may not be true.  I am not aware of any objective evidence one way or the other.  Just to give you a rough sense, our firm handled litigation between founders, one of whom was a client of mine, that went all the way through a bench trial (it was tried before a judge and not a jury).  The cost for our client, who won the case in its entirety, was just under $250,000.  We handled a different case, also for one of my clients, where we hired a solo practitioner in California to handle the arbitration.  He agreed to take the case on a contingent fee basis.  Again, we won a sweeping victory.  The contingent fee lawyer got one third of $2million and this was on top of our hourly fees, which were trivial by comparison.  Keep in mind these are the costs of the winners.  There were approximately equal costs on the other side, and they both lost and paid material fees.

As you can see, my experience is that neither method, arbitration or lawsuit, is cheap or easy.  While I also believe that judges and arbitrators actually believe (and behave as if) they are in the business of delivering a just and fair result, irrational things creep into both processes and can affect the results.  For these reasons, I often advise clients that it is in their best interests to find a compromise before getting into a formal dispute resolution process.  Not to be too flip, I actually often tell clients that if everyone is equally unhappy with the result, then it was probably the right result.

One more piece of advice, and this is certainly self-serving, if you really are going to go all the way to trial (or its arbitration equivalent), don’t be penny wise and pound foolish, hire a good lawyer with experience in the type of dispute you are dealing with.  You will be dealing with enough risk; don’t add an inexperienced attorney to the mix.

As far as I know, Matthew, Mark, Luke and John are still together enjoying the fruits of their labor in heaven.  I don’t know what your chances of getting to heaven are but your chances of avoiding Hell are better if you think about and deal with founder issues at the beginning than if you don’t.

Let us know what you think in the comments or on Twitter @simeons and @broadwin.

Following my posts on improving the performance of founding teams, founder agreements and strategies for dealing with poorly performing co-founders, I continue to receive many emails at FastIgnite from entrepreneurs having difficulties with managing and formalizing the relationships with their co-founders. I reached out to my blogger friend Dave Broadwin, head of the Emerging Enterpise Center at Foley Hoag LLP, and invited him to provide his perspective in a series of guest posts of which this is the first. (No, it’s not legal advice.) I hope you enjoy them and follow Dave’s writing.

Some time ago Sim Simeonov asked me to write a guest post on the subject of founder agreements.  For one reason or another it has taken a long time to get it done.  In part this is because I broke my leg skiing and in part it is because the number of founders walking through our doors these days seems to be on the rise.  So the very issues that Sim wanted me to write about have been taking up my time.

As Sim has pointed out in his two prior posts (Ten Rules for Better Founding Teams and Startup Founder Agreements), there are a lot of different types of contracts that founders have to enter into in the course of starting up a business.  Most of them, though, don’t give lawyers a lot of heartburn.  That is not to suggest that they are not important or that you should not pay attention to them, but from a lawyer’s point of view, there is not usually, a lot of controversy around NDAs and the like.  Having said that, Sim has mentioned that he routinely asks for changes in standard forms of NDA in the areas of information management, protection, destruction and return of information.  While it is true that most companies are very reluctant to make changes in employment related NDA (and other) forms which they ask all their employees to sign, it is also true that with the rise of the cloud and other factors, these forms may be at odds with the way information is actually handled.  If you have a legitimate point, most tech companies will hear it – so don’t be shy.

The shoals upon which founders founder, seems to me to be first and foremost, the allocation of equity among co-founders, and secondarily the use of equity to pay consultants and other people providing services in the early stages of the business.

I have said this elsewhere, but it almost seems like a rite of passage that founders give away too much equity to someone who later does not perform (and, often, who leaves the business to pursue some other job and wants to keep the equity).  Somehow you then have to get the toothpaste back in the tube.  This can be an ugly process.

Here is a very typical (perhaps I should say archetypal) fact pattern:  Sally wants to start a web based company.  She needs some coding done for her web page.  She meets Harry.  Harry is out of work (having been laid off from MondoHuge Software, Inc.).  Harry, who seems like a charming fellow, has the time and, apparently, the skills that Sally needs.  Moreover, Harry professes to have had his fill of big companies and is ready to launch an exciting new start-up.  So, for a mere 25% of the equity, Harry agrees to do all the coding and have the beta ready in six months.

Sally and Harry enter into an agreement (in the form of a letter that Sally sends to Harry without running it past her attorney, Clarence Darrow).  The letter says something to the effect of Harry will be in charge of software development and will be issued 25% of the common stock right away.  The letter says nothing about performance expectations or what happens if they are not met.  The performance expectations are all in Sally’s mind.  Sally never considers what might happen if Harry does not perform, let alone what might happen if he leaves the company.

Harry is issued a nice shiny new stock certificate.  Everything is cool for about two months.  Then Harry, who unbeknownst to Sally has been looking for a job all along, gets a job offer from Ginormous Software Corp.  He takes the job and tells Sally that he is moving to the west coast to run Ginormous’ new Flash division.

It turns out that Harry only wrote a few lines of code and is not planning to give back the stock, which he feels is his (since he is a co-founder).  Sally then calls Clarence ”How do I get the stock back?”  Although he uses other words, Clarence is thinking “I hope you are taking the little purple pill because heartburn is about to become a part of your life.”

Since an ounce of prevention is worth a pound of cure, I am not going to write about how to negotiate with Harry under these conditions, rather I am going to write about the things you can do to avoid walking a mile (more like 40 miles) in Sally’s shoes.

To paraphrase the famous line from The Graduate “I have one word for you “vesting.’”

Sim has a lot of great things to say about vesting, but here is my take on it:

Every member of the team should be subject to vesting. Unless you are planning to go it alone, in which case who cares, every member of the team should be subject to some form of appropriate vesting.  Consider the divorce rate among practicing Catholics, and they are expecting to suffer eternal damnation if they break up.  Breaking up may be hard to do, but people do it a lot.  Like the Boy Scouts, Be Prepared, in case it happens to you.  If Sally had followed this policy, no matter how sure she thought she was about Harry, she would have been OK when he bolted.

Consider this, if Harry leaves with a big chunk of equity and won’t give all (or some) back, you are going to have to figure out how to dilute his position.  This means getting more stock into the hands of the remaining productive team members.  This topic is beyond the scope of this post, but you probably can’t just give everyone (other than Harry) a pile of new shares.  If you did, then everyone is likely to have phantom income equal to the value of the new pile of shares.  So, you have to consider options (which have other drawbacks).  You also have to consider the impact on your investors, if any, and what rights they have in connection with your issuance of shares and options.  Fixing the capitalization once the shares are issued and vested is hard to do.

Vesting should be part of an express agreement between the stockholder and the Company. No handshakes, vague understandings, or oblique references in emails, unless you plan to become part of AstraZeneca’s cash flow (they make the little purple pill).  Vesting can be made a part of a stockholder agreement signed by all stockholders.  One drawback of the collective approach is that it may be cumbersome or a diplomatic challenge to have different vesting schedules and arrangements for different stockholders.  Vesting can also be set forth (to use a lawyerly turn of phrase) in individual agreements.  This approach makes it easier to strike different deals with different people for whom different considerations might apply.  If Sally had a written agreement with Harry, she would not be looking for a scrip for the purple pill.

Immediate vesting is a bad idea.  By this I mean that all stock vests upon issuance.  The day after formation Harry gets to (a) keep all 25% and (b) leave for greener pastures.  Having said that, some level of immediate vesting is often appropriate.  For example, if the founders have been working part time for six months pulling the business together in their garage and they have real sweat in the business, a recognition of that contribution may be entirely appropriate.  This does not mean that everything should be fully vested right away.  Another common situation is when someone puts in actual money (in addition to sweat equity).  Stock that is bought and paid for probably should not be subject to vesting.

Time based vesting is often a good idea.  Time based vesting means that stock vests with the passage of time.  A very common scheme used in venture financed companies is four year vesting.  This typically has a one year cliff (after one year 25% is vested) and then three additional years during which stock (or options as is often the case in venture financed companies) vests ratable on a monthly or quarterly basis.  Companies that are not (or not yet) venture financed, often choose time based vesting in which stock vests ratable over three or four years beginning right away.  With this scheme, when Harry left to work for Ginormous, he would only have two months of vesting (way less than 25%).  One issue with time based vesting is that it does not take performance into account.  Often founders are reluctant to let people go, with the result that they time vest way longer than they should and they don’t deliver.

Milestone vesting is often a good idea.  With milestone vesting, stock vests upon achievement of stated milestones.  By way of example, 25% might vest upon shipment of beta with more vesting on final shipment and more on V2.0.  If Harry had agreed to milestone vesting, he would be leaving all his stock behind, which is probably the right outcome in the little morality play that this post is based upon.  One of the issues with milestone vesting is, of course, how clearly defined are the milestones.  If there is ambiguity around whether or not milestones have been reached then there can be disputes around that.  For example, if Harry is going to vest 25% on shipment of beta, maybe Harry will ship beta before it is really ready.  The only way to handle this issue that I have ever felt good about is to have very clear and unambiguous milestones.  The CEO of one of my clients has milestone vesting tied to specific revenue levels.  Now, you might think you either have the revenue or you don’t, but you can grow revenue by dropping price (and margin).  That is not what the board had in mind.  Now, in my client’s case it is working out because the CEO is not playing games, but not everyone could resist the temptation. Keep in mind, the company can play games too.  Unless you can find some measure that is truly clear and unambiguous, you reach a point where trust has to enter into the equation.  BTW, milestone vesting is also good for consultants and certain service providers.

Note that VCs usually insist on imposing vesting on founders in early stage investments (Series A).  Depending on a variety of factors a common approach is to let the founders have 25% to 50% fully vested and have the rest time vest over three years.  VCs see a lot more situations than you ever will.  There is a reason why they do this, even while they believe enough in the founder to invest millions.  Learn from them grasshopper.

Negotiation when you let someone go is the norm.  I have noted that often underperformers stay too long.  When you finally get around to terminating Harry, it could be before the cliff (assuming you have one) or after.  Particularly before the cliff (but it could be at any time) Harry is going to want to hang on to some options.  You should be aware that options are contracts, and like any contract, the option terms can be changed by agreement of the parties.  Option plans typically provide that an employee who is terminated, other than for cause, will have a period of time (usually 60 or 90 days) after termination to exercise vested options.  This means there must be some vested options and the employee has to be ready to stroke a check.  Sometimes neither is the case.  Rank and file employees typically have to live with the plan, whatever it says, but “senior” people often negotiate for some vesting and for a longer period of time to exercise.  I have not noticed that there is any standard length of time but perhaps a year is common for additional time to exercise.  Typically, the employee is looking for enough time for the company to reach some new valuation that will give the employee clarity as to the wisdom of exercising.  Also, with respect to the amount of vesting I have not noticed any “standards” – the senior employee gets what he or she negotiates.  My experience is that employees ask for the cliff (in a pre-cliff termination) and some portion of the remaining in a post-cliff termination.  Usually the company is willing to do something in a termination (other than for cause) and the negotiating space is not that great, so it is readily compromised.

Your board must approve option grants and changes to option terms.  This may be a technical point, but all option grants (including those promised to new employees when the come on board) and all changes to the terms of options (for example the negotiated changes that might happen on departure of a senior employee) must be approved by your board of directors.  The Delaware law reason for this is that you are, in effect, proposing to issue stock and that is the right of the board of directors.  For this reason, option grants in offer letters are often conditioned on board approval.  You must make sure you understand what your board will approve before you make offers.  Otherwise you could be embarrassed or worse.  From the employee’s perspective, you should get some assurance that the option grant will be considered by the board at its next meeting.  You might also want to get some assurance from whomever you are negotiating with that he or she has at least discussed the proposed grant with key board members and they are OK with it.

Once in a very dark blue moon, the bad thing happens: an employee or consultant is promised options subject to board approval and the board does not approve.  Consultants rarely protect themselves from this sort of thing.  I am not sure why – perhaps because they feel it is not diplomatic to suggest that they are not comfortable that the founder or CEO hiring them is not in sync with her board.  In any event, if you think you might find yourself in that position, you might suggest some alternative compensation that is not subject to board approval.  For example, in some cases CEOs have the authority to commit to signing bonuses.

As if that is not enough, investors (and this is absolutely true of VCs) negotiate for and obtain contractual restrictions on the issuance of options and the vesting and other terms upon which they can be issued.  Your grants must comply with your contractual agreements or you have to get a waiver from your investors.

The Internal Revenue Code will also have something to say about your grants.  I don’t want to go too far afield with tax stuff about qualified and nonqualified options, but I do want to note that Section 409(A) of the Internal Revenue Code has the practical effect of requiring that option grants be issued with an exercise price that is equal to or greater than fair market value on the date of grant.  If this stuff is of interest to you, check out Options and 409(A) – Sometimes the Law is an Ass.

Finally, and I hesitate to mention this because I am a lawyer and it will sound self-serving, but don’t be penny wise and pound foolish.  Consult with Clarence; have him review (preferably actually draft) the stockholder agreement.  It may be a sad life, but it is what he lives for.   In addition, he, like the VCs, sees a lot more deals than you ever will.

There are many other arrangements among founders having to do with stock and what happens if the founders come to a parting of the ways.  These include things like transfer restrictions, puts, calls, repurchase rights, mutual options and the various methods of valuation that go along with buying and selling stock.  These are beyond the scope of this post.  Also, they don’t typically apply to venture financed companies.  But, if there is sufficient indication of interest, I will write another post covering those items.

There will be more posts in Dave’s series on my blog. Let us know what you think in the comments or on Twitter @simeons and @broadwin.

The same question came up a few times in different forms in the comments to the second post:

@Nivi

Simeon, can you tell us how you structure ownership and control so you can fire your co-founders if necessary?

This is a complex topic that has a business and legal side to it. I’m no lawyer, so I’ll look at things from a business perspective. I will mention legal terms and example language for illustration purposes only—for details, consult a lawyer. This isn’t just CYA. There are a lot of possibilities and variations that need to be thought through and for that you need legal and tax advice.

This post addresses the lifecycle of founder agreements and the key compensation and control parameters in them. A companion post suggests ten rules for building better founding teams.

Urban legends

Let’s start by dispelling some myths:

• There is a standard founder agreement. Well, there is and there isn’t. Every major law firm and every VC firm tends to have some type of template. These templates can have meaningful variations, some of which are founder-friendly and some of which are not. Most partners, be they lawyers or VCs, tend to tweak the standard with their own language. Even if you are an experienced entrepreneur, you’ve probably only seen a few founder agreements in your life. Almost anyone can benefit from a great lawyer or an adviser who’s seen dozens of these from different law & VC firms.
• All founders have the same agreement. Yes, it is convenient for all founder agreements to be based on the same template with the only difference being the number of shares. Don’t confuse a convenience with a requirement. In the last four companies I’ve co-founded, there were several founder agreement types. In two cases this was because of the special role I played as a part-time co-founder. In one case the CEO had a different vesting schedule because he had spent a lot more time than the rest of the founding team on the idea. In another case, for good reasons, four founders had three meaningfully different agreement types.
• Founder status == founder agreement. Founding status can be bestowed on anyone. That’s a decision a founding team can make for many reasons. As long as the decision is public and definitive, from an external perspective there is no issue. This can be a convenient shortcut to separate someone’s status (founder) from their role (employee or contractor or advisor, etc.) and the legal documents specifying its rights & responsibilities.

Which founder agreement?

There are several critical points in a startup’s life when founder agreements are put together.

There tend to be verbal agreements between founders for a period of time before anything is put to paper. Lawyers tell me that in many cases verbal agreements are enforceable, especially if someone did work based on the verbal agreement. It helps to communicate and set expectations clearly. It also helps to have some discoverable record of the agreement. An email would do.

At some point pre-incorporation, the founding team may create a written agreement, often in the form of a letter. It outlines key points of agreement between founders around IP ownership, equity ownership, vesting, etc. The FastIgnite one is two pages. The goal of the letter is to be simple and readable so that everyone is comfortable and aligned on the main issues. Perhaps the most important paragraph is the pre-formation agreement. It requires the various parties to behave during incorporation in a way that effects the agreement. It can be something along the lines of:

Pre-Formation Agreement.  If the addressee of this letter consists of one or more individuals, rather than a business entity, the individual(s), by his (their) signature(s) below agree(s) that they will cause any business entity formed by them within 24 months of the date of this letter agreement to conduct business in the Field of Interest to enter into an agreement with me identical to this letter agreement, whereupon this agreement shall become void.  If such individuals do not form a business entity to conduct business in the Field of Interest, but instead sell or assign their developments and technology in the Field of Interest to an unrelated party, I shall be entitled to [this will vary based on the type of founder] of the net consideration received by reason of such sale or assignment.

Pre-incorporation, removing a founder is complicated primarily by the potential lack of clarity around his or her rights and obligations and hence the consequences the removal. For example, without a clear vehicle (a company) to contribute intellectual property into, a founder who walks away may mean that the future company won’t own its own IP. This is typically not a problem, unless the company becomes very valuable and the founder who walked away decides that she is owed something.

During incorporation, the couple of pages of this letter will be turned into somewhere between 20 and 50 pages of mostly boilerplate legalese. The number of separate documents may vary but they fall into two categories:

• Those related to equity, typically a restricted stock purchase agreement (RSPA) and associated escrow and other agreements.
• Those related to other matters: IP assignment, invention disclosure, non-solicitation, non-competition, termination, etc.

At this point, there is a precise, well-defined legal framework for resolving conflicts that can’t be addressed through other means. However, founder agreements are not set in stone and it is common for them to be tweaked by a little or a lot during the first financing by professional investors. How to handle that or avoid it altogether is something I’ll do a post on if there is interest. [more details]

Founder roles, agreements and removal strategies

Different founders contribute different assets and capabilities and can play multiple roles. Their agreements tend to reflect this and, hence, the strategies for a founding team to remove these founders differ. Note that investors have additional tools at their disposal but that’s a separate topic.

• Employee. Compensation is a combination of cash (post funding) and common equity that is subject to vesting if professional investors are involved. There is some up-front vesting acceleration. The common number is 25% but, depending on the length of time and contributed resources, it can be up to 50%. (See my post on the best vesting schedule.) The rest of the equity typically vests monthly with no cliff for 3-5 years. Founders have rights as shareholders. They have voting rights which may entitle them to force or veto certain key decisions, e.g., hiring or firing the CEO, selling the company, raising money, etc. You need to understand the voting thresholds for key decisions and think very hard about whether you want to allow any one founder to have too much control. If you are the lead founder, this may not be an issue but it should be an issue for the founding team as a whole. Another issue to watch out for is any significant vesting acceleration on termination without cause outside of a change of control (an exit). A little bit is OK. A lot is unreasonable. Yet another issue is the price at which the company can repurchase unvested shares. To make this cheap for the company, you want the price to be the par value of the shares.
• Investor. Founders who also invest get additional equity in the company with no vesting. Some get common equity for their investment. Smarter founders structure things such that they get preferred equity together with other investors. The smartest founders who put money in their own businesses put it through a separate preferred class of stock before other investors come in. As preferred shareholders they will have additional rights. With the right legalese, even a small shareholding can exert a huge influence and make it near impossible to remove the founder. The only way to remove their equity holding in the cap table is by buying them out or through a recapitalization of the company. In this case you have to consider whether they are common or preferred holders and, in the latter case, their anti-dilution protection, pay-to-play provisions and willingness to participate in the recap financing. A much better approach is to restructure their holding during an investment, at the point of maximum leverage.
• Advisor. The structure depends on the nature of the advisory work. Very early on, if the equity ownership is small, the advisor equity may have no vesting. An example would be when someone gives you an idea and you run with it without their involvement. Typically, advisors tend to have shorter vesting periods (one or two years). If you like them and they have been helpful, you sign them up for another term. Sometimes, the vesting is milestone-based (upon the close of a financing) or performance-based (signing up customers, doing deals, recruiting). Advisors tend to have 100% acceleration on change of control. Typical advisory agreements have simple termination clauses. As long as that’s the case, there should be no major issues in removing an advisor founder.
• Service provider. Like the advisor role, a service provider can do many different things. The difference is that there is some type of cash component or cash equivalent value associated with the services. There are multiple ways to handle this before the company has cash. It can be deferred, with or without interest, to be paid after a financing or once revenues start coming in. Alternatively, it can accrue into equity at some pre-defined price-per-share, usually the next round’s, perhaps with a slight discount. For example, you hire a consultant for five months at $10K/mo and then you raise $500K on $1.5M pre. For her services, the consultant will own common stock equal to $50K/$2M or 2.5% of the fully-diluted capitalization of the company. If equity compensation and vesting are aligned with how value is delivered, terminating a service provider founder should be no problem.
• Board member. Board members differ from other parties in that they are purposefully difficult to remove. Therefore, they tend to worry less about vesting schedules. Founder directors often get the same initial acceleration as employee founders. They get 100% acceleration on change of control. Independent of shareholder rights considerations, whether it is easy or difficult to remove a founder board member depends on the rules of board composition. Be wary of board seats by entitlement. Rather than giving board seats to individuals, give them to (groups of) classes of equity and check whether the voting process doesn’t automatically give any one founder the right to be the board member. If a board member founder is not entitled to a seat, then there are various other processes described in the bylaws which may affect his removal.
• Executive board member. Typically, the agreement is a mash-up of a board member and a service provider agreement. The usual role that fits this is a founding executive chairperson. Initial vesting typically matches employee founders. Further vesting accelerators are common, e.g., on follow-on financings or the recruitment of a CEO. The removal strategies are the same as for a board member.

The same person can be in multiple roles and may even have multiple agreements. While there are no “best founder agreement structures,” just as there are no best vesting schedules, there are certain principles of approaching founder agreements that can be helpful in building stronger and more agile founding teams. Read the next post in the series for ideas on how to build stronger startup teams.

Let me know what you think in the comments or on Twitter @simeons.

No such thing as best

“Best” as a concept has natural appeal. It’s great to be best, to know you’ve done something in the best possible way, etc. It tickles our pride and makes is feel good about ourselves. In the process, we tend to forget that there are at least two ways to evaluate the quality of decisions: as determined by current information, given knowledge & experience, and as determined by hindsight.

Hindsight is the harshest and probably best judge. Even then, it’s hard to make accurate judgments since the decisions made earlier, especially if they were made years before, could have influenced outcomes and hence affect the accuracy of hindsight. Still, if we are to talk about “the best vesting schedule,” I can’t imagine anything better than a hindsight test. Did the vesting schedule in a startup help or hurt returns for various types of equity holders? Which is where we immediately get stuck on two issues about how we define “best”.

First is the notion of pareto optimality. A pareto optimal situation is one where we cannot make someone better off without making someone else worse off. Since vesting affects anyone who leaves before being fully vested negatively and everyone else on the cap table through the repurchase of unvested shares positively, almost any vesting schedule is pareto optimal. Therefore, we can’t talk about a best vesting schedule for everyone. We can only talk about a better vesting schedule for certain parties, which requires judgment as to some type of preference order. Do investors come before employees? Do execs come before individual contributors? Do founders count for more? Do you penalize people who’ve worked for years at the company and then leave and reward the ones who joined a year ago? I don’t know about you, but I don’t have set answers to these questions. A lot depends on culture and should be within the control of entrepreneurs, execs and investors. They can set it up however they think makes sense and then others can make decisions about whether to join as employees or investors later.

The second issue is simply that a company has to pick vesting schedules months and years before major events such as product launches and an eventual exit. We all know how uncertain things are with startups. To say that one can pick some type of “best” vesting schedule that positively impacts returns to more than one type of holder regardless of whether the company exits for $3M in 18mos when everyone on the founding team is still there or for $350M in five years after three different CEOs is, to say the least, improbable.

Standard vesting

Just to get our bearings, the so-called “standard” vesting schedules many companies use are along the lines of:

• Founders: 25% up front and the rest monthly over 3-4 years.
• Employees: 25% after one year and the rest monthly over 3-4 years.

An example alternative vesting schedule

A comment to my VentureHacks article on building agile founding teams asked about an alternative vesting schedule proposed by Basil Peters, a successful super-angel. Basil’s proposal has three key points, reproduced here:

• 50% of the shares daily over a three year period; and
• the other 50% when there is a sale of the Company.
• All vesting for senior employees accelerates on a sale of the Company.

My summary analysis is that this is an interesting vesting approach that is more investor-friendly than founder- or employee-friendly and that is likely to work better in the case of companies that have small exits in short periods of time and may actually hurt returns in the case of larger companies. Point by point:

• 50% daily vesting over three years
  • The 50% is related to the next bullet, I’ll address it there.
  • I don’t see a big difference between monthly & daily vesting. Daily is probably better. As rule, I like continuous functions–discontinuities and kinks sometimes influence decision-making in bad ways. That’s why I think quarterly vesting is a terrible idea–someone who’s ready to leave may stay on as dead weight for a couple more months to get that extra bit of vesting.
  • Three years for 50% is a bit long but that actually depends on the size of the initial grant (is it above or below market?), which is something the proposal doesn’t discuss.
  • No vesting cliff means there is a penalty to pay for people who don’t perform well or leave after a short period of time. I don’t have a problem with this–same argument as why I prefer daily or monthly vesting compared to vesting over longer periods of time. Perhaps it will make companies more careful about who they hire.
  • No founder acceleration is unfair to the effort founders have put in prior to funding the company. If founders have a choice, they may prefer to raise money from a different investor whose ideas about vesting do include acceleration. Therefore, this clause may actually hurt an investor’s deal flow / win rate and, therefore, returns in the long run.
• 50% on exit
  • The argument here is that up to 50% of the value is generated close to the time of exit and by running a great M&A process. This may be true for exits that are near rounding errors on the acquirers’ P&Ls. It’s certainly not true for larger startups most of the time. Analysis by M&A powerhouses such as Updata and Jeffries/Broadview suggests there is such a thing as a “market rate” for exits and it’s hard to get far outside the valuation curve of the day. Yes, there is such a thing as a strategic premium and I do agree with Basil that very few companies know how to make trade-offs between investments that grow their strategic premium and investments that just grow the business. The bigger the company, the more inertia there is and the harder it is to make changes that quickly impact the strategic premium. M&A execution also matters but I haven’t seen any data that suggests that M&A execution, independent of the company’s state, can influence exits on a regular basis by that much. If anyone has that data, I’d love to see it.
  • Holding equity/option grant sizes constant, withholding 50% of vesting till exit seems grossly unfair to founders and employees. What if a company takes six years to exit? Why should an engineer who built + helped launch many versions of the early product and left after four years be penalized that the company hasn’t exited yet? Why should a founding CEO who hits her ceiling, brings on a successor CEO and leaves after three years be penalized for doing that?
  • There is an additional macro industry impact. A provision like this restricts labor mobility perhaps in a bigger way than non-competes. Vesting shouldn’t be a tool to force founders and employees to stay with a company. It should be a tool to connect their equity stake to their continued contribution in building the business.
• Acceleration on exit
  • The way I read this, it implies full (100%) vesting on exit. This may be OK in the case of small companies that are being acquired for their technology as opposed to the ability of their teams to create additional value. If an acquirer doesn’t care about the incoming team in an M&A situation, there is little impact to the acceleration. If, on the other hand, the acquirer wants the team then full acceleration on vesting can depress exit values to an extent. The acquirer will need to create a retention package, say $5M, for the team since there will be nothing transferring over through the acquisition that has retaining value. That retention package increases the total cost of the acquisition by $5M. If the acquirer was willing to pay $100M at most in total, they’d only be willing to pay $95M of that directly to the company.

Let me know what you think in the comments or on Twitter @simeons.

As with many blog posts, the comments are very interesting. Here are some highlights.

Antone Johnson

Excellent article. As a lawyer, there’s only so much wordsmithing I can do in the financing documents to protect founders from their own promises that reflect unrealistic assumptions. Of course most financing rounds never lead to litigation, but if things crash and burn, and finger-pointing and recriminations ensue, I’d rather not have excessively rosy five-year financial plans floating around as Exhibit A for the plaintiffs’ lawyers.

Denny K Miu

I think bootstrapping is very important for both entrepreneurs and for the VC’s. In my experience, the only way to have a meaningful conversation with VC’s is when we are already shipping products. I usually don’t even prepare a separate PowerPoint presentation. Instead I start the company by saying, “Let me show you how I convince customer ABC to buy our product”. Life is good after that.

GK The pertinence of forward looking sales projections depends on the stage of the business. If you raise capital from investors who pretend not to understand this, you will be setup for financial incongruity.

Consider 5 distinct business stages:
1. Incubation
2. Build Product
3. Early-Adopter Success
4. Repeatable Sales
5. Scale the business

In (1,2) sales projections are useless, the time to prepare them is wasted effort.
In (3) sales projections are presumptuous; you have yet to comprehend WHY and HOW the buyer will commit.
In (4) sales projections become essential to internal planning.

Raising capital between stages 3,4, a 1-year plan is valuable, surfacing the right questions/equations within the business, and with potential investors. A 3-5 year plan is chimerical until stage 5 and the shift preceding it.

I wish there was a standard questionnaire, like one of those pop psych personality tests, that entrepreneurs can fill out to get the background information out. However, I’m not interested in whether someone wants to be an entrepreneur (they are rarely talking to me if they are not entrepreneurs already). I’m more interested in what they consider a success, what type of company they want to build, the impact they want to create, etc.

Here is some of what I’ve found.

• Personality tests for entrepreneurs
• Online personality test for entrepreneurs

Have you found a test you’ve liked? Have you seen a test that goes after what I’m interested in?

I’ve been an entrepreneur as well as a VC. The biggest travesty that VC firms can visit on a portfolio company is putting an inexperienced representative onto its board. Too many VCs have no real operating experience (sorry, having been a I-banker or recruiter does not count as experience).

I think this is an overly simplistic way of looking at things. Here is a quick test. Which one would you choose as your VC board member for your pre-product Series A startup:

• A really experienced former CEO who can’t get used to being a board member and thinks he can run the company better than you
• An really experienced former head of sales who has scaled companies from $10M on several times but who has never been in a pre-product startup
• A former lawyer or banker or accountant who’s had more than a decade of experience as a VC and a fantastic early stage investment record.

Not sure about you but, assuming the personalities work out well, I’d go with the VC w/o operating experience any day of the week. In fact, my first startup, Allaire, went exactly this way.

Two take-aways:

1. Comparing between board members is very, very hard. Especially if you don’t have competing offers to compare. Do not underestimate the impact that your investor board member will have on your life. First and foremost, talk to good people with good track records. Do not get tempted by the cash. I know this is very hard to say in the abstract but it is true. Go talk to CEOs of companies who’ve had a serious falling out with their investor board members. Listen closely to what they tell you.
2. There is no simple rule of thumb for comparing between investor board members. The key is to understand what you are comparing. You are not looking for a CEO or an exec. You are looking for one board member who’s part of a larger board. Boards are about strategy, governance, fundraising, exits and supporting the CEO. They should not be a crutch for your team, unless this is by design, e.g., with an executive board member.

from Start-Up CEOs Gripe About VCs’ Lack Of Operating Experience – Venture Capital Dispatch – WSJ.

First the details.

• The event: Tue-Thu next week (September 22-24) @ MIT. This is part of the Lab to Market workshop.
• The time: Tue @ 3:45pm at the Kresge Auditorium
• The panelists:
  • Bill Aulet, serial entrepreneur who’s run an Inc 500 company now at MIT
  • David Frankel, entrepreneur and super-angel now at Founder Collective, a new seed fund in Boston
  • Jeff Glass, former CEO of m-Qube now at Bain Capital
  • Rich Levandov, co-founder of Phoenix Technologies now at Avalon Ventures
• The details: follow @simeons and you’ll know

The secret to why we’ll do things differently lies in data. I asked the conference organizers to survey the audience about the types of financing they were interested in.

• A whopping 55% want to know about very early stage, non-VC financing (bootstrapping, customer-financing, pre-seed, seed, angel)
• Only 18% (1/3) were interested in early stage financing from traditional VCs (top-tier and smaller funds)
• 10% are looking to Uncle Sam for money
• The rest want to know about follow-on financings and M&A

At previous events, when I’ve asked about the split between VC and non-VC early stage financing the interest has been about evenly split. Here it’s 1 : 3. Is it just the MIT audience? I doubt it. More likely, the change is due to a big shift in the nature of startup creation as a result of the drop in the cost of building and distributing high-tech products and services. This is especially true of Web and cloud-based businesses but is also affecting life sciences and cleantech. (For more on that, stop by the panel I’m doing on cloud computing on Tuesday, the MTLC Innovation unConference on October 1st and by the Democratization of Innovation conversation Ray Kurzweil and I will have at the MIT Enterprise Forum on October 14.)

It’s a good time to have  a conversation about what’s the right funding path for companies and the value-add of various investor types. The dialog has been heating up. The NVCA recently made some outlandish claims about the economic impact of VCs. TechCrunch responded with a guest post from Vivek Wadhwa. The summary is “when things go well, VCs take too much credit.” My two cents are that if VCs are guilty of claiming or receiving too much credit when things go well, they certainly get too much blame when things go poorly. And I certainly think it’s foolish to only blame VCs for investing too much money in companies. It takes two to tango. In the background there is the “the venture capital industry is broken” refrain delivered by groups with alternative investment models and Bill Gurley’s data-driven commentary (the strong will get stronger, the weak will find something else to do). All in all, a great setup for a no holds barred discussion about fundraising.

I recruited the panelists with the audience’s interests in mind. They have all been successful entrepreneurs. They all are or have been investors and they all know early stage well.

Come armed with hard questions and help make this a great event.

Weather management

• Elevator pitch: What weather do you want today?
• How: Different ways to go about this one. You could create weather on a macro or micro scale. Or you could grab weather from one location, package it up and move it to a different location at reasonable cost. For example, ship rain from Boston to the Middle East. Ship sun from wherever to Boston.
• Business model: You have options here depending on how you solve the problem. Enabling equipment works, provided you slap on a hefty maintenance and operations contract and get your customers to fund the capex. Alternatively, you can go for a straight marketplace or exchange. If you want to have fun, don’t automate it. Instead, hire young up-and-comers from the commodities exchanges. They make for great footage.
• Why: Because you don’t just want to be rich. You also want to be the One Who Saved Earth.
• Who will back you: This one is custom-tuned for getting backed by a Boston or New York VC, especially after the never-ending rain this summer. However, if you have a credible plan, you can expect crazy bidding up of terms from Scandinavia and the Middle East.

Productivity enhancement

• Elevator pitch: Do you want to be super-human?
• How: Different ways to go about this one also. You could eliminate the need for sleep. If you can’t find any other way to do it, go for genetic engineering but read this first. Alternatively, you could find a way to pack way more than 24 hours in a day. (Caveat: it’s been tried several times before and everyone has gotten stuck on the cost analysis of the fast-moving spaceship.) Last but not least, if you are based in Massachusetts and, therefore, part of the best robotics community on Earth, you can go the cybor path but watch the aesthetics–they matter a lot in social media world.
• Business model: This one is custom-made for a subscription business on a per-life basis. Perhaps as a percentage of lifetime earnings?
• Why: Because you want to be the first to take advantage of the invention but don’t have the money to do it on your own.
• Who will back you: A Chinese VC with shady government ties will back you while the US VCs are tied up in congressional hearings.

With ideas of this caliber there is always a risk of being kidnapped and turned into a research slave for a powerful government’s dark agencies. That may, of course, be prevented through some startup innovation. Topic for another post.

Update: (thanks to FN’s comment) Bill Gates has already taken the lead in the weather management startup space. Hmm, I wonder you’ll back him?