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.