Co-Founder Equity Mistakes to Avoid | Startup School

Why Should You Be Generous with Co-Founder Equity?

Generosity with co-founder equity is crucial for the success of a startup. Here’s why:

• Long-term motivation: When equity is distributed generously, co-founders remain motivated through the company’s ups and downs, especially in the critical first few years.

• Avoiding resentment: If one founder holds significantly more equity, others may feel undervalued. This can lead to resentment, which harms teamwork and productivity.

• Benefits of near-equal splits:

  • Promotes a sense of ownership and commitment.
  • Encourages everyone to work towards a common goal.
  • Reduces the risk of co-founders leaving due to insufficient reward.

In summary, sharing equity generously keeps your team motivated, united, and committed to the long haul. This gives your startup the best chance to succeed.

What Are Vesting and Cliffs?

Vesting and cliffs are key elements in startup equity distribution.

Vesting is a mechanism where equity is earned over time. Typically, founders receive their shares gradually, ensuring long-term commitment.

Cliffs provide an initial period (usually a year) where no equity is given if a founder leaves early. These help protect the company from premature departures.

Typical Vesting Schedule:

• Four-year vesting: Equity is earned over four years.
• One-year cliff: No equity is granted if a founder departs within the first year.

Importance of Vesting and Cliffs:

• Protect the company: Ensures founders stay committed for the long haul.
• Flexibility: Allows for adjustment if a founder isn't performing.
• Fairness: Distributes equity based on actual contribution, not just joining.

In summary, vesting and cliffs safeguard both the company and the founders, creating a fair and motivating startup environment.

How to Identify Essential Co-Founders?

Identifying essential co-founders is critical for your startup's success. Here's what to look for:

• Role in Building the MVP: An essential co-founder is someone who can help develop your Minimum Viable Product (MVP). They should possess the necessary technical skills or creative know-how needed to get your product in the hands of customers.

• Customer Acquisition: Co-founders should have a knack for bringing in customers. They must be able to market the product effectively and identify the right strategies for customer acquisition.

• Overall Contribution: Their contribution shouldn't be limited to just one area. Essential co-founders bring multiple skills to the table, including problem-solving, leadership, and operational capabilities. They need to be indispensable in the startup's daily operations and long-term strategy.

In summary, choose co-founders who can significantly impact your MVP development, customer growth, and overall success. This ensures that your team is well-rounded and capable of overcoming the many challenges startups face. For more insights into what successful founders possess, check out the key attributes highlighted by Gustaf Alströmer.

What Happens During Co-Founder Breakups?

Handling co-founder breakups requires clear guidelines to ensure fairness and continuity. Here's how to navigate this challenging situation:

Equity Retention Before and After the One-Year Cliff

• Before the One-Year Cliff: A departing or fired founder should receive only a token amount of equity, typically 0.5% to 2%.
• After the One-Year Cliff: If the company is still pre-product market fit, it’s recommended that the departing founder retains no more than 5% of the company. This often involves giving back some equity to ensure the remaining founders are adequately motivated.

Severance Considerations

• Founders Who Are Fired: It's reasonable to offer a small severance, generally one to three months' pay.
• Founders Who Leave: Usually, these individuals do not receive severance. However, exceptions can be made on a case-by-case basis.

Resignation from the Board

Regardless of the circumstances, every departing founder should:

• Resign from the Board: This helps streamline decision-making.
• Sign a Release: Legally protects the company and remaining founders.
• Provide Proxy Voting Rights: Transfers the voting power of their shares to the remaining founders, ensuring smoother governance.

In summary, co-founder breakups need careful handling to maintain motivation and fairness. Clear guidelines help protect the company's future while being fair to all involved.

What Are Bad Reasons for Unequal Equity Splits?

Unequal equity splits can create tension and distrust among co-founders. Here are some common but flawed reasons for unequal distribution:

• "I came up with the idea": Ideas are plentiful, execution is what matters. Your co-founder's role in turning the idea into a reality is crucial.

• "I started working earlier": Starting six months or even a year earlier doesn't justify a massive equity difference. The bulk of the work, often 99%, is still ahead.

• "My co-founder needs a salary and I don’t": Equity should motivate long-term commitment. Separating salary needs from equity ensures everyone can live, while equity keeps them driven.

• "I’m older and more experienced": Experience does add value, but every co-founder should feel motivated. Generous equity helps maintain that drive, regardless of age.

• "I hired my co-founder post-funding/launch": Fundraising or initial launch are just stages. The majority of the journey remains, requiring motivated co-founders.

Avoid these short-term reasons. Instead, focus on equity splits that motivate the entire team for the long haul.

What Is Bad Advice to Avoid in Equity Splits?

When it comes to equity splits, certain bad advice can hinder your startup's success. Here’s what to avoid:

Performance-based equity

• Setting equity based on milestones, like a number of lines of code or revenue, is unrealistic.
• Goals can change especially in the early stages, making these agreements complex and impractical.
• Focus on best practices like vesting and cliffs instead of over-complicated formulas.

Part-time founders

• Part-time commitment often lacks the dedication needed. Successful startups require full-time effort.
• It’s rare to see thriving companies led by part-time founders. Full-time founders ensure sustained growth and success.

Dynamic equity agreements

• Variable equity agreements create uncertainty. Co-founders need clarity and assurance about their stake to stay motivated.
• Simplicity works better. Vesting schedules and cliffs offer clear protective measures without the complexity.

Avoid these pitfalls. Stick with clear, proven methods like vesting and cliffs to maintain fairness and motivation among co-founders.