It seems like every week I talk to other founders or entrepreneurs who are going through the fight of their lives to try and avoid their entire company from falling apart or being dissolved and every time it is over the same issue: equity. They didn't have the equity discussion up front or if they did, they talked about it in very general terms and split up equity based on emotions rather than logic and an eye for the future. Hopefully this post will do three things: Inform you, motivate you and scare the hell out of you.
First why do we avoid having the equity discussion when we all know it is so important and so crucial? Here are some of the reasons from my own experience.
- We are scared. We might be scared because we know that we deserve more of the equity and the other founders aren't going to either agree or are going to fight it despite knowing it is true. We might be scared because the opposite is true and we know that one of the founders deserves more.
- We don't want to damage relationships. Let's be honest, having the equity discussion is uncomfortable, awkward and can be hurtful. It isn't easy to talk to friends or co-founders about why our input is worth more or to hear that our input is worth less.
- We think that it will eventually work itself out i.e. - we are procrastinating. We think that it will get easier as time goes by. We think everyone is on the same page. We tell ourselves that we don't know how things are really going to work and need to give it some time to test it out. Although this can often be true, there is a much better way.
Are you avoiding the equity discussion for the reasons above? Or are you avoiding it for another reason? Do you believe that you have a legitimate reason? Share in the comments below. So what is the first step? First you need to change the way you think about talking about equity.
Change your Intellectual Approach
First, stop thinking of the equity discussion as a singular event that you do once and never go back to again. One of my best friends has been working at a startup for the past 2 years. He said that this was one of the biggest surprises for him. He said equity came up a lot more than he would have expected. It wasn't a one-time discussion. Approaching it this way sets a culture of openness and transparency. If you want schedule a quarterly meeting to reconvene and see how it's working.
Second, ask yourself the question: why don't I want to talk about equity? Whatever the reason it's helpful to sit down and even write your reasons. I believe that we avoid having the discussion because deep down we know something is not equitable and having the EQUITY discussion is going to by its very definition highlight that issue. Rather than putting it off take the time to ask why you feel this way. Do you know that your partner isn't contributing or that something is unfair in the way things have been discussed? Do you avoid conflict or feel uncomfortable bringing up difficult topics with your partners? These issues all should be addressed sooner rather than later. Once you know the reason tell yourself over and over that "This will only get worse as time goes by". The equity discussion is hard enough as it is, it only gets worse once people have put time and money into the company. Don't put it off because it will get worse.
Third, understand why equity is rewarded. Equity is rewarded for the following reasons: 1. For investment 2. For work 3. For expertise (This is essentially a subset of work but it's an important part to take into account. This expertise can be based on experience, contacts, research, and many other factors) 4. For an idea (I'll discuss this more in detail but this is always less than people think, especially the person who had the original idea). Equity should not be given out just because everyone was there at the beginning and all said they would help. Also realize that even if you are all equally contributing you still need to have this conversation to discuss potential situations that may arise in the future.
A Cautionary Tale
My friend's wife, let's call her Jill, started a company 9 months ago with a friend, Ashley. They had an idea for an awesome product for Moms and they knew it had a lot of potential. Jill and Ashley were really close friends and so when they had the equity discussion they just said, "Let's each take 50%". They then got some prototypes, shot a video and started a Kickstarter campaign over the course of several months. The product was something that Moms wanted and 30 days later they had sold over $100,000 in pre-orders on Kickstarter. During this time my friend started helping them with the business in return for equity (although they didn't get any signed documents but had everything in emails) and they brought on another friend to help. Ashley moved out of state because her husband got accepted to grad school and started working less on the business because of both being separated from the company geographically and also because she took on some freelance work to help make some extra money. All of the sudden two friends whose equity discussion had been very simple had to now ask the hard questions they had avoided in the beginning but now there was hundreds of thousands of dollars on the line. The company had only been founded 9 months ago. Now the two are no longer talking, have no desire to be friends, and my friend and his wife Jill just bought out Ashley for a lot of money. As in mid to high 5 figures. Ashley never worked on the business full-time and most weeks was putting in 5 to 10 hours. So many of these issues could have been avoided by having the difficult equity conversation up front. And this is just one example but some of the biggest companies in the world (Snapchat, Facebook, and many others) went through a lot of difficulties because equity wasn't clearly defined.
The Equity Conversation
So hopefully I have motivated you to have the discussion and helped you analyze why you are avoiding it. Now let's talk about what you should discuss. Here is a general outline which is by no means perfect but hopefully gives you a framework. Remember the goal of equity discussions are not to find a perfect solution because one doesn't exist. You're working with flawed humans so the situation will be flawed however so many future problems can be avoided by simply sitting down and talking for a couple hours.
- At the time of our discussion what is the company worth? If you're just starting than the value is going to be a lot lower. That's why I always recommend doing as much as you can alone before you start either taking investment or inviting too many people to help you. If you have an idea get going on it and then invite friends. This allows you to control the equity conversation. If you and a friend come up with an idea together then start working on it and only invite other friends or people to help once you really need them. Most of the time people start working on an idea and immediately think they need to "build a company" and invite four or five friends to help. By doing that you don't have the chance to build as much value as they can. If I have an idea and immediately call four people I know could help me then all there is an idea and you'll most likely give away most of the equity. If I wait and go and do as much as I can alone, then I can come to those four friends and still get them to help but you will have more equity.
- Equity - Base your discussion on the four items mentioned earlier:
- Investment - Is anyone putting in any cash today? If so are they being rewarded with equity or are we going to pay it back as a loan? Often when you are first starting and getting investment from friends or family they will want both. Don't give it to them. Make sure they understand that if they invest and get equity they don't get paid back before anyone else and get equity. That's a terrible deal. In my experience see if they will loan you the money. If not see if they will loan you money that is backed with equity. This means that if you can't pay back within a certain amount of time the loan converts into equity. So they may give you $100,000 for 10% and if you pay it back within 2 years with interest than you get all or a portion of that equity back.
- Work (also called sweat equity) - Who is going to be working for the company without getting paid? How much time are they going to be spending working on the idea? How long can they work on the idea before they either have to go find another job (assuming they are working on this full-time?
- Expertise - Do any of the founders have expertise in this field? Do they know a lot of investors or potential customers? Have they started a company in this space before?
- Idea - This is in my opinion the greatest cause of conflict in startups especially in the U.S. Most Americans have this delusion that their idea is the next great thing and that they are like Edison or Jobs or Tesla or Elon Musk. Think of Tesla. If in 2002 I had said to an investor "I'm going to start a car company that makes electric cars and they are going to be really well-designed, really fast and really high quality. So please give me $10 million for 5% because one day this idea will be worth billions", they would have laughed me out of their office. Your ideas aren't worth much until you've done something with them. If you have spent an average amount of time thinking about and working on the idea ( I would say 10 - 40 hours) than the idea is worth no more than 5-10% and probably even less. I have worked in startups where the founder or co-founder who had the idea thinks they should get anywhere from 25% to 75% for their idea. Honestly run away from those kinds of people. They drastically overvalue themselves and their input.
- Vesting Schedule
- Questions to Ask - You need to ask lots of questions about how equity is going to work. Questions like:
- Is anyone planning on working for the company full-time without pay? If so is that person being rewarded for taking so much risk during the riskiest time in the business' life?
- If no one is working on it full-time in the beginning what happens when we are making enough money for all of us to work on this full-time? How much do people need to be able to commit full-time? If one person will dedicate all of his time for $1,000 a month despite needing more but another guy needs $4,000 a month then is the first guy being rewarded for the risk he is taking? What happens if we can start paying people what they originally committed to in order to commit full-time but they don't want to quit their full-time job? Do they lose all of their equity? (Hint the answer is yes) If one of your partners says something along the lines of "Let's just start and then if it gets to the point where we can do it full-time we will decide then" realize three things. First he probably has a solid well-paying job, second he probably isn't as committed and third when the time comes where you can pay him what he needs to get by he won't quit his job.
- If no one is working on it full-time how do we make sure that everyone is not only committed to work on nights and weekends but to also ensure that work is being done and progress made? I can't tell you how many times three or four people will start a company but one guy always has a reason for why he didn't get things done that week whether it is because he got sick, busy at work, etc. You need to make sure that there is a commitment and a way to track accountability. Often if everyone is working part-time it is good to get together every week or two to give a report.
- When is equity rewarded? I would recommend having yearly cliffs if you want to base it on time, especially for the first year because you're going to find out that first year who is committed and who isn't. This means people get equity at the end of each year rather than at the end of each month. So if one of your partners works on the idea for 3 months and then stops working on the idea then he gets nothing. This also helps you avoid an issue of having dead equity which is where one of the sweat equity partners works for long enough to get some equity and then quits and has equity that is essentially dead because it isn't doing the company any good anymore. I was in a startup where there was so much dead equity we couldn't get funding and it killed the whole thing. In my opinion it is often better to reward equity based on performance. So the CMO is rewarded on reaching a certain number of users and lowering the acquisition cost per customer by a certain percentage. The CEO is given equity based on how much money he raises. It doesn't have to be crazy but it avoids having leeches who just stick around as long as they can to get equity. Some of these may be unrealistic so you'll have to come back and with honesty say whether or not that person did everything they could to reach that goal.
- How long does it take everyone to earn all their equity? So if someone receives 30% of the initial equity you can split that up over 1 year, 2 years or as many years as you want. I would recommend at least 4 years and again to do yearly cliffs. So if you did a 4-year vesting schedule with yearly cliffs, the person who received 30% will get 7.5% at the end of the first year and every year after until you reach year 4. This gives them a strong incentive to work hard and to stick around long enough to actually build the company. This can be adjusted based on how quickly you will get to market and start generating revenue.
- If equity is based on performance what happens when they don't reach the full goal but do get close or accomplish it in some way? Is equity still given and how?
- What happens if one of the partners decides to move because of work or school?
- What happens if one of the partners starts working on the company less?
- What happens if one of us dies?
- What happens if one of us goes to jail or commits a crime? If your partner commits a felony it could impact your company. You should have a clause stating that if anyone commits certain kinds of crimes they immediately lose all of their equity. If you have a partner who embezzled money from a previous company that could negatively impact you. I had some friends who shortly after college wanted to start a small e-commerce site. One of their dads invested and while running the company it came out his dad had been running a ponzi scheme. It completely ruined his company because he didn't have a clause in there about what would happen if someone committed a crime and so because his dad owned equity in his company their accounts were frozen for over a year.
- What happens if one of the partners significantly lies or deceives the other partners?
- Who has the final say when it comes to making company decisions? Is that based on equity or management?
- What roles are each person going to play? In my experience although most people want to be the CEO, it is a much more difficult position in the company with a lot of responsibility. Do we want to reward those who are taking on more difficult roles and responsibilities?
- Are any of the founders investing as well? Are those stocks going to be different than sweat equity stocks?
- What happens if at some point in the next year or two one of the founders is obviously the wrong person for his job?
- Vesting Schedule Enforcement
- How do we plan on enforcing the vesting schedule? Is that going to be a quarterly meeting, yearly meeting? Who is going to have the final say? Do we want to involve a mediator or impartial third party like a trusted adviser?
- What happens if someone is just not working hard? How many people need to agree in order to punish them?
- Questions to Ask - You need to ask lots of questions about how equity is going to work. Questions like:
- Future Discussions
- When are we going to come back and discuss how things are going? It doesn't have to be really frequent but you should check back soon, especially in the beginning to decide whether something is totally off. If someone isn't contributing as they should have that discussion right away. Don't wait until the end of the year to say "You didn't work hard so you're not getting any equity". In that case they were never notified so they would most likely be able to claim the equity.
Some Huge Takeaways
There is something you should take away from this conversation that at the end of the day is way more important than deciding who gets what. That is "Do I want to work with these people?". The equity conversation will reveal so much about the team and that is why you have to have it as soon as possible. You will learn so much about the other founders and their attitudes and the ways they handle conflict. Does the person who had the original idea think that fact alone should get them a ton of equity? If so they might be expecting to coast off the fact that they came up with the idea. Are the people on the team reasonable? Are they greedy? Are they selfish or do they put the team before themselves? Does anyone seem like they aren't fully committed? If so why are they not committed? It isn't always because they are selfish but it may be because they have a really good job and are risk-averse. Also by changing this discussion from being a one-time thing to an ongoing discussion you will be able to create a culture of transparency. Everyone will be committed to either staying up on the work or knowing there will be consequences. Finally by having this discussion right at the start and following up throughout the early months you will often get rid of a toxic partner. People who are planning on coasting or taking advantage of the hard work of others will absolutely hate this conversation. They will say it's unfair, that you don't trust them and a slew of other things. Run away from those types of people. People who are confident in their ability to execute and perform are never scared of being held accountable. If someone is nervous or has questions don't hold it against them and that is natural for all of us. But if someone becomes combative or manipulative it's just a sign of what you're in for by working for them.
Hopefully this information is helpful. It is knowledge that has truly been earned the hard way and hopefully it motivates you to have the equity discussion today. We would love to hear from you. Post a comment below with your experience or any advice you may have.