Founder Shares and Equity Distribution

With the nuclear winter in financing starting to loosen up just a bit (although there's a couple of questions where I talk about some fundamental changes in the financing landscape in Michael Dunlop's interview that might make for interesting perspective), I've started getting questions about start-ups and founding companies again. I recently published a post Founders vs. Employees and now this post will address founder shares. If you just want to see all of my posts on general topics about startups and early stage financing, click the "startup" or "financing" labels to the right.

Of all of the start-up topics I get asked about, I think founders shares must be the most common. What are founders shares? Who should get them? And, within founders shares, who should get what percentage? The key to teasing this apart is to understand that there are three distinct types of 'players' in a company's equity capitalization structure and we'll address each in turn:
1. founders
2. funders
3. employees

The fundamental insight of this post is that most of the confusion and problems in setting up a company come when these roles aren't kept distinct. Which isn't to say that one person can't actually be all three things...it's just that they are three separate roles and should be treated as such.

The core essentials of a company are an idea and common stock. A founder (or founders) has an idea, he starts the company and he owns 100% of the common stock. If the company doesn't require equity funding and its employees don't require equity incentives, the founders can continue to 100%. Otherwise, founders get diluted as they build value. We'll come back to this and the division of founding shares below.

The first place dilution usually comes from is equity funding. Although occasionally investors will take common stock, I think it's a bad idea. Capital from investors should come in as preferred stock, which keeps it senior to common stock so that investors get their money back before there is a payoff to the "intellectual" capital. As a corollary, a founder who "writes a check" should get preferred stock (or in some cases, straight debt). A founder should never get talked into allowing a capital contribution to get counted toward "sweat equity".

The grey area in this is that many founders work not just for a low salary, but for no salary at the beginning. That's generally still sweat equity. But if you actually write a check for expenses, put it in as preferred stock in the first capital raise.

Employees get options and a salary. Of any of the players, they are the most likely to effectively get anti-dilution protection, although that should never be contractual. Senior managers will get options that are measured in percents of the company (.2% to up 6% for a rock star CEO) and generally there are new grants every year or so or around the time of capital raises.

Back to founders. They don't get dilution protection...not from capital raises, not from the employee option pool. So the problems come when you have a "primary" founder (to borrow from my previous post) who comes up with the core of an idea and then wants partners. People call me up and say, "I've been asked to be a co-founder and the main guy has offered me 5%." For someone who probably at most had .5% of a company in options in the past, it sounds potentially ok. But its not. That 5% will be 1% after about 2 capital raises and an option pool...and it will be headed further south. If you read the post on founders vs. employees, you'll realize 1% isn't a good trade-off for sleepless nights, writing checks to cover payroll and the other sacrifices founders make.

How do you tell someone who just offered you 5% of a company that it isn't good enough? My advice is to put it into the appropriate context by saying, "5% implies I'm a founding employee, not a co-founder. I'm willing & ready to be a co-founder and that suggests I should start at at least be at [30% if only 2, 20% if a total of 3 founders, and so on]."

If "primary" guy balks at giving up such a large stake, make some / more of your shares subject to vesting. That should get him / her over the fear that you'll take the shares and bolt. Vesting in this case shouldn't have a cliff and should vest quarterly or monthly. Don't go overboard on this...any VC who sees that you're "open-minded" on vesting is likely to re-restrict shares for all of the founders.

That should get you started. Feel free to ask questions.