A while back, I asked for feedback from the community on potential topics of interest. One email had a host of questions around founders’ equity. I have been negligent in responding (I hope better late than never!). Great questions and ones that come up often.
1. How should founding teams allocate equity amongst themselves? What is the VC viewpoint on how this should be done?
I am not certain how other VC’s feel, but I like to see the various members of the management team have enough equity each that they a) think like equity holders versus just salaried employees and b) are excited to come into work each morning to build value for themselves. The core founders will clearly have the lion’s share of equity. A founder should think about carving out 10-15% in an equity or option pool for the first wave of hires. These shares can be either stock grants with reverse vesting or options that vest over 4 years. The core founders can divide the remaining portion equally or based upon perceived value being brought to the game. Equal division for the core allocation creates the most "egalitarian" approach though it might not be the fairest one.
2. Many software startup founders now do the seed round themselves
and get to a working prototype. How should the money invested be
treated?
A number of my friends have asked me this question when they are starting up. I would first divide up the equity pre-$ according to the discussions in question 1 above. Once that is set, determine a value for the company (most likely between $2-5m) and let the money buy an ownership stake. A simpler approach so as to avoid the potentially contentious pricing of the firm by founders is to have the money come in as a convertible note that converts at the same terms as the first professional money. This works if a venture or angel round is likely in the next year. Else, price it yourselves.
3. Any opinion on founders getting some (but low) liquidity at time of funding?
There has been a trend lately with late stage deals, for the founders to take money off the table during funding. These companies are usually cash flow positive and the only way for the VC’s to get enough money to work in the deal is to buy founders’ shares. Couple of things to note:
1) this stock is usually common and the new money coming in is preferred. If preferred is priced at $1.00, then common will be priced at a discount to this (often 20-50%) depending on the size of the preference stack (preferred money in). The more preference in, the greater the discount. Founders are often shocked by this discounting. Also, remember to keep this pricing of common consistent with how you are pricing your options. This common sale is a third party pricing of the common. You have to issue your options at that price as well.
2) VC’s generally don’t like to see founders take money off the table. Historically, it has led to founders losing drive and some motivation if they already have their nest egg and the rest is "house" money. Some founders remain equally motivated, but it is hard.
4. Is there such a thing as "deferred compensation" for the founders — and a way to recoup some of This at time of funding?
Founders equity is supposed to account for this. It is truly deferred comp in that you don’t get it until the company is sold and shares are liquidated. Some founding teams will put an IOU in place for a couple of themselves (like an accounts payable). However, new investors are keen on this. We want new money to go towards future growth, not to paying back wages. Also, we would like to see founders acting consistent with an equity culture versus a cash/current comp culture. When founders think and act like shareholders, their interests are much more aligned with the VC’s. Unless there are specific, unique family issues (three kids, etc), taking money off the table for past salary usually doesn’t play well with new investors.