At the same time, I see the difficulty with assigning a concrete value to the shares early on. The angel investment world solves this exact problem using convertible debt. Why not take the same approach with investments-in-kind made by the founders?
If a founder forgoes a salary, why not agree to convert the pay difference relative to the other founders into stock at the time of the first equity financing at the share price negotiated with the VCs?
If I work for someone, they need to compensate me right away. This may mean I receive an option grant that is eventually worthless, but at least in that case I would have had an upside to my risk. The IOU has no upside but has the same possibility of worthlessness.
Made up numbers, but say you get 500,000 from investors. And the going rate for engineers is 100,000. Two founders can take a salary and hire two, maybe three, employees. If they can afford not to take a salary, they've doubled their staff size. Since each one of them owns 25% of the company, it may be worth the risk to them. It's obviously not worth the same risk to the first round of employees, who each end up with 2.5% of the company.
The fact that one founder may have bills to pay, and him being the only guy having to cash in very early, will beat the morale out of him: he'll be working as an employee. This is also your guy whose tolerance for risk is the lowest precisely because he's got bills to pay. He might as well quit and go work 9-5 for steady pay in that case.
In lieu of equity, deferred pay is a bad deal for the employee: no upside, only downside, and usually on terms that are a lot less creditor-friendly than what banks can negotiate.
A further problem with deferred pay is that when things become difficult, it's not much of a motivator. After a year or two, people assume they're never going to get it back and become resentful. It's better off for them to have equity, where they knew full well they might not be repaid.
This is a decent first-order approximation, but for true fairness, the valuation should be set at the time the deferred-payment arrangement is made and should be lower than what is expected from a VC in the future. Because a deal may not happen, the fair valuation when this arrangement is set is lower than the expected VC valuation.
Why? Hypothetically someone could take a standard loan and use that. That would be cumbersome, and sometimes impossible, but it wouldn't require a "super high" interest rate.
They both work as hard and they both share the same risks. If they fail, the IOU still applies. One just happen to have more money stashed away.
Both partners might work as hard, but they don't share the same risks. One has put X thousand more into the business, and they should be compensated for that additional investment. The fairest way to do that is to consider what terms you'd find reasonable on an investment of similar risk.
I re-read the entry and it isn't clear to me if Spolsky thinks the IOU should be there even if the company ceases to exists. Me and my two co-founders had a similiar arrangement, albeit with very small amounts, and after the company died they paid me back the unofficial loan. We were all students and I happened to have some more disposable money for initial investments (under $3000 though).
I've been a first 10 employee (As an infrastructure contributor, not core engineer) twice in companies that eventually were valued at greater than $1 Billion. The first time I received 0.03% Equity (Before Dilution) - the second time I received 0.1% Equity (Before lots of dilution).
For one of those companies, I know that some of the core engineers received 3-4x what I did, so - extracting to all of the six core engineers in Layer 1, Plus the Administrative crew - comes around 6 * .4% + 3 * .1% = about 2.7% for the first nine employees. We had our series A before anybody came on board, as an employee.
There is probably a different allocation method for teams comprised of "Serial Entrepreneurs" - Your risk in joining that team is much less, so your equity is typically much less. Also, the approach usually goes like the following:
Step 1: Two - Four Founders create a company. Roughly sharing the equity, though, if there is a "Named" founder that will Garner Press/Financing/Customers, they take a bigger chunk.
Step 2: Founders brainstorm for month or two, commit to working together for a minimum of four-five years, and then go pitch their preferred VCs. VCs give them a valuation of $5-$10mm (pre-money) and invest $1mm-$2mm.
Step 3: First 5-10 Employees are hired, with a stock pool of 3%-10% - Sr. Employees with a great track record who currently have great jobs at Google/Facebook/etc.. will require a larger equity share. Out of work contributors who have a solid, if not exceptional track record will receive significantly less. The team now has a clock ticking, and has to demonstrate some traction within six-nine months to get their next round before the money runs out.
I resonate w/ this article a lot because to me, the appearance of fairness trumps everything. The 50/50 split lets me know that I don't have to worry about who does what exactly or who is working harder, but sets it up so we are both "all in". I feel like if you're debating equity split at that stage (provided you're both at the same point, quitting your job, etc) you're already setting up a rocky relationship. Either that or you're not really finding a co-founder, more of a dedicated employee.
I guess I'm just a little unclear on how you can define clearly what a "60/40" workload split looks like when they might not even be the same type of work.
That's one of the advantages. It's fluid. 60/40 isn't measurable, but if you know you're providing more value than the other founder, it's going to be close enough unless the other one stops working entirely.
You lost me there. My wife and I have a 50/50 split on life, but we don't both contribute equally "all the time".
Sometimes one of us will go out to dinner with friends and have an awesome meal while the other one struggles to puts three snotty, sick kids to bed. Certainly not equal contribution that night.
The beautiful thing about a 50/50 split in any partnership -- be it a marriage or a startup -- is that you don't have to keep track of every nickel and dime of contribution.
The problem, of course, is that you have to convince the other founder that you're doing 50% more, will always do 50% more, and should get 50% more equity, without poisoning the working relationship.
2. I respectfully disagree with Joel on certain aspects. He is very unclear about how to split equity among a few founders. He seems to advocate 50/50, which I strongly advise against. Fairness is one thing. But my litmus test is: if you quit, would the project die instantly? Then you are the CEO and you should get more.
I have advised tens of founders on those issues, including convincing some to fire useless co-founders. It's painful, but usually pretty clear when an outsider (like me) listens to all sides.
1. Nitpick: What if all co-founders meet the criterion (i.e. the project would instantly die if he left)? Are all CEO's then?
2. Instant vs. delayed death: Lets say if A leaves, the project instantly dies - and if B leaves, the company will die the next 6 months if no replacement is found who is just as good. Who is more important? What if the skills of B are the leverage you depend on to become successful and stay competitive?
And with 2) you are right in the middle of the discussion you want to avoid: Who is worth how much, who works harder etc., which is just distracting because nobody can tell for sure, and endangering your company because it hurts morale. That's why I agree with Joel to just split equally. And as joeag has pointed out, since it's vested, co-founders that really turn out to be useless won't get a large chunk of the company anyway.
That being said, I prefer that people don't give bad advice online. When you recommend 50/50 split, what is your experience for advising so?
I know of several technical startups products where the CEO can be replaced. Those companies would die if key technical people left. Since some of them have replaced CEOs already, their CEOs were not essential.
Are they doing it wrong? Should they have the tech people take on CEO responsibilities in addition to their tech work? What benefit will they get that compensates for the loss of tech productivity that will result from said shift?
But for most other cases in the real world, these two resources offer a more rational and open/honest approach:
I created a poll, so maybe we can get some data: http://news.ycombinator.com/item?id=2445715
If you go without salary, while the other people don't, and get IOUs, but the company goes bust anyhow, you'll be out of pocket but the other people won't. You're taking more risk; why not have more upside?
But the other side is this notion that reward is necessarily justified by risk. What if the company is motoring along steadily for a couple of years but as a lifestyle business, and then gets a star employee who creates a new product that takes off? Are they necessarily not justified in seeking more compensation - perhaps they have created more value than even the founders? Or are the founders better off with a bigger slice of a smaller pie, and not trying to reward innovation in their employee base?
No one is suggesting that anyone gets a nice, ample, plush salary. This is a survival salary (anything more should not be allowed until the company can pay all founders). If the startup goes bust, a poor founder working 1 year on survival salary is no more "in pocket" than a wealthier founder working 1 year without salary. The valuable thing that they've both lost is a precious year of their life.
And if the startup has enough money to pay everyone, it makes no sense that someone would get more shares simply for taking less salary out. That's not what shares are for in an early startup.
re: star employee example--it's not how much you made the company, it's how much of the company is yours to begin with. Founders will be smart to reward performance, but to reward proportionally based on contribution wouldn't work. If the star is unhappy, he's welcome to quit, take the risk and start his own company.
as a side note, taking the emotional impact of your decisions into account is not acting irrationally. indeed, it's more rational than deciding things on a purely monetary basis, because it takes all possible inputs into account.
Sure. That is treating that early founder as founder + lender and recognizing that IOU as a debt of the company.
In other words, if someone takes an IOU instead of cash then they are assuming risk. This risk has value, and in the real world this is what your interest rate reflects. The Lender adjusts the rate relative to the risk.
So by all means agree on the interest rate. We have an interest rate here set for both "lending to" the company and "taking from" the company. ie there are times when a founder needs some extra cash, and it makes sense to borrow it from the company rather than a loan-shark. We have that rate in place too.
The key here is not to use _equity_ to cover _operational_ expenses, at least at the founder level. Loan accounts should be used to cover operational expenses.
Equity has implications beyond pure "cash" because it contains a "power" component as well. The ability for one founder to "out vote" the other leads to poor conflict resolution on both sides - the one knows he has the ultimate decision, and the other knows it too.
More than that, the "cash value" of equity is a thumb-suck and will not be reflected in the final outcome (either way). Thus it's a complete gamble which will inevitably leave one side feeling screwed when the outcome happens (whatever the outcome is.)
Consider when you have a technical and a semi or non-technical founder. Let's say the technical founder is the visionary for the product you are building, understands what the customer needs (which means he has some/good business savvy) and give direction to all engineering related activities - from technology stack selection to what features and how they will be built. He/she is the one who will take the lead in defining the product and its -hopefully- many iterations going forward. A quick high profile example that comes to mind is Mr. Zuckerberg - he did the programming and he continues to give direction to the product.
Now you also have the semi/non-technical founder, who is obviously there because he/she is talented, smart and will have large impact going forward in building customer relationships and contribute to higher level discussion on where the products should go. There is a good chance the company won't go anywhere without this guy either.
How would you now do the split? A 50/50 arrangement would mean both parties get the same say/leadership over where the company/technology needs to go. Is that right? This is not about money, as both parties will be in good shape as long as a reasonable arrangement is chosen. It is about what is fair/right/sensible regarding what the company is going to be about and how it is run.
I've heard of a so-called "shotgun clause". It's analogous to the problem of fairly cutting a cake. One person cuts, the other person gets to pick a piece. IIRC, in the shotgun clause, one founder can demand that the other founder leave, and names a price for the company. If the other founder wants to stay, he can buy out the first founder for the named price. This sounds reasonable, except that founders might not actually have the money to buy out the other founder.
Or half the company for a $1000 investment.
The investor who puts in $1000 for x% is an investor, not a founder. They have already completed _all_ their obligations.
The founders are "earning equity in return for work". Their obligation is to work for a period of time.
Incidentally int he case you're referring to, his shares would have been diluted in proportion to the "other 50%" - so his 50% then does not equal 50% now.
There are tax implications with this description. This equity could be called compensation and taxed at the income tax rate instead of the capital gains rate, in the US. This could be the difference between 15% and 35% tax rates.
I prefer to think of it as "earning the right to have restrictions lifted from the equity they own". At the same time, their work is causing that equity to have more value (if they're doing it right!)
I am not a tax expert, or a lawyer, but this exact thing has been an issue for me personally for this tax season.
If your company is a success, great, but is it really going to matter if you're worth 50 million vs. 60 million in the infinitesimal chance that it pops?
Anyone has example of a startup that actually did that ?
AFAIK the total employee pool is rarely beyond 15% total. And that number is for a few layers ahead.
Each person hired will get an equal share, but I'll probably put in some sort of probationary period (3-6 months), just for safety.
As for governance, it always makes sense to divide up responsibilities instead of making every decision via consensus, but for the big things (taking on a big financial risk, selling the company, etc) the employee-owners are the board, and get to make the decision.
We've made some mistakes along the way, and refined the system somewhat as well. What we realized (somewhat painfully) was that we wanted those working "in" the business to "own" the business. So while we have a vested system for earning shares, we also have a vested system for getting them back.
Once you leave, over a period of time, your shares revert back to the company. (we're a private company, not public, so the shares would only have any actual value in the event of a buyout, or dividend. The length of this vesting-out phase is proportional to the time spent in the company (with a cap). During the vesting-out phase dividends are paid out to "not present owners" in proportion to their share. To make sure this isn't completely manipulated we limit bonuses to the owners to the same % as what the staff get.
The idea is that while you're here, you're adding value. That value persists after you leave, but will becomes less important as time goes by.
The key thing - know how people get _out_ and agree on that before you start. Getting out is harder than getting in.If the rules are in place while everyone is still keen then they'll be fair. when it comes time for someone to move on, they already know the rules so there's no animosity on that front. By determining the rules _before_ you know which person will actually _use_ them you're likely to come to a very fair agreement. You know you could be on either side of the agreement later on. If you're negotiating this after one person has decided to use, then you've both staked out your camp and so both sides have very different goals - which leads to very difficult and painful arguments.
My partner once described business as a "marriage" and like a good marriage a pre-nup serves the interest of both parties.
Yeah, consensus is something I'm toying with. I'm writing a CEO into the bylaws who, in spirit, should be the vision guy; not sure how powerful to make him or how influential. But the board is elected by the members, have short term limits, and I'm making it really easy for members to review board members and officers. The trick for all this working is vetting prospective new members. Until we get more than 10 members, the board meetings will also be membership meetings (sorry, you 3: you have to sit this one out).
Third Coast Workers for Cooperation is a great organization to help out with the pesky legal details and bylaws; I'd give them a ring.
- For ownership, fairness, and the perception of fairness, is the most important because arguments are very likely to kill the company. 50-50 is simple and acceptable.
- For stakes, divide people into layers by risks they take. Taking the biggest risks, founders the first layer should end up with 50% of the company, total. Each of the next layers take 10% respectively, split equally among everyone in the layer.
- Do use vesting to prevent some jerk that quit after two weeks and still think he owns 25% of the company for his two weeks’ work.
- For founders, ownership can never be calculated accurately. We’re human beings, we can come up with excuses as many as possible to claim our benefits. That’s why 50-50 works in most cases.
- 50-50 is a perception of fairness, is a symbol of “Hey guys, we are equal to each other, we are working for our company, not any of us!”, no matter who brings up the idea, who has more experiences, etc.
- Ownership is a process, not a decision. What determine your cake is risks you took, value you created, how long and hard you got involved, etc. Instead of a meeting, a discussion, or even an email.
I can see this causing all kinds of problems. You're not going to allocate an option pool for employee layers one through five all at once, prior to your seed round, because that'd be massively dilutive to you in the event of an early sale. (The unused options go away, but the premoney the VC invested at takes the unused options into account.) But creating such hefty option pools down the road is going to cause issues with your existing investors, who at that point would be diluted.
The conflicting interests of founders and earlier investors (who don't want to be diluted by a large new option pool) and later, new investors (who want to make sure the company has a lot of options to incent new employees) will get you to an 'industry-standard pool' pretty naturally. Unless the market's changed dramatically recently, that standard pool is a hell of a lot smaller than what Joel's suggesting.
If the 2 founders can't make a contentious decision as a team, they're not much of a team.
Zuckerbergs need Sean Parkers so that VC would invest faster
a little humor goes a long way
Neither you nor your employees need that kind of perverse incentives.
If an employee is good there is no way you would want to fire them, disrupt and demotivate the other employees plus have to go out and look for a replacement. The disruption hit would be far greater than the equity gain.
The way you handle that, if it's day 330 or so, is to negotiate a fair severance and buy out the equity on a pro-rated basis. "I don't have to give you anything, but you've worked nine-tenths of the year and your equity stake would be worth about $50,000 at the current valuation. Here's $45,000 not to make waves."