Pete Tormey: How to Keep Harmony Among Founders

I recently sat down with Pete Tormey, a startup attorney in Silicon Valley, to discuss how to keep harmony among founders in a startup.

Pete Tormey: How to Keep Harmony Among Founders

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Sean: Hi, this is Sean Murphy. I’m talking with Pete Tormey an attorney in Silicon Valley who does a lot of work with startups. Today we’re going to talk about key factors in allocating equity in a startup.

Pete, I know you work with a number of early stage startups and you get into a lot of conversations about how do you divide the pie–how do you figure out who gets stock and how to structure that. What are the kinds of questions or what’s the most important question that founders should answer first in thinking about the problem?

Pete: Well, the problem of allocating the initial equity, there’s a lot of topics that come into play, but usually if you’re big enough to have a co-founder and that’s really the place we’re looking at. Prior to that a lot of times you can keep the company for yourself and just pay your coworkers, they are not yet not co-founders. When you get to the point where you have a team–ideally at least three or four member–then you have to decide how to split the pie. Your real focal point has to be keeping harmony among your team, so that people feel like they’re contributing and they’re valued. Sometimes we hear people say we want to protect against wishful thinking, so we want to be realistic about what people are doing and making sure that they feel that their contribution is equally valued.

Defaulting to Equal Split May Not Lead to Harmony Among Founders in the Long Run

The default rule approach is that everyone gets equal shares. The problem with that rule is not all of the founders feel that every other founder has contributed equally. I think the classic example is the techie guy, let’s say the software developer works real hard getting the prototype out, and that’s before the salesperson or the sales and marketing person gets into the game. It looks initially like the people developing the prototype are working real hard, and they are. To them the appearance that the sales and marketing people aren’t really doing anything. Then once the product is built, the sales and marketing people are out selling and they get the impression that the technical people aren’t doing anything.

What happens is when you go in with a team, it often looks like the work isn’t evenly distributed, or sometimes that the work isn’t evenly valued. I think there’s a split sometimes between the visionary often has a very grandiose impression of their contribution, when really all they have is the idea, and ideas tend to be relatively inexpensive, whereas the technical people that develop, say software developers are really critical and way more valuable maybe than the visionary at this point. What we like to do is come up with some type of equitable split that appears reasonable to everybody involved in the team.

A Cofounder Can Arrive a Little Late

Sean: Do you ever have folks that realize that they need another founder or they start to grow, and instead of hiring somebody as an early employee, they take on another founder? How do you handle that?

Pete: If it’s very early on, they’re really co-founders, and technically I think a co-founder is someone who’s really there at the beginning, and has a, for lack of a better term, a real ownership interest in it, versus an early employee who’s there more for the paycheck. I know that that varies. There’s always that right at the cusp, where you’re working for equity, but you’re really working for a paycheck. I think smart founders recognize what their limitations are and would be looking for a co-founder who can fill those, who can complement them and have the skill sets they don’t have necessarily. In that case, you’d want to bring that person on as a founder, even if they’re the second person and you might be a little further down the road, and give them some chance to earn enough in there so they have that buy-in, that ownership stake like a founder would have.

Family, Friends, And Other Investors

Sean: Then how does the team look at bringing investors? Do people normally know that they’re going to take investment before they start, or do they discover that as they go? How do you balance that?

Pete: Well, most of the time when they come into my office, and our scenario is a little different, because we’re patent attorneys and people come in and they have a concept they want to commercialize somehow, and they haven’t really decided necessarily when we first meet whether they want a corporation, whether they want to fund it or license it off or something along those lines. You go through this process, but some inventions or some new company ideas inherently will require funding. They don’t have the money to do what they want to do. They have a very big picture and they know they’re going to have to pitch for money at some point. Some of them you realize they probably can bootstrap it, or they can probably do a family and friends round or something along those lines that will give them the money they need to get to some revenue stage.

Then at that point they can make the decision of whether or not they want to bring on other investors. Once you’re at a revenue point and you have some kind of numbers behind you, getting investors should be a lot easier to do. I’m not saying it is necessarily, but assuming your numbers look good, it’ll be easy to find investors. When you know from the beginning that you’re going to look for investors, then you want to plan your equity offering with that in mind, so that you don’t have … Your capitalization table, they call it the cap table, who owns what stock, you want to keep that as clean as you possibly can, because future investors want to make sure they’re not buying into any kind of strange deals.

You want to avoid making a deal to sell options to your Uncle Fred because he was good to you in ninth grade–one of those foolish things that I have actually seen happen. They borrow a little money from grandma to get going , but they never finalize the deal, so grandma owns something of the company and no one knows what it is. You want to make things are clear from the beginning and continue cleanly so that in the future potential investors will look at the capitalization table and say, “Okay. This is a good investment for us.” Don’t leave any arrangements dangling and avoid side deals that all of the founders have not signed off on and that won’t scare off future investors.

Firing a Founder

Sean: How should teams handle it if a founder is not really performing? How do you handle firing a founder?

Pete: I wish there was a short answer for this one, and there really isn’t. When you issue equity to someone, they’re always going to have that equity. The question then becomes are they employees for the life of the company or not. If you don’t have an employment agreement, the answer is they may very well be. You really don’t want that scenario to happen. We do a couple of things. The first is everybody working in a company should have some type of an employment agreement. Even though it sounds funny you would have an employment agreement with your own company, but you want people to be fireable, and the reason is if they don’t perform you want to be able to get them off your company and take away their authority.

That’s always a very awkward conversation to have, especially when you only have two founders, because that means one of them is going to be firing the other one. The reality is you’re going to grow, and when you grow you’re going to have a bigger board of directors, you’re going to have different executive officers and things like that. You should plan for the fact that you may want to leave the company yourself, and that should be part of your planning. I think a company with a growth strategy, especially if you get up there in years, you’re not in your 20s anymore, you’re going to think about wanting to retire, and hopefully there will be enough money where you don’t work at the company anyhow. You’re going to have a personal exit strategy in that regard.

The other thing that lawyers can help with is to have your stock plan vest in over time or something along that lines, so that if people don’t perform or stop performing, and you sever their relationship with the company they don’t continue to earn all the equity. I know I switched topics a little bit there, but I’ll go on and explain that usually even among founders when you divvy up the initial shares you should plan for the fact that one or more of them may have a problem completing their obligation over the next few years. They might meet a girl and run off, or maybe life happens, family member dies, or they die, or something along those lines, and they never perform. If they’re sitting there with 30% of the company, then you’re going to have a little bit of a problem. You’ve given away 30% of your company to somebody that will never do the role you were hoping they would do, whether it’s bring in money or sales or write code, or whatever.

What we often do when we divvy up the initial shares of the stock is we put it in some type of vesting schedule. Usually we have a restricted stock purchase plan or something like that. If one of the founders stops performing for whatever reason, the other founders can say, “Okay, we’re going to exercise our option to buy back your shares,” and in effect they will no longer be building up all their equity in the company. They will slowly get diluted out by all the other players. I know that’s kind of a long answer to the question.

Vesting –Restricted Stock and Option Plans–Can Help

Sean: Just to be clear, when you’re talking about vesting there’s really two scenarios. In the first scenario with restricted stock I put the money in put front to fund, and then the company has the right to buy back my stock at the price that I paid for it on some schedule that essentially over time they lose the right to buy back.

Pete: That’s correct.

Sean: In an option plan I am granted the right at a future date for a fixed price to buy, or on a schedule to buy shares of stock on that schedule. In one case I hold the stock, in the restricted stock case, and in the other case I’m going to earn the right to buy it if I stick around or I achieve the milestones in the vesting plan.

Pete: Yes. That’s right. I think among founders that we’ve dealt with usually a restricted plan is what they prefer, because it gives them the right to control the stock. They actually get to vote with their shares. They’re happier with that, whereas with the stock option you don’t get the right to vote until you actually exercise that option in the future.

Sean: From a tax perspective as well, if they file an 83B, they also start the shot clock on long-term gains, so financially it’s much more favorable. Have you had much experience with milestone-based versus time-based vesting? Do you have an opinion on that?

Pete: I have. I don’t have as much experience. It turns out, well, the answer to your question is time-based seems to be the preferable one. The problem with milestone-based vesting … Originally I did quite a bit of it, and I’ve actually kind of gotten away from it simply because the ability to measure the milestone is often very subjective. When we say milestone what we mean is when you get to alpha version you will get X shares, or the right to X shares, and when we get to the first sale, you’ll get the right to more shares. When we get $500,000 in funding, you’ll get these shares.

Let’s say my job is to go get investment funding for a company that we’ve formed. When I get 500,000 in investment I’ll get 100,000 shares, some vesting schedule like that based on the milestone of me getting the money we need. If we don’t get the money, I will think the reason I didn’t get the money is that my team didn’t perform. You promised me we were going to have A, B, and C, and all we had is A and B, and I had to go to market with A and B, and I didn’t get it. There’s going to be resentment there. Even though everyone went in with the best intentions, it’s often very hard to clarify all the expectations. With time-based it’s pretty straightforward. You’re there for six months and the vesting schedule says after six months it’s whatever it’s going to be.

The problem with time-based, of course, is that I may sit around for a month and do nothing, or one of the partners, one of the co-founders may. The best solution I’ve seen to that is some startups where they actually have regular work hours. They work every Monday and every Wednesday and every Saturday, and you’re expected to be there. Your work hours go to the time vesting. They were young people and could afford it. It’s very different sometimes if people have families, but what happened is they actually had hours that they worked, and that went to their vesting schedule.

Pete: Their vesting schedule wasn’t one month, two months, and three months. It was something like 100 hours, 200 hours, 300 hours. Then they had an office they could share, which was a luxury, and they all met after their day jobs, had dinner together, and then they worked into the evening. That became, whatever, a four hour shift or whatever that worked out to be. They did that a few times a week. I think that was a very workable model.

Allocating Board Seats

Sean: Interesting. As you get formed, what do you see in terms of board seats or defining the board?

Pete: That’s a good question. The board controls the company, so the board are the one who appoint the executive officers, and the boards are elected by the shareholders normally. Often your early stage investors and things want a seat on the board. You have this trade-off with founders of control of the company. Probably the best partnership early stage arrangements I’ve seen are when some of the people don’t really care if they’re on the board. The board has obligations that come with it, because you’re responsible for running the company. Some people really just want the ownership interest for the profit, not necessarily for the control.

Pete: I think what I would advise startups to do is to look carefully. If you have two competing egos that are trying to control the company, that’s probably a bad sign. My experience is I’m a lot happier when the don’t … The visionary, they’re quite happy to let the visionary be the president and chairman of the board, and kind of be the visible face of the company, and the other person is going to do whatever role that they’ve agreed to do. If you’re struggling for control of the company then you’ve met what we started talking about, you have a problem among the founders. Often that’s going to be an omen for future bad things to happen.

Sean: That’s an interesting perspective.

Pete: You see it. Unfortunately, coming from the legal environment you get involved in these cases where there’s a falling out between the owners, and often what you hear is a story that says I signed on because we were going to do A, B, and C, and then the other person says, “We were, but once I got there I realized we had to do D, E, and F.” Then they have that kind of falling out, because the vision of what the company will be has changed. If you end up in a situation where there’s no dominant, controlling person for your company, so let’s say it’s two owners in a 50-50 split of the stock, the company can just die right on the vine. Most lawyers, I think, have seen that happen, where the company is no longer in a position to act. When it can’t act, there’s no governmental way to make it act. There’s no force you can use to exert the company.

While the owners are fighting among themselves, they’re losing market share, they’re losing product development time, and eventually the company becomes worthless and no longer worth fighting over. You’re probably better off making sure that in your structure for your board there is some way to reach a majority control, whether that means bringing on a third person, fourth person, fifth person, or something like that, or one person owns 51 and one person owns 49, if they can do that. Often that’s not always the best recipe, but you don’t want to have a situation where a company can’t move forward because it’ll never be profitable if that happens. Everybody loses in that scenario. They’re holding each other hostage.

Partners Don’t Have to be 50-50: HP was 60-40

Sean: I do know that Hewlett and Packard, a very successful two founder startup, actually split 60-40, with Packard getting 60 and Hewlett getting 40. It’s not necessarily the case it’s got to be a pure 50-50 split.

Pete: I think a lot of that ties onto the value of the company. I know this sounds funny, but you and I are both in the service business, and our companies without us have very little value. When a law firm gets large, there’s equity in it, but when it’s a small law firm or a small business development firm, you’re the player. You’re the key player, and without you the company has very little value. Maybe you’re better off getting 40% ownership in the Hewlett-Packard situation, but entitled to 50% of the profit, so your pay structure allows for even sharing of the profit even if the equity split is a little bit different. I think in law firms that’s very common. I know it is in ours where the pay is pretty much based on the work you do, not ownership at the end of the year how much earnings per share we had.

Revenue Split and Equity Split Can Be Different

Sean: In a cash flow-oriented or bootstrapping scenario you might have a revenue split that’s distinct from the equity split.

Pete: Absolutely, and that can solve a lot of problems especially for the first couple of years. Let’s say, for lack of a better scenario, you’re going to have the visionary and he needs a technical co-founder. The technical co-founder doesn’t want to work for free, and he doesn’t necessarily want equity in a company that might not fly, or might not have long legs or a long lifetime. He may be very happy to take a smaller equity position in exchange for a greater share of the profit or a percentage of the revenue, which is always a little dicier. You’d rather give him profit than revenue, because you got to make a profit first, and that’s your goal. That can be one of the tools you use to bring on early-stage employees or maybe you want to call them co-founders at that point.

Pete: Usually the visionary wants to keep control of the company, you can make that kind of offer, so they may only own 25% of the company, but they’re entitled to 30, or 40, or 50% of the profits they make, and for a period of time, three to five years or something, whatever their written employment agreement says.

Sean: Interesting. What we’ve seen happen sometimes–especially for bootstrappers–is that you have cofounders who are freelancers or who have other side income. They intend to join this entity full time that’s going to build and sell a product, but there is a period of time when they have overlapping commitments. One strategy is to start working together full time sooner and run the existing revenue through the new entity. Now you have two splits: one for the equity based on the expected contribution in the context of the future product, and one for revenue based on current contribution. This makes things much more real. There are a number of ways to approach this, and there are reasons to proceed more cautiously until all of the cofounders are really comfortable with each other, but the revenue split can be adjusted periodically and be different from the equity split.

Pete: I’ve seen that scenario actually quite a few times where somebody has a business idea and they want to grow it, and they’re bringing on a co-founder to help them grow it, but they already have a revenue stream that they don’t want to give up. Often I think that a good choice of partnership and careful selection and good writing on what the deal really entails, that’s a great solution for getting to that next level for those type of companies.

Granting Equity to Advisors and Consultants

Sean: What’s your take on if and when to grant equity to advisors or consultants?

Pete: Good question, and one we face all the time. The pragmatic answer is what is that person doing that you’re going to give them equity for, because fundamentally when you agree to work for equity you’re an employee. You’re agreeing to do something for the company. Arguably that has a cash value, even if you don’t know what it is. When you look at the like advisory panels and things like that, whether you should pay them and how much you should pay them, you have to ask yourself this question: what are they doing for the company that is worth giving them anything at all? Your option is to sell those shares for cash that you can use to fund the company. In that kind of scenario, you have to put some kind of valuation on it.

You have someone on your advisory panel that can help you get the funding you need to make the company go, and you’re going to have to pay them something. That’s the reality of what it is, and you don’t have cash so you’re going to have to pay them in equity. Although, my feeling is that valuing a company too early is doing a disservice to all the existing shareholders, because you’re selling shares and you don’t know what the value of the shares really is. The question then becomes can you pay that advisor. Let’s say the advisor says, “I can help you get a million dollars in funding.” Can you agree to give them equity in exchange for completing the deal?

That was one scenario we were working with recently where instead of just granting the advisor stock options, we would say, “We will give you stock in exchange for bringing in this deal.” Often the advisors would be investors themselves, and they would want to participate in that deal. If that happens, what you’re really doing is giving stock to someone so they have the right to buy stock, and that’s a little bit circular reasoning I think. Like anyone who provides a service to a startup company, you’d like to have some way to put some type of valuation to it. Then if you pay with equity, at least you know what you’re buying and what it’s costing you. I know that’s probably a really strange answer to your question, but I look at it from a pragmatic basis.

Sean: My perspective on the advisory side is that it’s definitely a marriage. It’s not a transaction: you really should only be offering equity to folks that you think are going to be providing value for at least 18 months to two years or longer. Now, you presented the special case of the fundraising–which is something we normally don’t get involved in directly except to help with revenue generation to demonstrate traction in the target market–where it’s cleaner to compensate an advisor with stock than a percentage of the raise, because it may make the investors a little leery that we put in a half a million dollars and then 50,000 goes right back out. They’d rather accept a dilution than the loss of the cash.

One mistake I see a number of consultants make with early stage startups is that they don’t realize it may take five to seven years to see any real return on that equity, so you have to be willing to be patient to see that pay off.

Pete: Sure. I think the marriage analogy is a good one. What you want is your advisors out promoting you everywhere they can, whether you need money or whether you need your product sold. The purpose of part of the advisory panel is in a way to be a cheerleader for your company. Whatever offering you do make with them, you’d like to have it either vested in or after some time, or something along those lines so that the marriage stays together.

Sean: At least when we’ve done it, we take common and we essentially put ourselves in the same boat or subject to the same conditions as the founders. The argument is, over time, our interests don’t diverge because if you’re not able to make money, then we’re not going to be able to make money.

Pete: Exactly.

Valuation For Investor Equity

Sean: You talked about the valuation and you had some interesting theories. Could you go into a little bit about how people should think about valuation or set value?

Pete: When I first started in the startup world, like that’s the question. Someone has an idea. They walk into my office. They have a great idea for a patent and they want to raise some money to make it real. What’s it worth? I think the honest answer is no one really knows until you … In fact, the value of a product in my hands and in your hands is probably very different, simply because you have more skills in the sales and marketing, business development side. It depends on what you do with the product. Trying to put a value always seemed like a dog chasing its own tail to me.

When I started doing my own research, what I found was you go to angel investors, and they’re going to give you … The short answer I got is they want 20-something percent of your company, and your job is to sell that 20-something percent for as much as you can. When you go to VCs, they’re going to want 40% of your company in round one, and your job is to sell that for as much as you can. I was at one seminar once and the guy said, “And as much as you can is about a million and a half dollars.” People started chuckling, because it turns out they always said million and a half dollars, no one wants to invest in a company worth less than a million, and two million sounds too high.

Now, that number might have changed, but you realize that a valuation is extremely arbitrary. In fact, I had a client call this week and he said, “In California this would be a $2 million valuation, but the state I’m in this is a $5 million valuation.” Based on what the perception of the value of the company was in the eyes of the investors. He was unhappy. He thought that five million was too high, but he was from California. When he moved, he was surprised at what the valuation was. Now, with that said, the question is how do you, getting back into the bootstrap model, how do you bootstrap? I’m a fan of convertible notes. You and I have discussed this before.

The idea is that you’re contributing to the company something that has cash value and when you do some actual monetization event where you’re in the sale of shares of stock, that cash value converts to shares. I probably didn’t do a good job of explaining that, but basically if someone were to loan you $100,000 and then when you do some seed round of financing, you say, “Okay, what’s our stock worth?” Buck a share, well you owe him $100,000. You give him 100,000 shares. I know that’s a little tension, because the person who has the convertible note is hoping for a low valuation, because then they get more shares that way. Reality is, everyone’s hoping for a good valuation because you want the company to be successful.

For the very early, very early, I prefer something along those lines where you avoid the step of having to value your company and putting a dollar value to stock. The few deals I’ve been involved in where there’s very early stage, where they put a valuation to stock, the valuation was totally false. A couple of years down the road it became clear that their valuation was just a guess, and it became a meaningless thing. I’ve been jaded a little bit in that regard to be more favorable towards convertible notes now, than actually trying to do a valuation, until you’re at some revenue stage and you can actually calculate numbers and hopefully do something.

Not Every Startup Succeeds: How to Manage an Orderly Shutdown

Sean: Let me ask one more question. Everybody talks about the upside and going public and all that, but I guess my question was part of what you’re doing also is preparing for some kind of orderly shutdown. I mean not everybody that starts a company is able to actually get to profitability or to get to scale. How often do you get involved more on the orderly shutdown or disorderly shutdowns?

Pete: The disorderly shutdowns tend to be ugly, and unfortunately I’ve had more of those than orderly shutdowns.

Sean: Probably more profitable for you too.

Pete: Well, actually no. They’re kind of more like a divorce. Everybody fights until there’s nothing left to fight over, and then you go to bankruptcy court. With a company it’s a little cleaner than that, because you don’t have kids and long-term alimony or anything. Pretty much the assets are split, whatever they are they are. The nice thing about a corporate structure is it allows for orderly and disorderly shutdowns. If you have a corporation that has failed in the market, and I don’t want to trivialize it, but if the only thing wrong is that you failed in the market when in other words you may have great technology, you just couldn’t market it, or you applied it to the wrong problem, or you have really good people, that’s when the corporate structure is actually favorable, because you can sell the corporation.

You can sell the assets of the corporation and get rid of it, if you end up in a situation where you have a lot of debt or there’s some unfunded liabilities or something like that. You can just sell the corporation outright to somebody who can put that technology to better use. You see this a lot in the intellectual property world, where people will buy a company simply because of the patents it has. That’s usually a large company past the bootstrapper stage. The company has failed, but they happen to own some dynamite technology. The company owns that and that will be, when it’s sold, whatever is left or whatever they generate from that will be divided among the shareholders per share.

That makes the shutdown a lot more orderly, because your only stake in the shutdown is your number of shares you actually own. It’s not a personal thing. The law requires us to get the maximum value for all the assets it has and pay off the debts and then divide it up among the shareholders. Hopefully if you’re functioning and you have some type of cash flow, you can negotiate your own sale to somebody that can do something better with it, maybe a competitor or something like that. Somebody who would see the value and be willing to pay a little bit more.

In Summary: Put Expectations With Co-founders in Plain English

Sean: This has been a very interesting exploration of the equity allocation and what the stock is good for at different points in the lifecycle of the company. Was there anything else, any final remarks you wanted to make before we wrapped up?

Pete: No. I think just the major caution that I started out with. Protect against wishful thinking. Whatever your co-founders are, be open and clear with them about expectations so that when you get to the point of maybe having to sell the company or having to bring in an investor or having to bring in another early stage employee, everyone’s clear we’re going to use equity and this is what it’s worth and this is how we’re going to split it up. Your battles between co-founders, they’re ugly battles and they impoverish everybody. You want to go in with everything clear, everything in writing, even employment agreements so that, knowing there’ll be bumps in the road, the process is as smooth as you can possibly make it.

Sean: When you say in writing, you’re also a fan just of plain English agreements. In other words, when you sit down with your co-founders just memorializing that or writing that down. It doesn’t have to be a formal legal document in legal language.

Pete: Absolutely not. I get in trouble. Lawyers hate it when I say this, but I’ll say it again. If you can’t get a written agreement, even an exchange of emails that’s a writing, legally, that shows what your expectations are is better than nothing at all. I think the famous quote is even the dullest ink shines brighter than the brightest memory. If you have to have a dispute that’s going to go to court, you need to show in writing that you had an … We know in the United States an oral agreement is binding, but you still have to prove you had an agreement. Have the meeting, talk about what’s important, and then follow it up with an email, and hopefully they’ll follow with an email so you have confirmation that you had a conversation going. Save that email. That can lay out the terms you agreed to.

Now, there may be terms you didn’t agree to that the court’s going to have to settle, but you want to at least have what you did agree to. If you don’t want to pay a lawyer, just write down. Take a piece of paper and write your agreement. If that’s a problem, hammer it out in email. Email it back and forth to each other so you know you each received it. That is better than nothing, and it gives us something to go on if there happens to be a dispute among co-founders.

Sean: Well, Pete, thanks again for your time today. This has been very educational.

Pete: My pleasure. Thank you Sean.

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Pete Tormey: How to Keep Harmony Among Founders