If you want to raise money from VC’s, here’s a really tough, really important question you ought to ask yourself very early in the process: “How many co-founders should I have?” Having the wrong “answer” to this question can make your life difficult in some subtle (and odd) ways. Plus, unlike some miscalculations, here the wrong answer hurts only the founders, not the VC or later employees. Here’s how to look for the right answer.
Although entrepreneurs are motivated by things in addition
to money, money’s important to everyone I’ve ever met trying to start a
company. Monetary rewards in a startup,
as everyone knows, ultimately derive from ownership of stock (not salaries or
bonuses). Since there can never be more
than 100% of the founders’ stock available for allocation, every co-founder should
focus on ensuring that the allocation best matches the realistic, expected contributions
of each founder to the success of the Company.
In Silicon Valley (assume it’s the same in other startup regions), “founders” have a bunch of iconic attributes, some good, some bad.
Although we don’t, we should have a statue dedicated to “The Startup Founder” prominently displayed somewhere in Silicon Valley. Founders are passionate about their businesses, and will run through brick walls to make them succeed. In large part, Silicon Valley’s success is attributable to this passion and “never-say-die” attitude.
That’s the good part.
Founders are also “expensive” in terms of equity (usually,
and sometimes even rightfully, to reward them for taking the risk in joining a
startup). Founders are harder than
normal employees to transition out of the Company (not legally, just
emotionally: “How can we fire Joe? He’s
a founder.) Just like most people
(including VC’s), founders usually have skills and experiences that are
narrower than they, themselves, believe (even sincerely). And finally, founders don’t always pick their
co-founders with a beady, cold-eyed, highly calculating gaze with a
tough-minded focus on who can actually make the biggest contribution to the
Company. Often, co-founders are picked
because they are friends, or like-minded, or “great people, the kind you’d pick
if you were in a foxhole under fire”.
That’s the bad part.
Let me illustrate the problem with a hypothetical (though
not uncommon) four-person startup.
Four friends decide to start a new company. After some jockeying (since they’re “peers” at their current company), they finally settle on the following titles, roles and percentages of the equity: (1) President and CEO (35%), (2) VP Marketing (25%), (3) VP Engineering (25%) and (4) VP Finance/CFO (15%).
To them, it seems logical to have these four (eventually)
important business functions covered by the founding team. Moreover, these responsibilities roughly
match their (perceived) skills and experiences, although none of them has ever
had a title higher than Director, and none has ever had general management experience
(i.e., responsibility for a complete P&L).
They work hard on their business plan and actually come up
with a very interesting idea.
Having studied the “Ten Commandments for Entrepreneurs” at www.allensblog.typepad.com and mastered its lessons (sorry, had to do it), off they go to Sand Hill Road.
Because the idea’s interesting, they quickly arrange several
first meetings at top-tier VC firms, but receive no call-backs. They know that the odds of getting VC
financing are low, but can’t figure out why they are having no success at all. Without exception, their first meetings have
been energetic and enthusiastic – and no one has pointed out any blind spots in
their planning or preparation.
As it turns out, the VC’s actually liked their idea a
lot. The VC’s also actually liked two of
the four founders (marketing and engineering) a lot, although no VC they met
believed that either of them was ready for a “real” VP role. Unfortunately, when asked, the marketing
founder and the engineering founder were defensive about deserving “their
chance to step up to the VP level”. That
paled, however, in comparison to the defensiveness of the CEO when questioned
about his future role in the Company. Finally,
the CFO couldn’t really describe what kinds of CFO-like duties he would perform
for the first two years. Every duty he
did describe could be done by a competent, high-level office manager.
Spotted the problem….?
Actually, there are several: (1) the CEO and CFO, who owned 50% of the founders’ stock, were not
appropriate for their roles, (2) neither of the “continuing” founders was
really ready for a VP role (and was defensive about the issue) and, though less
importantly, (3) no startup needs a VP Finance/CFO.
From the VC’s perspective, this is a deeply “broken”
situation, despite the interesting business idea. And since the “broken-ness” involves founders
(with all the iconic complexity that entails), “fixing” the situation involves
some really hard work and tough decisions. Given the tensions (and lurid myths) that surround VC’s replacing
founders, any VC with decent deal flow will simply move on to some other
interesting startup that doesn’t have these problems.
What’s the big deal?
First, it is extremely difficult to transition a founder out
of “their” company. Moreover, as hard as
it is for the Board of Directors to make such a transition, it’s virtually
impossible for the other, continuing co-founders to do it. After all, they were friends and “peers” who
took a huge risk together, as well as a blood oath: “All for One and One for
Second, even if it can be done, it’s usually “expensive” in
terms of founders’ equity. Frequently,
all founders have some form of accelerated vesting (or full vesting) of their
founder’s stock if they leave the Company otherwise than by voluntary
resignation. In our example, if some VC
had loved the business idea enough to undertake the tough job of reorganizing the
founding team, the departing founders would have taken as much as 50% of the
founders’ stock with them.
It’s important to note that it is NOT the VC or angel
investor who gets screwed here – it IS the continuing co-founders. How so? Think about it for a second…
When considering an investment, any investor, whether
VC, angel or otherwise, will place a pre-money valuation on the Company when
they offer to invest. That’s what they
think the Company’s worth, regardless of who owns the founders’ stock (a slight
oversimplification). If a good chunk of
the founders’ equity is in the hands of co-founders no longer with the Company (and
therefore who won’t contribute to its success), it doesn’t alter the investors valuation
calculation. So, the continuing founders
will end up with substantially less equity than they “deserve” – but not
because the VC’s were unfair.
In fact, it can actually be worse than this for the
continuing founders. If enough stock has
left the Company in the hands of the departed co-founders (in our hypothetical,
up to 50%), an investor may simply decide that there isn’t enough equity left
to properly motivate the continuing founders (calculating what additional stock
must be reserved for future hires). In
this case, the top-tier VC simply moves on to an equally interesting, but less
What would have been a better strategy for this startup? Like everything else important in life, it
In my next post, I’m going to suggest some things
for entrepreneurs to consider as they put their founding teams together. Hopefully, they'll help.
Hopefully, they'll help.
In the meantime, however, before you prick your fingers and take the startup company blood oath, do the tough part and carefully evaluate who is on the founding team – you owe it to each other.