Featured First Steps Start Up Resources Tech News July 9, 2018 BY eric@ericlittlelaw.com

The First and Second Biggest Mistakes You Can Make

There is no good time to make a mistake.  Some of the worst mistakes you can make are with respect to ownership of your company.  Unfortunately, it is easiest to make these types of errors early on when they can damage or cripple your company forever.

It is important to share ownership in your company.  It takes more than one person to start a new company and grow it rapidly.  And the type of entity and commitment you will need requires that you have partners in this effort.  No one is smart enough to do it all, and even if you are, there are not enough hours in a week.

Most people know this instinctively.  So they find like-minded friends or acquaintances to join their effort and start promising them stock.  Trouble starts shortly thereafter.

Mistake #1.  So, lets assume that there are three of you and you promise to give the each of the other two co-founders 3 million shares each – a third of the company.  That sounds good to them, and in truth, it’s not a bad way to go. Equal shares among founders can minimize disputes later on.  But before you do the paperwork you focus on raising money, building the product and dealing with a thousand day-to-day decisions.  And in the natural order of events, there will be some skills that the three of you don’t have but which are desperately needed, so you bring in a fourth person and since you can’t pay them at this point, you promise them some stock. And maybe a fifth or a six person.

And now the math gets complicated.  Does employee number 4 get the 10% of the company you promised before or after the $1,00,000 you are in the process of raising?  He or she is thinking that it is after the investment.  But really, you were thinking 9 hundred thousand shares (on top of the 9 million shares held by the three founders).  You will be creating 1,00,000 shares (50 cents a share) to give your new investor and 2,000,000 for an option pool, for a total of 13 million shares and 10% of that is 1.3 million shares.  Close to a 50% difference, and that’s not counting the promises to employees # 5 & 6.  If you’re lucky, there are only bruised feelings for a week or two.  If you are unlucky, your new employee’s commitment to your company is permanently impaired and they never make the sort of contribution to it that you counted on.

That’s how mistake number 1 happens.  And the solution is to incorporate very early on, create an option plan, up front and be totally transparent.  So that everyone knows how many shares they have, how the total amount of stock is allocated, and how everyone’s interest will be diluted as the company grows.

Mistake # 2 is even worse and it can happen even earlier.

Let’s assume that the initial idea for the new product is yours, but it’s a little rough.  And after weeks of discussions with your co-founders, it sharpens up and starts to gleam.  Everybody’s thrilled.  It’s the next big thing. And each of you gets a third of the company because it’s a multi-million-dollar idea.

So you incorporate, you draw up an option plan, hire employees and avoid mistake number 1 in all its various forms. You raise some money from friends and family and you’re good to go – so you think.

Only 2 months later, right after you’ve leased space for your manufacturing facility, Bob, your chief operations officer, tells you his wife is pregnant and he can’t quit his $100,000 job with a secure company and you will need to find someone else. You grit your teeth, swallow hard and then pat him on the back, offer congratulations and immediately set out to find someone else.

An you’re in luck.  Two days later you have a replacement candidate.  He or she owns their own home.  Kids are through school, he has money in the bank and he is willing to take a flyer and work for half the salary he was making because he believes in your idea.  But it is risky, and he wants a significant chunk of stock.  He wants to be a co-founder.

But you don’t have any stock to give.  At least not in those amounts.  So, hat in hand, you go back to Bob and ask him for his stock back.  You’ll even pay him a little (not much, you only raised $500k).  But Bob won’t sell.  “That 3 million shares was for my contribution to the idea,” he says.

And there is mistake number 2.   The idea is not worth 3 million dollars, not $300,00.  Probably not even $30k.  It’s just an idea, lying there on the street, ready to get picked up by the next smart guy willing to work hard.  The idea and $3 won’t even buy you a cup of coffee.

Hard work is worth $300,000, maybe even $30,000,000. NEVER GIVE PEOPLE STOCK. EVERYONE – EVEN YOU – HAS TO EARN IT.  That’s the hard truth.

I’m fairly confident you think the pregnant wife is a fluke, and anyway all your cofounders are single.  Let me tell you, I’ve seen this same scenario play out time over time in different ways.  A good friend started a company with a partner who promptly came down with stage 4 throat cancer, another wasn’t willing to move to the Bay area where the company was located.  The list of things that can mess up people’s lives is endless and the more founders you have the more likely it is that something will happen to one of them.  Ever hear the expression “That’s life”?

This problem comes up so frequently that there is a solution.  Every founder (again, including you) absolutely, positively, has to enter into a repurchase agreement with the company.  At the outset, if something bad happens, the company can buy back 100 percent of their shares.  After a year it can buy back 75% of the founder’s shares, and a declining percentage on a regular basis after that.  This protects the company; moreover professional investors will insist on it.  But don’t wait for them to force a repurchase agreement on you.  If you wait, the buy back will be on their form, not yours.  Do it now, while you can assure that the terms of the buyback are at least somewhat founder friendly.

Resources:  I have a separate blog on how to incorporate, which can be found on the NC Tech Connection.  For some great advice on repurchase agreements and option plans, watch one or more of the following Youtube videos:

Kaufman School on Founder Agreements: (Founder’s Dilemmas – 3 & ½ minutes) Kaufman Founders School has some very good videos available.

Another Take: (Issues with Partners, Early Employees and Equity – 13 minutes)  I don’t agree everything this fellow has to say – in particular the notion that you can anticipate everything that might go wrong and plan for it.  He is worth watching however.

Wharton Business School: (Industry norms and practices for the Venture-Backed Startup – 1 hour 9 minutes)  I know Doug Collom personally and he is perhaps the most astute attorney with respect to start-ups that I know.  Unfortunately, he no longer practices.  It’s a long video but well worth it.