Post Category → Equity

Splitting Founder Equity: Avoid “Grunt Funds”

TL;DR Nutshell: If you plan on building a scalable, VC-backed company, you need to learn (early on) to have hard conversations. Fact. Your first hard conversation may involve figuring out the equity split among founders. A few people (who are good at SEO) are pushing a concept called “Grunt Funds” in which founder equity, instead of being negotiated and set from the beginning, continues to change month-by-month according to some overly complex formula.  I’ve never seen it work well in the context of high-growth tech startups. Have the hard conversation. If you can’t figure out how to split founder equity, good luck building a company. 

Negotiating the “equity split” among a pair or group of founders is an extremely important part of a startup’s formation process, and there is a lot of good web content available providing guidance on how to get it done. Below is a list of a few articles worth reading. I don’t necessarily endorse all of what they say, but it’s your job as CEO/Founder to read, make your own judgments, and act on them. Advisor Whiplash is part of the job.

Another piece of relevant reading on how to document founder splits: SHL: How Founders (Should) Break Up

The point of this post is to make one thing clear: if you are building the type of startup that will raise angel and VC money, stay away from “Grunt Funds” or anything that attempts to create a variable, constantly changing founder equity split. 

Figure Out the Numbers. Don’t Hide Behind Formulas. 

I’m not going to link to any articles promoting the “grunt fund” concept to avoid giving it any more air time on Google than it already has. The origin is a book called “Slicing the Pie.” Basically, instead of figuring out founder equity %s like a normal company, “grunt fund” founders set up a formula with half a dozen metrics that are measured on a monthly basis to gauge “performance,” “contribution,” whatever, and founder equity is accumulated over time based on those metrics. It is tedious, ends up costing more in legal fees in the long-run, and in my experience never survives scrutiny from investors. It has, every time I’ve encountered it (thankfully, a significant minority of cases) ended up being a waste of founder time and money.

Good Founder Docs Are Already Flexible

The core driver behind the desire for an always-changing equity split among founders can be boiled down to one question: “what if things change?” What if one person turns out to be a dud, and another unexpectedly a rockstar? What if someone’s personal life causes them to leave? What if the business changes and a particular founder’s skills are no longer valuable?  These are absolutely valid questions, and they require that founder equity have built in mechanisms to allow equity to be readjusted if needed.

Thankfully, there already is such a flexible mechanism in well-known, standard startup formation documents: it’s called a vesting schedule. If one person is no longer valuable to the startup, then they can leave, forfeiting their unvested equity. Or if they refuse to leave, they can be fired, also giving up their unvested equity.  Or if one person knows they’ve turned out to be more valuable than the % they got, they can force a hard discussion, with a credible threat to walk. If they are in fact as valuable as they think they are, the other founder(s) will change their %.

Is this set-up totally flexible? No, it’s not meant to be. Is it as egalitarian as a grunt fund? Maybe not, but nobody said successful startups are democracies. Brilliance is rarely built by committee. See Mark Suster on “The Importance of Benevolent Dictators.” Founder in-fighting probably ruins at least as many companies as flawed business fundamentals.

Smart Founders Figure it Out.

In my experience, successful startups are generally built either by a single founder or by founders who, more or less, know their place in the hierarchy. They have a common vision, often have strong, trusting relationships (friendships), and have a pretty good feel for whose skills really are more valuable to the startup than others. The CEO is the CEO, and the other founders know exactly why he/she is CEO. They have the tough conversations early-on, and if circumstances warrant a change from the original split, they figure it out. Ultimately, a solid founder group cares far more about building a successful company than about burning time in nonsensical formulas every month trying to see whose % went up.

I’ve seen all kinds of equity splits: 50/50 (generally a bad idea, but not always), 60/40, 33/33/33, 51/49, 80/20, all kinds of iterations. The “right” split is highly circumstantial. But in the end, the founders figure out the numbers, paper them with solid docs, and move on.

Does this mean “grunt funds” don’t work for anyone? No, I didn’t say that.  I work with the segment of the startup space that goes after scale and (usually) large amounts of outside investment needed to reach that scale. Founders jumping on that train know from the beginning that they are in for a very bumpy ride, and that anything short of complete trust and unity of vision among the team will result in a train-wreck. I’m sure GFs work in some contexts, just not in high-growth tech startups.

Have the hard conversation, avoid tedious formulas, and then get to work.  

Early Hires: Options or Stock?

Nutshell:  While the conventional equity path of a startup is to issue (i) common stock to founders and (ii) options to employees, early hires concerned about taxes will often insist on receiving stock as well. Voting power, along with other political factors, present a few tradeoffs for founders to consider in that scenario.

Vocabulary:

  • “Option Pool” – a portion of the company’s capitalization set aside (after founder stock is issued) for equity issuances to employees, consultants, advisors, etc., and subject to a special “plan” designed to comply with complex tax rules.  Even though it’s referred to as an “option” pool, properly designed equity plans will allow for direct stock issuances under the pool as well; not just options.
  • “ISO“ – Incentive Stock Option – a tax-favored type of option issuable only to employees, if certain requirements are met. The main benefit is that upon exercise, the difference between the exercise price and the fair market value on the stock at the time of exercise is not taxed as ordinary income. However, it is subject to the Alternative Minimum Tax (AMT), which can hit certain people depending on their tax situation.
  • “Restricted Stock” – For purposes of a private startup, just another way of saying Common Stock. The same security that founders get, except for non-founder employees it’s usually issued from the “pool” (under the Plan) using different form documents.
  • “Early Exercise Options” – Conventional options issued to employees are not exercisable until they vest; meaning until the recipient has worked long enough to “earn” the right to exercise them.  Early exercise options have modified vesting/exercise provisions so that they can be exercised from Day 1 – with the underlying shares becoming subject to the vesting schedule.  From the Company’s perspective, early exercise options are very similar to restricted stock issuances. The only real difference is that the recipient has the option to exercise and receive the Stock on Day 1, or sit on it and exercise later.

Convention.

The conventional path of a Company’s equity issuances goes something like this:

  • Founders receive direct issuances of Common Stock (not options)
  • Non-Founder employees receive ISOs (options)
  • Consultants, advisors, etc. receive NSOs (options)
  • Investors receive Preferred Stock, or SAFEs/Convertible Notes that convert into Preferred Stock

Backround:  

  •  The value of restricted stock is taxable as ordinary income on the date of issuance, unless its fair market value (FMV) is paid in cash.
  • Options, both ISOs and NSOs, however, are generally not taxable on the date of grant, as long as their exercise price is equal to the FMV.
  • So, you would normally expect employees to prefer receiving options over stock. No tax > Tax. And this is the case when the stock’s FMV is relatively high. That’s why later hires (usually after a Series A) almost always receive options, without question.
  • Stock gets to vote on stockholder approvals. Options do not (until they’re exercised for stock).

The Issues: Early employees want to minimize tax. Companies want to avoid giving away voting rights/complicating stockholder votes too early.

  • However, in the very early days of a startup’s life, avoiding tax on restricted stock is easy because of how low the FMV of the stock is (fractions of a penny): write a check for a few dollars (the full FMV), or just pay the tax on the few dollars of ordinary income.  You therefore get the “no tax on grant” benefit of options, without worrying about paying tax later on an exercise date.  Receiving stock also gets the clock running on long-term capital gains treatment.
  • Therefore, very early hires, when they do their homework, tend to insist on receiving restricted stock (or early exercise options) over conventional options. Better to deal with tax when the stock is worth (at least to the IRS) virtually nothing, instead of years later upon exercising the option when the tax bill could be much greater (ordinary income for NSOs, or AMT (for some people) for ISOs).
    • Sidenote: Conventional equity plans also have a 90-day post-termination exercise period, meaning, when an employees leaves a company (voluntarily or involuntarily) they have to exercise their options within 90 days, or they then get terminated – even if vested. Paying the exercise price isn’t an issue for an early hire in that scenario, because it’s very low (the fractions of a penny FMV), but if the AMT comes into play it can hit them with a tax bill.  This doesn’t come up in a Restricted Stock scenario.
  • The tradeoff from the Company’s perspective is that, just like founders, those hires that receive restricted stock will have full voting rights (including seeing whatever is submitted for stockholder votes) for all of their stock on Day 1, before they’ve vested in anything.  When only one or two people are in question, this may not be a big deal. It can be a way of making early employees feel like a part of the core team, because their equity is being treated just like founders.  When there are more than a handful of hires, however, it can get unwieldy fast. The number of people to consult for stockholder votes can go from 2-3 to 10, 15, 20. If there are consultants and advisors in the picture, they may start to ask why they aren’t getting the same tax benefits as early hires. And then at some point you have to draw a line and start granting options. Is the first optionee not as special as the restricted stock people? Politics. 

Generally speaking, the decision to give restricted stock v. options to very early hires is a practical/political one.  While the tax-favored nature of ISOs means that most early employees won’t see much of a tax difference between receiving ISOs v. restricted stock, the prospect of an AMT hit in the ISO scenario does make restricted stock, on net, better for recipients.  That needs to be balanced, on the company’s side, against the early voting power/information rights given away when an employee receives stock instead of options, and how it will play out with all of the company’s other hires.  

My general advice to founders is to be aware of the tradeoffs, and to consciously treat the early voting power and tax benefits associated with restricted stock as currency not to be wasted.  If there’s a very early superstar that you deliberately want to single out as a key player, use the currency.  If not, then make the decision based on all the other factors. Company culture will likely factor greatly into the calculus.  Many, many founders prefer to avoid the politics/complications and simply draw a line at the founder (stock)/non-founder (option) division.  Others are more selective. There’s no magic formula.

A few separate issues worth addressing:

  • The 90-day post-termination exercise period (after which unexercised options, vested or not, are terminated) often gets criticized as being unfair to employees, and there’s some justification for that criticism. The view is that the employee shouldn’t be forced to “use it or lose it” if they did their time (their option vested) and are now moving on to a new company.
    • The actual 90-day number comes from tax rules requiring that ISOs be exercisable only within 90 days of termination.  If an option is exercisable after that, it automatically becomes an NSO for tax purposes. But there’s nothing in the tax rules requiring that the option be terminated at 90 days. That’s largely meant (i) as a deterrent (frankly) to people quitting, and (ii) a way to clean up the cap table for people who didn’t want to pay their exercise price, allowing that portion of the pool to then be re-used for new hires.
    • While the 90-day period is still convention, key executives/hires will often either negotiate for an extended exercise period for their own grants, or the Company will as a gesture of good will, decide on its own to selectively extend the period when someone leaves on good terms.

Obligatory Disclaimer: This post contains a lot of fundamentals and generalizations on tax rules, but it’s obviously not intended to be an exhaustive statement of those rules. Circumstances vary, and you should absolutely not rely on this post without consulting your own attorney and/or tax advisors.  If you do, don’t blame me when it blows up in your face.  You’ve been warned.

How Founders Lose Control Of Their Startups, Apart from Ownership

Summary: There are many ways, apart from ownership %, that founders slowly lose control of their companies. Some of the more obvious ones get spelled out in term sheets, but professional players in startup ecosystems know how to use more subtle mechanisms to erode founder control.

Seasoned founders and startup lawyers know that there are really two things that matter most in negotiating a term sheet: economics and control.  In other words, from the perspective of a founder, (1) what % of the Company will I own after the deal closes (and, more specifically, what % of exit proceeds do I get), and (2) whose permission is needed to make key decisions? Of the “control” terms, there are explicit ones, like protective provisions,  that competent founders know to focus on.  But there are more subtle aspects, like the composition of the Company’s advisors, and even who the Company’s lawyers are, that when ignored can significantly erode the ability of founders to maintain influence over their companies; particularly in high-stakes situations when there’s significant internal disagreement.

As I’ve written before, being an entrepreneur raising capital means learning to give up control. That’s a given. However, I’m very much a believer in transparency and having your eyes wide open. By educating yourself, you ensure you give up control at the appropriate time, and with fair terms; instead of with subtle power plays that slowly hand control to other people without you even noticing it.

The More Obvious Forms of Control

  • Voting Thresholds and Protective Covenants – These are typically spelled out in stockholder agreements and organizational documents. There are 1,000 ways to draft them, but they basically boil down to: you can’t do X without getting approval from stockholders holding Y% of the Company’s overall capitalization, or a specific % of various classes of stock.
  • The Board of Directors – Who is on the Board, and who has the ability to elect/remove people on the Board? The Board is the core governing body of the Company, which means nothing serious happens without their approval. In a 5-person board, whether founders (common stockholders) elect 3 directors or 2 dramatically alters the power dynamics of a startup.

The Often Overlooked, But Important Control Mechanisms

While voting power and board composition are definitely the most important issues, I always advise founders that maintaining control/influence over the companies they started is much more nuanced than what gets spelled out in a term sheet.

How “Independent” is Your Independent Director?

It’s very common for VC-backed boards to have an “independent” director – usually an industry expert that gets elected by both the common stock (founders) and preferred stock (investors).  However, it’s also fairly common for VCs to suggest that the “independent” director come from their own network of executives.  In judging whether their VCs recommended “independent” is the right person, founders should absolutely include the loyalty of that director to the VCs in the calculus.  He’s in their network, and knows that keeping them happy will mean more influential board appointments in the future. If a founder CEO is well-informed and connected in her startup’s own market, she likely has her own ideas for more independent directors. Put them on the table for discussion.

Board Observers – Who is at the Board Meeting?

Investors often will ask, in addition to a Board seat, for one or two board “observer” positions; meaning, at a high-level, non-voting people who can nevertheless attend board meetings and (usually) engage in discussion with the board. The presence of board observers matters and absolutely will influence discussion on board-level issues, even if they ultimately can’t vote. Don’t hand them out without understanding how they alter a founder’s influence at meetings.

Whom do your lawyers work for?

I’ve touched on this issue before here: Don’t Use Your Lead Investor’s Lawyers. There are hundreds of scenarios in which, in the middle of high-stakes decisions and disagreement among decision-makers on the right (or legal) course of action, founders will turn (protected by attorney-client privilege) to company counsel for advice – what’s legal?, what are the consequences?, what are my options?, what’s “market?” etc. etc..  Many times the “right” decision for the Company is one that won’t sit well, and even piss off, certain groups on the cap table.  You don’t want lawyers who work for those people.

“Don’t just go with the lawyer that the VCs insist upon. These lawyers will work with the VC on a hundred financings and with you on only one. Where do you think their loyalties lie? Get your own lawyer, and don’t budge.“ – Naval Ravikant, Lawyers or Insurance Salesman?

Despite arguments from certain investors and lawyers who claim that the above is a non-issue (you can imagine why), most founders immediately recognize the problem when this reality is described to them.

Where do your advisors and executives come from?

The theme of “pay attention to loyalties” carries on into a Company’s advisors and outside executive hires.  Where did they come from? Who got them this job, or their last job? Are they all part of the same investor group or business network? The conversations they have with you (the founders) will not be the only ones they’ll be having. Pay attention. Careers are long, much longer than the life of a single startup.  Advisors and executives, even those with strong ethics, pay attention to who can get them their next position when their current one exits.

Nutshell: Voting control matters, but it isn’t everything. Loyalties, particularly long-term loyalties, drive human behavior. Don’t be lazy and let every influencer (director, executive, lawyer, advisor) in your company come from the network of a single investor group. Smart ecosystem players know that’s one of the best ways to gain influence over a company without putting anything on paper. Leverage peoples’ contacts, and of course contacts will overlap, but make sure you ultimately have real diversity of perspectives to turn to.  Otherwise, when it really matters, a dozen back-end conversations will end up with really only one voice whispering in your ear.  

It’s precisely when the stakes are highest that a founder needs brutal honesty from advisors and counselors. And nothing ensures honesty like transparency and true independence of viewpoints. Make sure you don’t lose it.