Winter 2004

The Art of Allocating Founder's Equity (1)

John H. Chu    
Introduction. I often analogize the co-founding of an enterprise to a marriage. It shares many of the same key elements, including a common purpose, shared culture and commitment, and some degree of permanence to the relationship. And, like marriage, conflicts can arise over the so-called "marital assets" if things do not work out in the relationship, even when the separation is otherwise amicable. For this reason, whenever there is more than one founder, one of my first tasks is to help the company work through an allocation of "founder's shares" and in that connection to raise the possibility of preparing what I characterize as something akin to a prenuptial arrangement. While there is always the possibility of disputes arising down the road among the founding group, in my experience a properly designed arrangement at the start can substantially help reduce the potential for conflict. But before I proceed to describe the nature of arrangement, allow me to provide some further context with examples of problem situations derived from real life cases.

• Mr. Knowitall and Mr. Big, equal partners in an investment banking firm, set up Webco, an internet company, dividing the founders' shares 51/49. Just a few years later, Big enters politics, never having worked for Webco. Knowitall, on the other hand, spends all of his working hours getting the company successfully off the ground and funded. But due to successive sales of shares to investors, Knowitall's ownership has been substantially diluted. Foreseeing the need for further funding rounds ahead, Knowitall worries that he will own only a small fraction of the company by the time it is sold or goes public.
  
• Ultraimaging Company is a start-up medical imaging device company based on patented technology developed by two medical doctors, Dr. No and Dr. Zhivago. At a meeting at Logan Airport both doctors agree to assign the patents to the company in exchange for equal shares of the founding equity. Months later, No drags his feet over assigning his interest in the patents. Forceful arguments from patent counsel cause him to relent. However, No's relations with the company are now frosty and he is generally uncooperative, leading the company to seek company counsel's advice on how to dilute his position.
  
• Ms. Tech and Ms. Biz co-found BizTech Corp. Well over a year later, they manage, finally, to agree on an equity split between the two. Neither is full-time. Biz, who is a certified public accountant, initially does a good job taking care of administrative and financial matters. However, she becomes involved in another venture and begins to neglect her duties at BizTech. Eventually, BizTech fires Biz. Tech retains counsel to consider ways to reduce Biz's equity position.
  
• Dr. Jekyll and Professor Hyde co-found Innovateco based on Jekyll's ideas. They agree to share the equity 50/50. Hyde runs the company full-time while Jekyll continues to teach at Ivy University. Two years later Innovateco is profitable. Everyone is pleased except Hyde, who has worked for no pay during the whole period. He demands some of Jekyll's equity, threatening litigation if Jekyll does not accede to his demands.

Common Parameters. These situations reflect the following common parameters:

• There is no scientific formula for allocating founders' shares.
  
• There is potential unfairness if one or more of the founders decides to change careers, get a "real" job or relocate, while the remaining partners continue to toil long and hard for the company.
  
• Once issued, founders' stock can be difficult to get back or reallocate due to emotional, legal and tax reasons. I can only recall rare occasions where a founder voluntarily relinquished his/her shares. In addition, diluting a shareholder can raise legal exposure as a "freeze out."
  
• As a founder, your ownership position will almost always inevitably go south from your starting ownership percentage as investor rounds and employee options serve to dilute your stake.
  
• At the same time, there is the old saw: namely, a smaller piece of a bigger pie is preferable to a bigger piece of a smaller pie. For this reason, if your partner has the potential to be instrumental in creating value and growth it can be in your own interest to motivate and reward him/her with a substantial or bigger share of equity.

To help address these parameters, the proper allocation of founders' equity should begin with an objective and frank assessment by the founders of their past and anticipated future contributions to the business, both individually and on a relative basis. Past contributions might include technology, property and so-called "sweat equity" in the form of time spent helping to create the company. Future contributions are almost always going to be in the form of services, i.e., employment or consulting.

The Vesting Solution. Beyond an up front assessment of each founder's relative contributions, however, I often suggest placing those shares that are intended to reward future contributions on what is called a vesting schedule. Returning to my notion of a prenuptial arrangement, this consists of a written agreement that would be entered into at the founding of the enterprise. Under this agreement each founder would earn all or at least typically a substantial portion of his or her founder's shares based on continued service to the company (employment or consulting) over a preset duration. It is usually structured to provide that if and when a founder is no longer working for the company the company would have the right to repurchase the then unvested portion at a nominal cost. The percentage that can come back to the company usually declines over time - typically over a four-year schedule, with variations as to whether these shares would "vest" annually, monthly or even daily over the four-year period. On occasion, vesting accelerates on the achievement of specified milestones, such as on a FDA approval, product commercialization or a sale or initial public offering.

This type of arrangement quite simply ties each founder's ultimate equity position to the length of his or her future service to the new enterprise. In the examples provided above, a vesting agreement would have automatically adjusted the ownership of the founder whose contributions unexpectedly ceased, for good reasons or bad, reducing the potential for conflict and unfairness in the ownership scheme.

Allocation Matrix. I have set out below a suggested matrix that can be adapted for use in determining how many shares to allocate to each founder and which shares should be fully vested and which ones not.

To help illustrate the use of this matrix, I have assumed the hypothetical set forth below:

• Cofounder I developed the platform technology, which she will assign to the company. She is expected to be the CEO although if the company receives venture funding, a professional CEO will probably be brought in at that time.
  
• Cofounder II will be head of marketing and sales and helped write much of the business plan.
  
• Cofounder III's contributions to date have been principally related to the preparation of the company's projections. She will be the CFO and COO. Her efforts are expected to increase over time as the company begins to staff up and begin its operations.

Shares granted for "Past Contributions" would be fully vested. The company would have no right to those shares under any circumstances. Shares granted for "Future Contributions" would normally be placed on a standard vesting schedule, allowing these shares to be earned based on anticipated future service to the company.

Conclusion. The allocation of founders' shares is one of the most important and fundamental decisions to be made by a new enterprise. Because the future course of the enterprise and each founder's role is always impossible to predict, it can be important to work with counsel at the founding stage to implement an appropriate vesting arrangement - one that is designed to recognize past contributions while fully rewarding those founders whose abilities and efforts over time create substantial additional value in the enterprise. While this type of arrangement does not guarantee a smooth road, it can often help to painlessly reduce the size of otherwise severe bumps, enabling the enterprise to focus on other critical issues at hand.

Footnotes:
[1] As published in the Women Entrepreneurs in Science and Technology (WEST) newsletter, Issue No. 27, November 25, 2004.