Defining a business agreement in the early stage is leaner than you might think

You have a decent business idea, made your homework, found a partner willing to start up and got out of the building. Several weeks of customer and product development have passed and you learned quite some lessons on your way. Feedback was quite positive and you feel like you are on to something potentially big. You believe in the team so far, but you don’t have any kind of formal agreement to work together yet. Furthermore, you still have your job and can’t work full time on the business idea. Your feel like you need to decide soon: “all in”, team pivot or fold because your wife said “Are you really sure this is going to be a viable business? I am not sure whether this is the right idea to pursue now. Why do you not start with a small side business first.”.

I have been there. This is the situation where I would recommend to start with a formal business agreement in order to build a working basis for the core team and facilitate the decision process. Sooner or later the distribution of equity will become a topic in your team. Many teams – especially unexperienced ones – think that the easiest and fairest solution is to just give everybody an equal number of shares. Based on many talks with experienced teams and additional research, this is typically not a good idea. This might get clearer once you had a look at the following aspects:

Arguments for not sharing equally

  • Nothing is exactly equal
  • “Skin in the game” is a situational measure
  • Risk perception differs from person to person and situatuion to situation
  • Avoiding the “early trouble” does not help in the end

Consider the following factors to come up with a reasonable and as objective as possible apportion:

Factors

  • Pre-existing IP and effort – Rule: the more up-front, the higher the stake
  • Opportunity cost – Rule: fair market value vs. actual compensation for all founders (larger sacrifice in terms of cash compensation raises equity stake)
  • Focus of the company – Rule: tech vs. sales & marketing
  • Contribution – Rule: cash investment (can be treated separately from the equity allocation (founder = investor)), time (keeping day job, contributing only x% of time, etc.), network
  • Qualification – Rule: skills & experience

Once you have thought about the factors listed above, additionally consider the following watchouts:

Watchouts

  • Issue shares (e.g. 100) and write a cheque to the company as a matter of record
  • Shareholder agreement:
    • Vesting plan for early quits (4 years, 25%) – repurchase of company or other stakeholders
    • Cliff vesting versus graded vesting – some preferences towards a model like this: 25% one year cliff vesting with 6.25% quarterly vesting thereafter combined with individual goals/milestones
    • Common shares
  • Company valuation calculation:
    • Average web startup with three founders: $285k – according to Y Combinator model (for more info, see sources at the end of the article)

You think this is heavy stuff? It is. The discussion about the agreement with your team will most likely be even harder. Emotions come up, misunderstandings get disclosed and commitments waver. However, starting this process early on and getting clarity on where you are and want to be with the team and can save you a lot of time and trouble in the future. Much more time than you might think you waste when racking your brain over the content of this agreement rather than coding or selling. Take the time and energy required to think about and discuss the difficult topic of who gets how much equity and why as well as when they should get it. As every startup is more or less unique, the equity structure and incentive plan should reflect this uniqueness. 

Furthermore, you should also think about and document other topics that are important to you and your team in the agreement on your way towards a potentially viable business. E.g. cultural aspects and decision making rules, etc.

In the next post, I will briefly discuss a possible structure for a business agreement that reflects the issues mentioned above.

Sources

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