Once the entrepreneur has an idea for a business opportunity, the next step is to find the members of your team and create an entity such as a corporation. In today’s economy, everyone is eager to jump on the bandwagon of a new enterprise. But many start-ups begin to stumble because of lack of transparency of what each team member gets in terms of equity from the start-up at the “get go”, from the titles being dispensed, and what roles and responsibilities have been allocated. I strongly urge any start-up that it should be the first task a start-up team should finalize way before drafting the business plan.
I had a former colleague, a graduate from a top ten business school, contact me out of the blue, whom I had not heard from for over year, with an urgent call that he and his “partner” were about to close on a blank check funding of $150 million through a private equity fund. The corporate entity was located in Delaware. A hedge fund representing itself as the investment bank was situated in Connecticut. And the law firm’s principal office, handling the private placement, was located in Miami. Both his “partner” and he had been traveling for this informal road show throughout the U.S., Europe and Asia for over a year. My first question was whether he had formalized his business relationship with his partner, given the extensive investment of time and capital. He stated in the negative. Just to confirm what he said, I requested all the Powerpoints and any drafted materials both he and his partner demonstrated to all of the potential investors. True enough his name was placed near or next to his so-called “partner”.
Now he sent me the PPM because the Miami firm required his signature on several documents to close the deal. After reviewing the materials, I asked him what he wanted from this investment opportunity. He told me that expected 50% ownership of the entity. After reviewing the documents, I immediately told him that the documents show that he is on the board of a couple of holding companies, but in no way was there any document indicating that he owned any equity, was entitled to any type of options or bonds, or even had an employment contract to draw salary during the lifespan of the investment. And even with the nomination as a board member, he was not entitled to a honorarium. Meantime, the final closing by the investors was expected in six calendar days.
I also told him that all investors are skittish by nature. If he were to delay the closing or even hint that there already was an internal conflict between him and his so-called partner, these investors would walk away. His investment of time and money for raising this capital will be nullified. Potential investors look for any reason why not to make a deal with any start-up or deal. Any evidence of conflicts or ill-will between members of a management team is enough to discourage any investor from moving forward.
My former colleague’s mistake was rather simple (and prevalent among many start-ups) – not defining the economic relationship in writing between himself and his partner in a document or email somewhere. Now, during a trial, a lawyer could win for my colleague since considerable case law supports the thesis that the implied relationship was 50-50, but that approach might only satisfy a trial lawyer’s coffers However the investors would walk away anyway, and he and his partner will be arguing over an empty bank account. That is not the right way to begin the new enterprise. This matter should have been resolved from the very beginning.
The lesson to be learned here is to define the relationships economically and managerially as soon as possible, before any substantive work has begun. The compensation model among the initial members of the management team should be outlined.
Now you will notice I did not use the word, “founder”. The term “founder” is nowhere in any statute or regulations within the State of Delaware’s corporate law. Standard corporate bylaws describe CEOs, Chairman of the Board, VP, treasurers, corporate secretary, or president. And yet, I receive many business cards stating “founder”, “co-founder”. Law firms even espouse the term, “founders’ equity”. I am personally bothered by the term “founder” because it raises so many questions in my mind and becomes the fodder for unnecessary disputes among founding members of a new company.
No start-up company can be successful without an effective “team”. The use of the term, “founder”, suggests that it was a single person’s original idea, that he labored countless hours in drafting the complex business plan, or that this person is the “visionary.” I am already suspicious seeing that title on someone’s business card.
I have met too many “founders” whom I would never allow to bring me a cup of coffee. Some of these “founders” would never have had successful companies without their management team. And I have met too many founders who had no management skills to speak of. Even I have worked with others where I should have had the title “co-founder”, but I never raised this issue since my economic relationship had been defined.
What I think is important and should be the first task of any start-up company is to define each person’s roles and responsibilities (generally through the corporate bylaws), establish a written document of how equity will be distributed and executed (verbal promises are not enough!), possible employment agreements, and a short, comprehensive shareholder agreement in the event things do go sour. Standard management titles are sufficient. The term “founder” is not a corporate title and is not needed.
And even though there are no specific rules on how to distribute equity, the initial equity distribution for the initial management team should be done in such a way as to expect additional equity to be dispensed to outside investors and for later members of the management team. Every member of the initial team should be aware of the dilution of ownership after outside investors enter into the picture. There are some guidelines for allocating equity for incentive programs. Most importantly, do not procrastinate in putting this material together formally by executing the paperwork. It is always on my first to do list on any start-up after what happened to my former colleague.