Co-Founder Equity Mistakes to Avoid | Startup School

Co-Founder Equity Splits and Breakups

Introduction to Co-Founder Equity

• Michael Cybal introduces the topic of co-founder equity splits and breakups, specifically targeting tech software startups expecting VC funding.

• The discussion focuses on early-stage companies, particularly those pre-product market fit, emphasizing that advice may not apply to other business types.

Core Advice on Equity Splits

• The key takeaway is to be generous with co-founder equity to motivate the founding team during challenging initial years.

• Both "Jedi founders" and "dumb founders" are noted for being generous with equity; however, mid-level thinkers complicate calculations based on contributions and skills.

Motivating Founders Through Equity

• Founders often fail to consider how equity distribution affects long-term motivation; resentment can arise if one founder feels undercompensated compared to others.

• It’s advised that close-to-equal equity splits are beneficial for maintaining motivation among co-founders over time.

Vesting and Cliffs Explained

• Equity typically vests over four years with a one-year cliff, meaning founders earn their shares gradually and must stay for at least a year to receive any equity.

• Vesting and cliffs protect the company from potential issues when a founder leaves unexpectedly due to personal circumstances or performance issues.

Essential Co-Founder Roles

• A founding team should consist of only essential members who can build an MVP (Minimum Viable Product); unnecessary titles can dilute accountability.

• Generosity in equity helps identify non-essential co-founders who might be better suited as employees rather than founders.

Accountability in Leadership

• Most work remains incomplete when distributing co-founder equity; thus, it serves more as motivation for future efforts rather than rewards for past contributions.

Guidelines for Co-Founder Breakups

Key Considerations When a Co-Founder Leaves

• Y Combinator (YC) provides guidelines for co-founder breakups, especially when pre-product market fit is involved. It's crucial to discuss these considerations among co-founders.

• If a co-founder leaves or is fired before their one-year cliff, they typically receive a token amount of equity (2% to 5%). This reflects the uncertainty of the company's success at this stage.

• The recommendation is that if a founder departs, they should retain no more than 5% equity. This encourages motivation among remaining team members and ensures that those who can contribute to the company's growth are rewarded.

• A departing founder's retained equity can diminish the chances of company success; thus, it's essential to redistribute equity to active contributors.

• Founders leaving or being fired should resign from the board and sign releases, allowing remaining founders proxy voting rights. This maintains control within the founding team.

Handling Severance and Board Resignation

• It’s reasonable for a fired founder to receive severance pay (1 to 3 months), but it’s less common for voluntarily departing founders.

• New CEOs must manage departures carefully, ensuring all parties understand expectations regarding equity distribution and board roles during transitions.

Common Misconceptions About Equity Splits

Reasons Behind Unequal Equity Distribution

• A frequent misconception is that unequal splits are acceptable if agreed upon by co-founders. However, this often leads to future dissatisfaction as circumstances change over time.

• Founders should focus on long-term motivation rather than short-term agreements. Ensuring equitable compensation helps maintain morale during challenging times in the startup journey.

• Claiming more equity because one had an idea overlooks that execution is critical; both founders must be equally committed to bringing ideas to fruition.

Evaluating Contributions Over Time

• Starting work earlier than co-founders does not justify significantly higher equity since most work remains ahead in traditional tech startups—often spanning years of effort.

• Salary needs should not dictate equity distribution; salary covers living expenses while equity incentivizes hard work and commitment from all founding members.

Experience vs. Contribution: Finding Balance

Assessing Experience in Equity Decisions

• While experience can enhance fundraising efforts and strategic decisions, it shouldn't automatically lead to disproportionate equity unless it directly correlates with essential contributions needed for success.

• Each founder's role must be evaluated based on their ability to drive value rather than solely on past experiences or initial funding rounds which do not guarantee future success.

Understanding Founder Equity and Long-Term Thinking

The Importance of Long-Term Vision

• Founders must recognize that generating significant revenue, such as a billion dollars, requires extensive work beyond initial investments.

• Successful founders think about the future and consider their co-founders' needs, fostering a collaborative environment essential for success.

• Equity should be viewed as a motivational tool rather than something to hoard; it can drive hard work among team members.

Common Misconceptions About Equity Distribution

• Performance-based equity is often misguided; setting precise goals early in a startup's journey is challenging due to evolving circumstances.

• Startups should focus on product innovation and customer interaction instead of complicating equity distribution with performance metrics.

• Part-time founders are generally not considered true founders; full-time commitment is crucial for building viable companies.

Dynamic Equity Agreements and Their Pitfalls

• Unclear dynamic equity agreements can demotivate team members; clarity in ownership fosters motivation and commitment.

• Vesting schedules with cliffs provide necessary protection against underperforming co-founders, ensuring fairness in equity distribution.

The Role of Co-founders in Startup Success

• If a founder relationship isn't working out, it's vital to address it before vesting cliffs come into play to maintain team integrity.

• Founders must have the resolve to make tough decisions regarding co-founder performance; lack of this resolve indicates unpreparedness for startup challenges.

Valuing Early Contributions Over Time

• Successful companies often see one founder remaining long-term, but early contributions from all co-founders are critical for initial momentum.