Without belabouring the issues, the following are common mistakes founders make with cofounders.
Equal split equity
Letting co-founders slide
Co-founders with a full time job or side hustles
Friends and relatives as co-founders
To prevent these issues, it’s important to first understand why they call a company a “legal entity“. Collins dictionary defines an entity as the following.
An entity is something that exists separately from other things and has a clear identity of its own.
In other words, you are creating a person. This person owns 100% of itself and its ownership is measured by shares. The value of the shares, or valuation depends on the work involved that can be directly tied to revenues.
With no revenues, we need to project the value of the shares based on two factors which can be used as a “pre-money valuation“.
Time spent on the work involved that can be directly tied to revenues
Money given as capital to the entity
Since we all know time is money, we can convert time to money by multiplying the work hourly rate. This is the rate you would pay if you hired someone to do it.
Money = rate * hours
If one of the works involved is to make a logo and the rate to make a logo is $100, then the value of that work is $100, even if the one working on it get’s normally paid $6,000 a month. This means the first step is to itemize all the work needed to generate revenue.
Case Study: T-shirt Store Stage 1
So to quickly understand how to itemize the work to revenue, let’s take the case of a t-shirt store. In this example, the work and the value of the work are assigned. All founders need to mutually agree to both the work and the value are correct before assigning. Doing it this way additionally describes an exact business direction step-by-step.
Create Logo/Branding - $100
Set up the E-commerce store - $300
Buy the Store theme - $100
Acquire the t-shirt supplier - $100
Acquire the t-shirt maker - $100
Design 20 t-shirts (1 week) - $300
Digitize product information - $50
Sell 200 shirts (5% commission) - $200
So if you’re really lean, you can simply add up the value per task to get $1,250. This can be treated as a pre-money valuation. If one person were to do all the tasks, then that person should get 100% of the company because it’s the same as that same person investing $1,250.
If a founder is expecting immediate compensation for their work, then they should not get equity. Founders need to choose either one.
So hypothetically we can split the work per founder like the following.
Create Logo/Branding - $100 - Founder A
Set up the E-commerce store - $300 - Founder B
Buy the Store theme - $100 - Founder B
Acquire the t-shirt supplier - $100 - Founder C
Acquire the t-shirt maker - $100 - Founder C
Design 20 t-shirts - $300 - Founder A
Digitize product information - $50 - Founder B
Sell 200 t-shirts - $200 - Founder C
Summarizing these founder contributions and determining their equity could look like the following.
Founder A - $400 / $1250 = 32%
Founder B - $450 / $1250 = 36%
Founder C - $400 / $1250 = 32%
This is fantastic because if a founder fails on their work, another founder can pick it up instead thus deserving of more equity in their favour. If Founder C needed immediate compensation of $200 and Founder A paid Founder C that amount then the equity split would change to the following.
Founder A - $600 / $1250 = 48%
Founder B - $450 / $1250 = 36%
Founder C - $200 / $1250 = 16%
Different Ways to Compensate
In an ideal scenario, all founders would be financially stable to perform the initial work. In most circumstances however, founders need immediate compensation in order to survive. There are 3 considerations to structure compensation.
Immediate compensation
Deferred compensation
Equity, or vested equity
Assuming that all the work has been successfully completed and 200 t-shirts were sold at $20 and the cost to make it was $5, then your net one margins are $3,000.
Your net two margins would be less the rent, electric, internet and water, but we won’t use this in this example.
This means that the founder split would look like the following considering if no one took immediate compensation.
Founder A - 32% * $3,000 = $960 from $400 invested
Founder B - 36% * $3,000 = $1,080 from $450 invested
Founder C - 32% * $3,000 = $960 from $400 invested
At this point the deferred compensation has matured, and founders could exercise any of the following options.
Keep it all in the company to keep their equity
Get the deferred compensation with a bonus
In a real life scenario, it is not in the best interest of the entity to compensate founders with their entire share of the profit. They need it to grow or suffer repeating this stage all over again.
Deferred compensation for Founder C would look like $400 plus 20% or $480. The 20% is an incentive rewarded to the founder for accepting compensation to be deferred. Oppositely, it is a way for the other founders to absorb the equity of Founder C. Any founder could accepted the deferred compensation or the equity awarded, but not both.
The 20% bonus is a variable you can set or change on your own, but make sure overall it’s less than the value of the Founder’s shares.
Salary + Equity Stage 2
In this stage, it is assumed the entity does not need anymore seed capital because it’s getting revenues. Usually founders going full time would need to compensated regularly as well for the time they put in daily. Unlike regular employees, founders should consider only the compensation needed in order to survive because their personal profit is tied to the success of the company overall. This doesn’t mean they need to forgo their industry value, as founders could have different rates depending on their needs and expertise.
Consider a technical founder that has proven to receive $6,000 a month from regular employment and his personal costs are $4,000. In this case, the company could set up the $2,000 as an advance back to the company each month. That liability against the company has the following features.
To be paid (plus bonus) before a capital gains call like dividends or an external investment
A financial shield for that founder during a capital call up to the amount that is already owed to them
To be used as an instrument to buy shares in order to maintain their equity up to the amount that is already owed to them
Dividends are profits paid to shareholders. A capital call is when the company requires money to be infused in order to survive.
In this model it is right to favour the founder working day-to-day on the venture vs the ones that are not. It is important that there is a board resolution for each founder’s compensation package. When thinking about starting off with co-founders, here are some key points to consider.
Protect the entity, even from yourself by setting up contracts and board resolutions for each founder
No one should work for free, in fact they should be compensated fairly
Watch out for founders multi profiting (through salary, commissions, bonuses, advances, and equity)
Remove emotions by staying fair and factual
Here’s an example directors agreement
A great video to watch: