Compensation · Equity

What's the best way to fairly compensate an ex-cofounder who funded most of the startup expenses for several months?

Anonymous

Last updated on April 5th, 2017

Advance apologies for a long post. I omitted/simplified all non-essential details of my situation, but it still ended up to be pretty long. I'd greatly appreciate any thoughts on this. As someone else here has said, I know I should eventually involve a lawyer, but I'm bootstrapping and funds are tight.


Several months ago my long-time friend & workmate (I'll call him "John") and I had quit our extremely frustrating jobs and incorporated our new company "Co.", not quite knowing what exactly we are going to work on, but knowing that we like to work together and want to build something cool. We incorporated in Delaware, and both he and I were appointed as the initial Directors of our new company. We verbally agreed on 50-50 ownership structure, opened a joint business bank & credit card account and started exploring ideas on what to build and how to generate short term revenue. In our years-long relationship, more often than not I've been the "ideas man", and so this time most of the ideas we were considering also came from me, and the product idea that we've decided to pursue in the end was my brainchild, extremely aligned with my larger passion and interests. John was excited about it from the business POV, but, looking back, I don't think he heart was fully in it. Nevertheless, we plunged ahead with it and started spending some money (beyond the incorporation fees). John was the CEO/finance guy and I was the CTO/product owner/visionary.


It's important to note that at this point, as far as the company setup was concerned, all we had were the Delaware incorporation docs and the shared bank/credit card accounts. We haven't issued the founders stock, signed any IP/technology assignment docs, none of it. John was working on post-incorporation steps and it was taking him a while (the lawyers were slow and he was also dealing with some personal drama going on at the same time).


Meanwhile, we did rent a tiny office, bought some modest furniture, and were also paying for lawyers, internet, and some SaaS software. We funded these expenses with John's personal stash. Neither of us were getting paid any salary, but I had a family and John didn't, and he persuaded me (and I didn't resist much) that this arrangement will allow us for longer pre-revenue runway. In hindsight, I shouldn't have agreed to it, as it was creating an imbalance in our relationship, but I was too busy researching, validating and building the prototype. I was also putting in 14-hour workdays, and John was not nearly as engaged and spent a lot of his time on his personal issues, so even after I realized that things were getting out of balance money-wise, I kind of felt that the imbalance on the time commitment side was compensating the imbalance on the money side.


The last bit of context before I get to the actual question: once we agreed on the product idea, we realized it needs a name on its own, so we registered a domain name for the product ("Prod.") in addition to the domain name for the company ("Co.").


The above unveiled in a time frame of about 3 months. Predictably, John and I eventually had a disagreement that led us to rethink our partnership, and we decided that we both want to go our separate ways. The split was peaceful. We still consider ourselves to be good friends. John wanted to keep the original company ("Co.") & related domains, which I was fine with. I decided to go ahead on my own, and am in the process of incorporating a new company, named after the product that I conceived ("Prod."). John is fully on board with releasing all the IP rights he might hold (if any) to the idea in exchange for a "fair" compensation. The "only" question is, what would a fair compensation in this case.


As I mentioned, John was the finance guy, and I was foolish enough to not double check our total spending. He is still collecting the actual bills and will present me with details this weekend, but he estimates that between the rent, the lawyers, the furniture, the internet, etc. we have spent somewhere around 20K. We also have obviously both spent time working on our joint venture before parting ways, although I was mostly working on the product and he was mostly doing admin stuff.


John's preference is to be compensated with equity. He is asking for 10% of my new company ("Prod."), but has said that he will go with "whatever I decide". I very much want to compensate him fairly, but I feel that giving him straight equity is a wrong way to do it.


I don't want a "dead weight" founder entry in my cap table, and I don't want risking raising tax/valuation issues by making it "equity for money" kind of deal. My preference would be to do a convertible/"safe" note with a discount and a valuation cap. John dislikes this option, feeling that, with a relatively small size of his investment, the note route will discount the disproportionate risk he took by being the very first investor.


To me, the cleanest way to do it would be to pay him back fully with cash in exchange for his release of the IP rights. Then, if he wants to re-invest (some part) of that money into my new company, I'd be delighted, but I'd do it through a convertible/"safe" note.


Am I off-base here? Missing anything critical? Any ideas/feedback would be highly appreciated, and I'll be happy to answer any additional questions anyone might have for more context.


Thank you in advance!

Mike Moyer

Last updated on April 6th, 2017

THANK YOU FOR THIS QUESTION!!!


You have experience a CLASSIC founder's problem that beautifully demonstrates the crippling flaws in old-fashioned, fixed, equal equity splits. You will get other answers to this question referencing vesting agreements and other solutions. ALL of the other answers will simply set you up for the same problem you have now. The problem is that you can't predict the future. You couldn't several months ago and you can't do it now. So, like many founders before you, you have to compromise and renegotiate your deal. If you continue applying conventional thinking you will be back in the same position in the near future.


The good news is that there is a solution. It's called the "Slicing Pie" model and it is a formula for solving this exact problem. It will tell you exactly what to do.


Slicing Pie not only tells you how to allocate equity, but also tells you how to recover equity in the event someone leaves. Both parts of the model apply to your situation.


Think of your startup as a game of blackjack. You agree to go in 50/50. You and your partner each bet $1 on the same hand. You have no idea if you're going to win or how much you're going to win. All you can know is what you bet.


The dealer deals: two aces. Nice.


You split the aces and decide to double down. Your partner is broke, but you are not so you put down $2 more and cover the bets. So, you've bet $3 and he's bet $1...does 50/50 sound fair? Nope. It should be clear that, if you win, you deserve 75% and he deserves 25%. You still have no idea if you're going to win or how much you'll win. All that you know are the bets on the table. This is a logical, obvious, unambiguous result and it's totally fair.


Your share of the equity should be based on your share of the bets. Same for your partner and future partners.


Any other way you split it will be unfair. Remember, you had a 50/50 deal in place. But, just because you agreed to it doesn't mean it's fair. As you have learned, things change--things always change. Things will continue to change and the betting isn't over, it will continue until the game ends and you bust or get paid.


Startups are the same thing. You and your partner both placed bets on the future profits or proceeds of a company sale. You bet ideas, time, money, relationships, facilities and other things like supplies and equipment. The value of the bets is equal to the fair market value of the inputs. For instance, if you and your partner have fair market salaries of $100,000 and you each worked full time for "several months" you each "bet" about $20,000 in unpaid salary. You put in 14-hour days so when you break it down hourly ($50 per hour) you may have bet more like $30,000 in unpaid salary. Your partner also bet $20,000 in cash.


In Slicing Pie, bets are represented by a fictional unit called a "slice". You get 2 slices for dollar in non-cash contributions (like time) and 4 slices for every dollar in cash contributions. This normalizes the inputs to accommodate things like interest rates and taxes.


At this point in time, based on what you explained, you have $30,000 x 2 or 60,000 slices. He has ($20,000 x 2) + ($20,000 x 4) or 120,000 slices. This puts him at 66% and you at around 34%. If you sold the company for $1 million today, he would get $660,000 and you would get $340,000. A fair split given the value of your bets.


But the company is not selling. You still have a long way to go. Your partner is quitting. This is where the recovery framework applies. People leave companies for a number of reasons. Sometimes the company causes the separation and sometimes the employee causes the separation. Slicing Pie protects both parties.


In Slicing Pie, if a person decides to quit and leave the company in the lurch they would lose slices for non-cash contributions and the normalizers would be removed from cash contributions. So, your partner would be left with 20,000 slices giving you 75% and him 25%.


However, you were not using Slicing Pie since the beginning so, in reality, he would actually keep his slices at the current level of 120,000 slices


But, you will continue to work. A year from now, if you continue to work at your current pace, you will have 200,000 - 250,000 slices and have a larger share. You may choose to add other partners or investors which would simply grow the number of slices. His number of slices would stay the same so his percent share would shrink in an entirely appropriate, fair way.


No matter what happens, Slicing Pie always maintains a fair equity split.


In a Delaware C Corp you would simply issue a fixed number of restricted shares and use Slicing Pie to vest the shares upon termination which is triggered at breakeven or Series A.


This is an iron-clad, guaranteed way to fix your problem. The model is used all over the world and continues to grow in popularity. You can learn all the details at SlicingPie.com





Anonymous

April 11th, 2017

Thanks for repeating that point, Mike, I didn't get it the first time, but I think I did now. Does your offer of privately sending the book to people on this forum still stand?

Steve Procter Tech entrepreneur seeks cybersecurity startup team

April 7th, 2017

oh this is all so familar, it is scary and sad that we keep seeing the same mistakes ... but it is great that sites like this one now exist. So before anybody dives into their first startup, spend a week reading every scare story like this on here!


I built my first internet startup in 1999 and within a few months took on 3 cofounders and gave them 25% each. A simple even split without even blinking was a BIG mistake. When we sold we all did ok so there are no complaints, although trying to agree on whether we should sell was a nightmare with 4 evenly split shareholders. And the years of never being able to agree anything, votes were always evenly split ... it was like pulling teeth to get anything decided. And one of the other guys does very slightly resent to this day that he personally took a bigger risk than the other two but they got the same shares.


so @MikeMoyer, a real shame your idea and book were still only a twinkle in your eye back then ;-) ... really needed it! Please keep getting word out about it!! People dont need to follow your model down to the last tee. But everybody who wants to build a startup must understand the general concepts and know that there are ways to get round most issues by "thinking smart" about ownership.


And i would call for more historic scare stories from people on here. The more that budding entrepreneurs can see how not to do it, and

learn how others overcame similar startup issues, then the more chance they will not make the same mistakes we all did.


Mike Moyer

April 7th, 2017

The alternate framework you linked to will set you up for the same problem again. You are seeking the wrong thing. You are looking for numbers. The future, no matter how you predict it, is always unknowable. Pinning equity splits to anything except the facts will steer you in the wrong direction.


Slicing Pie gives you a way to discern the right answer in the face of uncertainties.

Anonymous

Last updated on April 6th, 2017

Thank you for your reply, Mike! You are absolutely right, I wish I had the wisdom to research this more thoroughly when we were starting out. I definitely won't do a 50-50 split again, and going forward I'm adopting a formal system similar to what you describe (personally, I feel like some of the points in http://blog.gust.com/cofounder-equity-split-framework-objectively-divide-equity/ hit closer to home for me than the Slicing Pie model).