In our 10 Things to Be Clear About Before You Start, we suggested that you decide whether to build a team of partners or fly solo. If you have decided to build a team of partners, even a small team of two, you'll need to also decide how this partnership will work. Your only currency will be equity in a company that has not been formed and a venture/Web service that is no more than a gleam in the eye.
Create a Small, Balanced Team
Here is the advice of Naval Ravikant, serial entrepreneur and angel investor. His advice is directed at other angel investors, but that is a good context in which to look at this as an entrepreneur:
- "Invest in teams of two to three founders. Five is unstable, one is too hard.
- The best combination is one founder who can sell and one founder who can build.
- The team matters more in enterprise deals, traction matters more in consumer deals"
There is a reason why people talk about "putting the band together" and "rock stars" in this context. Solo artists can do great (think Bob Dylan), and when they get some success, they can bring in session musicians (contractors). But the history of pop music is more about the great combos: Lennon and McCartney, Simon and Garfunkel, Jagger and Richards. Those bands may have had four people in them, and the other two members in each may have been talented and driven, but it was clear who the stars were.
One Leader Might Emerge
But business is different from music. A great band like the Rolling Stones ends up becoming a corporation, but the skill-sets are different. Typically in a business, one founder emerges as the leader and CEO. Think Bill Gates rather than Paul Allen.
There are instances of two partners staying together and really building a big business together. Hewlett and Packard are great examples of this. But this is unusual because it does not fit the need of a company to have a CEO/leader who is recognized as such by employees, customers, and investors.
This is why drawing up some kind of buy/sell agreement is a good idea. You don't even need a lawyer. Download the terms from the Internet. As long as the terms are mutual, nobody will get screwed. The buy/sell agreement simply acknowledges the fact that people change: their needs and motivations change. You might be the one who wants to get out of the partnership and move on. Or you might be the one who buys your partner out. Either should be possible.
But don't get too hung up on the buy/sell agreement. Plenty of founding partners cross that bridge when they get to it. It is a bit messier doing it that way, but something can usually be worked out.
Dividing Up Something that Does Not Exist
We'll cover the basics of creating a legal entity in a later chapter. Most ventures start without being incorporated. You may have heard legendary stories of founders getting a check from an angel first and then having to set up a company and create a bank account.
If the founding team is of two people, it's pretty simple. If you have three or more, you will need to define the founders' agreement one way or another. Here are four options:
- Purely verbal. "We're all buddies and understand each other, right?"
- Each of you hires a lawyer and lets them hammer away at each other on your nickel. Hm, now where's that nickel?
- Document what you have verbally agreed on via email exchanges, and the next time you're all together, print it out and sign it.
- Download a legal template, put in the terms you have agreed on, and sign it, possibly after getting one hour of legal advice from a buddy at law school.
Somewhere between three and four partners is recommended. Even buddies can misunderstand each other. When there is nothing to fight over, there are no fights. But when it looks like the venture might take off, greed sometimes kicks in, and one founder develops a case of "selective amnesia" regarding something that was verbally agreed on. Even an email record prevents that danger.
The reason to be careful about the legal agreement between the founders is that it helps with the next stage of your startup: bringing in external investors.
Get Your Due Diligence Ducks in a Row
The earliest-stage investor will be looking at just the team and the website. That's it. If your site sucks, sorry. If one of you has a criminal record, whoops. In other words, due diligence (the step after the term sheet and before the contract and cash in bank) is simple.
There is one show-stopper you want to avoid. Anybody who has worked on the website or helped with the venture in any way should sign something that acknowledges the venture's Intellectual Property (IP). If someone comes out of the woodwork and says, "They stole that from me," most investors will be scared off.
You can and should do this even before you form a legal entity. You simply want what in the old days was called a "paper trail," and is now an "email trail," which records what was agreed on. This trail could include:
- The two to three founders saying that each of them owns X amount of Newco (your to-be-established company) and assigning all of their IP related to this venture to Newco.
- A buddy who writes some super code just because they're a friend confirms that they have no financial expectation and assigns all of their IP related to this venture to Newco.
- Somebody who provides a service in return for equity and assigns all of their IP related to this venture to Newco.
Paying with Equity
You may not be able to pay in cash for the things you need done. So, you could agree to pay in equity. Don't do this as a percentage. Use a formula along these lines:
- What cash rate would this person normally charge? Check that this is normal for the market.
- Agree to pay twice that amount in equity. The doubling is to cover the risk that they never see anything.
- Convert the cash into equity at the valuation of the first round.
Don't treat this person or vendor like an investor or partner. They are not. They do not know how to evaluate the venture, so don't waste your time trying. They are a vendor whose payment is being deferred. KISS.
Note: a long-term adviser is a special case that we'll deal with in the next chapter.
This comes down to the actual term sheet with the first investor(s), which is covered in a later chapter. But this item is worth considering at the beginning. When somebody invests in a founding team, they invest in the work that the team will do in future. So they want to invest your founding shares over time.
You can haggle about vesting some founding shares from the start if you have already built a lot and gotten some traction. But this is really "at the margin." Don't obsess over it.
You also need this protection with your partners. Say you have a team of three founding partners, each with 33% of founders' stock. You don't want one of them to leave just after funding comes from another venture, or to go off to play music, or whatever. All three of you need that same protection. Build your own partner vesting schedule, typically four years, and present this to the investor(s). They will appreciate that you have thought this through and that your interests are aligned.