Startup founders

4 Important Decisions for Startup Founders to Get Right From the Start

Startup founders face countless decisions and tasks every day. Fortunately, there aren’t too many early legal decisions that can have lasting, irreversible implications for founders down the road. However, your equity arrangement with co-founders and the company’s early cap table is one thing that should be carefully considered from a legal standpoint to avoid massive headaches later. Whether you plan to take on investment or exit the business in the future, below are tips to navigate common startup equity mistakes.

Following these four critical steps from day one can help avoid equity ownership disputes and red flags for investors in the future.

1. Be thoughtful about the founder equity split.

Many founders assume that an equal equity split is the easiest way to allocate equity and avoid conflict. This is not typically the best answer. Instead, founders should sit down together prior to formation of their business and have frank conversations about their expected contributions and the resulting equity. The parties should be sure to communicate the expected contributions of each founder upfront, such as their experience, expertise, network, time commitment, personal investment, and more.

Founders must ensure that the equity split aligns with and reflects each party’s relative contribution. For future fundraising, investors will appreciate seeing a thoughtful equity arrangement that accurately reflects each party’s contributions. This also showcases the founders’ experience and signals their ability to handle tough conversations and decisions.

2. Establish a clear, conventional vesting schedule (and forfeiture). 

A few years ago, I spoke at a university MBA class where a student raised his hand and explained that he had formed his company several years earlier with two friends during their freshman year of college. Within six months, those two friends left the business. The student continued to run the business himself over the next few years and eventually got an offer for several million dollars to sell the company. In class, the student asked whether he needed to pay out his co-founders. Unfortunately, because the absent co-founders didn’t have stock subject to vesting and forfeiture, the absent co-founders kept their equity even after leaving the company.

Founders should establish a vesting schedule detailing how much equity is earned within a specific timeframe and under certain conditions, such as continued involvement in the company and/or reaching specific milestones. This should also delineate forfeiture guidelines that provide that unvested equity is forfeited when individuals leave the company. The vesting schedule should align with the company’s long-term strategic goals and should be relatively conventional to look attractive to future investors and acquirers. Whether you settle on a time-based, performance-based, or milestone-based vesting arrangement, it’s important that the vesting instruments and employment contracts are clear.

It’s also beneficial for companies to work with experienced corporate counsel to ensure that their equity incentive plans comply with applicable rules and regulations.

3. Protect founder equity and control. 

When raising outside money, it is important for founders to ensure that they are comfortable with how the company will be managed post-investment. Giving up equity means giving up some influence and control over business decisions. Consider whether founders want to maintain majority ownership of the company. Be wary of early dilution of equity and giving up management rights and decision-making authority. Many savvy companies will choose to raise only what’s needed until the next financing so as to maintain maximum control.

In short, be sure to balance the long-term interests and growth objectives of the founders, employees, and investors. Understand that the investment terms and ownership and management decisions made today help lay the groundwork for all future investment.

4. Choose the right investors for the business. 

Look for investors that understand and align with founders’ strategic business decisions and long-term objectives. While investors will be looking to protect their investment and maximize returns, partnering with the right investors can bring expertise, contacts, and connections that founders don’t have.

Following these tips and working with experienced corporate counsel to navigate your equity arrangement will help keep your cap table clean, help founders maintain equity and control, and make your business more attractive to employees and investors.

John Gaddis is a corporate partner at KO Law Firm, a results-driven corporate and commercial law firm with a team of experienced lawyers and a practical, efficient, business-focused approach. Founded in 2003 on the philosophy that a different approach delivers better value, our business-first legal and industry expertise helps established brands and emerging companies achieve meaningful business outcomes. KO is headquartered in Denver and Boulder, Colo., and serves the software and SaaS, retail and manufacturing, professional services, energy, food, beverage and consumer goods, eCommerce and internet, healthcare and life sciences industries. Reach John at [email protected].

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