Richard Hendricks' first mistake

Being a founder is hard, and with so many things going on, it's easy to forget or procrastinate on some basic legal protections. That's where we come in. In this series, we'll be highlighting some common mistakes and issues that can arise when starting a business, through the lens of Silicon Valley.

In the very first episode of season 1, Minimum Viable Product [1.01], we see Richard Hendricks make his first founder mistake - moving into a "hacker house" and giving up 10% of his company to the (questionably helpful) Erlich to do so. While Erlich's character is over-the-top, nerdy, and lovable, he's probably not the ideal early-stage advisor/mentor/investor that you want to be giving away 10% of your company to.

Richard: I have a meeting with Gavin Belson. He wants to talk about Pied Piper.

Erlich: I own 10% of Pied Piper.

Richard: You said it was a shitty idea.

Erlich: It was a shitty idea. I'm not sure what it is now.

To avoid becoming Richard Hendricks, read the rest of this guide - The 5 steps to dividing equity among Founders, Investors, Directors, Advisors, and Employees are featured below - and for more specific info and to arrange your free consultation with a startup legal pro, just click "Ask About This" on any section.

Introduction

One of the first tough decisions facing startup founders is how to allocate equity among the founders, investors, directors, advisors, and employees.

There are a few decisions that, contrary to your first instinct, often prevent otherwise good ideas from developing into full fledged companies:

• Splitting equity equally among all co-founders. While founding a company with your friends seems like a wonderful idea, the reality is that every co-founder will bring a specific set of skills to the table. Some of those skills are more valuable than others. Before granting equity, have an open conversation with all your co-founders about roles, responsibilities and commensurate compensation.
• The “idea person” gets 90% of the equity. In Silicon Valley, the idea is a very small part of the overall success of a business. Successful Silicon Valley startups are all about one thing - execution. Don't make the mistake of granting a disproportionately large amount of equity to a co-founder who will not be involved in the business on a daily basis.

The 5 steps to dividing equity among Founders, Investors, Directors, Advisors, and Employees are featured below.

Step 1 - Dividing equity within the organization

The first step is perhaps the most important - you must divide the total amount of equity (100%) into three groups:

• Founder Group
• Investor Group
• Option Pool Group (for directors, advisors, and employees)

The standard amount of equity allocated to each of these groups (as followed by Advent International, Madison Dearborn Partners LLC, and Austin Ventures) is shown in the chart below. Treat these as guidelines and a starting point for discussion. The percentages in column 2 represent a typical equity breakdown for a company looking to raise a round of funding prior to Series A financing. Column 3 represents a typical equity breakdown of a company post-Series A financing.

Step 2 - Dividing equity among Founders

Founders ideally receive equity based on what assets and skills they bring to the table. The role of a founding team is to increase the likelihood of successfully turning an idea or insight into a viable, sustainable reality. Founders can contribute in many ways - some bring patents or insights from years of research, some bring technical abilities and business experience, and some bring network connections.

L. Frank Demmler, professor at the Tepper School of Business at Carnegie Mellon University, came up with The Founders’ Pie Calculator - a way to divide equity among founders that is both logical and fair.

The idea is simple - a founder’s value add is divided into 5 categories: Idea, Business Plan Preparation, Domain Expertise, Commitment and Risk, and Responsibilities. Based off of your particular business model - each category is given a value on a scale of 0-to-10. This value is then multiplied by the founder’s score to come up with a weighted score.

Here’s an example:

Absolute Scores (0 - 10)

Weighted Scores (0 - 10)

Let’s assume that your company reserves 55% of the equity for founders, 30% for investors, and 15% for the option pool - this means that each of your founders will have own the following percentage of the company’s equity:

• Founder 1: 29.93%
• Founder 2: 25.07%

Step 3 - Allocating money to Investors

The basic formula is simple: if your company needs to raise $100,000, and investors believe the company is worth $2 million, you will have to give the investors 5% of the company. The remainder of the investor category of equity can be reserved for future investors.

For companies with high growth potential, a common approach adopted by many Silicon Valley and more sophisticated early-stage investors is to defer valuation through a convertible debt instrument, often called a "convertible note". Your company might raise $100,000 as a loan from investors, without specifying a valuation, on the basis that the investor receives $100,000 worth of shares at a future valuation placed on the company as part of a future investment round. Convertible note holders generally receive a bonus of 10-30% of the amount invested as reward for the additional risk taken. This bonus is referred to as "the discount", because convertible note holders because the 10 - 30% bonus represents a discount on the investment compared to future investors.

Step 4 - Dividing the Option Pool: Board of Directors, Advisors, and Employees

In our example, we've reserved 15% of the total equity for the option pool. This means that all of the equity you allot for directors, advisors, and employees must come out of this 15%.

Board of Directors

Each of your Directors on the Board of Directors can expect to receive 0.5% - 2%.

Advisors

Advisors typically receive 0.1% to 0.5%.

Employees

The goal of giving out equity to employees is to incentivize early employees to have a long-term, invested stake in the company. This often creates a company atmosphere in which each employee feels ownership over the idea, product, and long-term success of the organization.

Your first key hires (think the first 2 - 5 employees) will likely expect to be granted some points of equity (ex: 1%, 2%, 5%).

Step 5 - Create a Vesting Schedule

Every grant of equity should be put on a “vesting schedule.”

What is a vesting schedule?

A vesting schedule generally dictates when a person can exercise their stock options. Vesting schedules are typically time-based. For example, you might have heard fellow founders saying they’re on a “4 year vesting schedule with a 1 year cliff.” This essentially means that the founder gets no equity grant until their 1 year working anniversary. On that day, they’ve hit their 1-year cliff and have full ownership of 25% of their equity rights. For the next 3 years - their remaining equity grant will typically vest either monthly or quarterly.

Why use a vesting schedule?

A vesting schedule which includes a one-year cliff protects the company from granting equity to employees who leave the company in the course of their first year. Vesting over a four year period allows the company to benefit from four years of an employee's commitment in exchange for the full equity grant

What are some of the new trends in vesting schedules and stock grants?

Silicon Valley tech startups started the trend of routinely granting stock options to employees, many of whom became multi-millionaires in their own right. California's employee-friendly legislation also means companies generally cannot prevent employees from leaving or being poached by competitors, except through offering better incentives and a stake in building something more impactful. Many employers are therefore putting in place "Evergreen" stock option plans, additional stock grants that normally kick in around the 2.5 year mark, to avoid the situation where employees are no longer vesting any equity after four years (or however long the vesting schedule was set for).

Pure performance based stock option grants are also an option some founders are considering as part of a carefully planned series of risk-mitigation steps. If you can find the Hooli rock star who'll make a working compression algorithm for your startup (in his free time, of course), maybe that is worth a few percentage points ... if the algorithm works!