The Very First Mistake Most Startup Founders Make

This article is based on a study of the equity splits adopted by over 3,700 founders from over 1,300 startups in the U.S. and Canada. This shown that even the best of ideas can falter when the founding team neglects to carefully consider early decisions about the team: the relationships, roles, and rewards that will make the founders a winning team.

It is said that a team has succeeded at splitting the equity if all of the cofounders are equally unhappy. Unfortunately, founder unhappiness tends to get even worse with hindsight; the percentage of founders who say they are unhappy with their equity split increases by 2.5x as their startups mature. Increasing discontent within the founding team is a prime indicator that destructive turnover may be on the horizon. Exhibit A: Facebook. As memorialized in the movie The Social Network, Mark Zuckerberg’s initial equity split with Eduardo Saverin went sour as the company evolved. Mark’s attempt to reclaim Eduardo’s equity landed him in court—maybe good for winning Academy Awards, but not good for business, let alone personal relationships.

When and How to Split Founder Equity

Different teams have different ways of splitting the equity: some do it up-front, others wait to get to know each other; some go through a careful negotiation process, others are quick to shake hands and get on with it. Most important, some divide the equity equally amongst all founders, others come to the conclusion that the fair outcome is actually an uneven split that reflects differences among founders.

Robin Chase, cofounder of Zipcar, a car-sharing company, had heard a horror story from a friend about how the negotiation over founder equity had derailed the friend’s startup. Eager to avoid that outcome, Robin proposed to her cofounder a 50/50 split at their very first meeting, just as they were getting to know each other professionally. The cofounders quickly shook hands and accepted the equal split. Robin breathed a sigh of relief, they had avoided the high tensions that often accompany an equity-split negotiation.

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At Smartix, Inc., which created a smart-ticketing system for sports venues, the founders adopted a very different model for splitting the equity. The founding team believed that “it’s best to delay [the equity split] because things are still unknown and changing.” When they finally split the equity, they took a very deliberate approach, fearing the effects that might emerge if any founder felt that the equity-split process was unfair. In their dialogue, the team delved into each founder’s past contributions, outside opportunities, preferences, and anticipated future contributions. They decided to split the equity unequally, with the founder-CEO receiving more than twice the stake of the cofounder with the lowest stake.

When founders are splitting the equity early in their company’s life, they face the heights of uncertainty — about their business strategy and business model, about their eventual roles within the team, about whether each founder will be fully committed to the startup, and about many more unknowns that will become clearer as they get to know each other. Things are even more uncertain for cofounders who have never worked together. Bypassing a serious dialogue about what each of the founders wants or deserves might be easier in the short-term, but is unlikely to be the right thing for the long-term health of the company.

Dive In or Take Time to Discover?

Robin Chase of Zipcar soon became very disillusioned with her “quick handshake” decision. She had never worked with her cofounder before, and had made some bold assumptions about how well they would work together, whose skills would be most valuable, and what the level of commitment would be. She threw herself into building the startup, crafting its business plan, and going parking lot to parking lot, looking for those precious parking spots that her company so desperately needed. Her cofounder? She didn’t even quit her day job, and contributed from the sidelines, at best. Robin soon came to realize the perils of that quick handshake. Her rushed negotiation had compromised her team’s longer-term effectiveness by causing her “a huge amount of angst over the next year and a half.”

Research sheds light on what Robin learned the hard way. We look at the amount of time founding teams spend discussing their equity splits, and find statistically significant differences between teams who split quickly – neglecting to have a serious dialogue about personal uncertainties and expected contributions – and those who have a lengthier and more robust dialogue. Robin rushed through that discussion, forfeiting the chance to discover what made her cofounder tick, whether her cofounder was enjoying her existing job, whether she was even willing to join Zipcar full time, and so on. In our data we find that those teams that negotiate longer are more likely to decide on an unequal split: the harder you look, the more likely you are to discover important differences. More generally, we argue that if cofounders haven’t learned something surprising about each other from their dialogue, they probably haven’t engaged in a serious enough discussion yet.

The Perils of Family

Data also indicate that splitting founder equity well between family members is particularly challenging. Cofounders who are relatives usually believe that they already know each other intimately and therefore don’t have much to discover about each other. However, we often act very differently at home than we do at the office, and also very differently under the extreme stresses that accompany startup life. If you’ve never cofounded together, it’s likely that you will be surprised by how your relative acts as a cofounder, often in negative ways. In short, relatives bypass detailed founder discussions at their peril, yet they are statistically more likely to do so.

Equity splits are a microcosm that beautifully reflect this. In our analyses, we find that founding teams that include relatives spent significantly less time negotiating equity splits. They were also much more likely to split the equity equally. Indeed, our research suggests that many founding teams care about displaying outwardly visible equality: not only does everyone gets the same equity share, everyone also gets exactly the same salary. This way no one can say afterwards that it wasn’t “fair.” This logic frequently trumps the alternative logic that a “fair” split should take into account that different founders contribute different skills, spend different amounts of time on the venture, or give up different job opportunities.

Equity Splits Have Longer-Term Impacts

Founders tend to think “our equity split is just between us; it doesn’t affect anyone else.” However, that “first deal” between founders could be a first sign of what troubles lie ahead. What do investors make of teams that split the equity equally? Our data suggest that they are less than thrilled. Even after statistically controlling for a lot of factors, our data still suggest the same basic message: companies that have equal splits have more difficulty raising outside finance, especially venture capital. Venture capitalists could obviously tell the founders to come up with a different equity split, but that causes a lot of strife and heightens cofounder turmoil and turnover. Given that venture capitalists invest in less than one out of every hundred companies that come across their desk, they are looking for reasons to say no. An equal split can send worrisome signals about the team’s ability to negotiate with others and to deal with difficult issues themselves. Interestingly, our research suggests that equal splits are more a symptom than the cause of trouble. It is not the equal split per se that turns off the investors, it is that equal splits are a symptom of bigger issues with the company.

Go Organic

Robin Chase’s painfully-learned advice: Adopt a “more organic” agreement than the static one typically adopted by founders. Vesting, in which each founder has to earn his or her equity stake by remaining involved in the startup or by achieving pre-defined milestones, is one way to achieve the dynamic approach advocated by Robin. Yet, for founders’ initial equity splits, such agreements are still the exception rather than the rule because there are many barriers to having the difficult conversation about adopting such mechanisms.

Essentially, such agreements are the equivalent of a newly engaged couple grappling with adopting a pre-nuptial agreement. Despite knowing about the high rate of divorce among married couples, we can’t bring ourselves to discuss the adoption of pre-nups with our fiancés. The same goes for the discussion of a “pre-nup” within a founding team. Setting up an agreement up front that outlines negative scenarios that might occur in the future, with corresponding actions to help avoid them, could help founders avoid headaches and increase startups’ chances of success.

Source: https://hbr.org/2016/02/the-very-first-mistake-most-startup-founders-make