Tag Archives: founders

Dilemmas of Founders

HartebeestsIf you are considering starting a company, or if you have recently started a company, an essential item for your reading list is Noam Wasserman’s The Founder’s Dilemmas. Based on years of solid research and experience, this book surveys many of the biggest problems facing founders of high growth start-ups. I want to share with you some of the thorniest of those problems here. But please don’t take my word for it. Buy the book for the complete story [No, I don’t get a commission].

1. Career Dilemma

You are currently employed and earn a comfortable salary. You have a great idea for a new start-up. How do you determine what to do?

If you stay with your current job, you maintain the security of a paycheck but likely give up the dream of starting a company, spreading your wings, and perhaps “getting rich.” Most investors will not invest in a startup without the founders/officers demonstrating a significant level of commitment, and that means “quitting your day job.”

If you quit your day job, you have the chance to make it big, but you give up the security of a paycheck. Can you afford to do that? Most start-ups cannot afford to pay the founders a salary for the first few years, so you need to have a significant enough nest egg put away to afford a few years of financial drought.

2. Co-Founders with Complementary Skills

Often entrepreneurs co-found companies with others who have very similar backgrounds as themselves. The advantage of this is you all speak the same language. The problem is that starting a company requires a diverse set of skills: technology, marketing, sales, financial, legal, and so on.

The best teams tend to ones that combine diverse skills and diverse personalities.

3. Title for the Founder

Many individual founders believe that they should lead their companies with a title such as CEO. Derived from Wasserman, the figure on the right shows the starting role that the “idea person” serves in start-ups. Although the initial idea person may be the perfect CEO for the start-up due to commitment and passion, the skills required for leading the company through long-term growth may not be present. Only 75% of founder-CEOs are still in the CEO position by the time of the first external investment round, and only 39% are still in that role by the time of the fourth round.

4. Who is in Charge?

Most start-ups have a single individual who serves as leader; s/he could have any
of a variety of titles; chief executive officer, president, and chief operating officer are typical. This individual reports to the board of directors. If you are considering having nobody in charge, or having two or more co-presidents in charge, think again. Tough times will come. And when those tough times arrive, somebody needs to make the tough decisions. The movie, Startup.com, exposes many start-up problems, not the least of which is what happens to relationships when one of two co-founders thinks they are “co-CEOs.”

5. Liquidation Multiples

When investors purchase preferred stock, they typical ask for (and receive) a liquidation preference, which specifies what multiple of their purchase price they will receive upon a liquidity event prior to general distribution of the remaining funds to all shareholders. I described some of the problems related to liquidation preferences in an earlier blog called Liquidation Preference and Avoiding Dilution.

According to Wasserman, Series A investors in 78% of all start-ups that raised external investments had a liquidation multiple of 1; 9% had a liquidation multiple of 1.1 to 2; 5% had a liquidation multiple of 2.1 to 3; and 8% had a liquidation multiple of greater than 3.

The dilemma is: Do you accept an investment whose terms include high liquidation preferences even though it in effect makes earlier investors’ return nil [and significantly dilutes the founders], or do you turn down the investment hoping for better terms from another investor?

If you accept the terms, you have thrown your earlier investors under the bus. If you refuse the terms, you may be throwing the entire company under the bus. Therein lays the dilemma.

6. External vs. Internal Boards

If you have a board of directors composed of the inner circle, e.g., co-founders and/or fellow officers, you can make decisions with your co-leaders and know they will be endorsed by the board. But now you have no “sounding board.” You have no independent thinkers. You have no checks and balances. The primary reason for a board should be to hear other opinions.

7. Control vs. Wealth

In an earlier blog called You Are Not Your Company, I described the problem founders have of trying to control their companies vs. distributing ownership and creating a much bigger pie to share among more mouths.

8. Compensation

Should officers of the company (and in fact all employees) receive cash compensation equal to what they would receive at a non-start-up company? Should they receive stock options as an incentive to join the company? Should they receive stock options in lieu of cash compensation? What is the right balance among these three?

There is no right answer. However, the decision is affected significantly by the amount of cash the company has (and this is affected by the desire to attract investors and/or the desire to time investments based on company valuation) and the amount of control that the founders demand or are comfortable with sharing.

9. How Long Should Vesting Be

When options are granted or stocks are sold to employees with reverse vesting, how long should the vesting period be?

On one hand, a long vesting period sounds like an incentive for the individual to stay with the company for that long period of time.

On the other hand, a long period of vesting could also cause a frustrated individual to say “I can’t wait that long; I might as well leave now.” The table on the right, from Wasserman, shows how long the vesting period is in start-up companies for founder CEOs vs. non-founder CEOs.

In summary

Starting a company is not for the faint of heart. Fortunately books like Wasserman’s Founder’s Dilemmas exist to guide you through the tough times.

ABOUT THE AUTHOR:

Dr. Al Davis has published 100+ articles in journals, conferences and trade press, and lectured 2,000+ times in 28 countries. He is the author of 6 books, including the latest, Will Your New Start Up Make Money? He is co-founder and CEO of Offtoa, Inc., an internet company that assists entrepreneurs in crafting their business strategies to optimize financial return for themselves and their investors. Formerly, he was founding member of the board of directors of Requisite, Inc., acquired by Rational Software Corporation in 1997, and subsequently acquired by IBM in 2003; co-founder, chairman and CEO of Omni-Vista, Inc.; and vice president at BTG, Inc., a Virginia-based company that went public in 1995, acquired by Titan in 2001, and subsequently acquired by L-3 Communications in 2003.

If you’d like to learn if your great business idea will make money, take a look at Will Your New Start Up Make Money?

Photo of fighting male hartebeests by Filip Lachowski (Creative Commons)

Why do I need a founders round?

No FoundationA founders round is an investment round that generates the initial cash needed to get the company started, but more importantly, it distributes equity to the founders of the company. In effect, it creates a foundation for the company’s ownership.

Do not start your company by simply giving stock to the founders. Doing this creates a taxable event for the founders because they have received something of value, a security, which is taxable. Rather, let the founders purchase a security, which establishes a basis for the purchase of the stock and which is not taxable.

What price do founders usually pay?

Since the company has just started, it isn’t worth very much. Usually, the founders pay a nominal amount, just enough so the company has enough runway to reach the first real investment round.

How many shares should founders purchase during the founders round?

No hard and fast rule exists. However, one million shares would give you good flexibility for the future. It would enable you to sell reasonable pools of shares to future investors and grant reasonable packages of options to employees, without having to do splits to create additional shares.

The only reason not to issue a million shares to the founders would be if your state of incorporation charges your company annual corporate tax based on the number of shares outstanding.

When should you conduct the founders round?

Ideally, you should conduct the founders’ round soon after you execute the paperwork that legally creates the company.

That way, the articles of incorporation and bylaws (if a corporation), the partnership agreement (if a partnership), or the operating agreement or articles of organization (if an LLC) can reflect the distribution of ownership.

Can you have a second “founders round” after the founding of the company?

Legally, founders’ shares are only available at company inception.

Founders can of course sell their shares to somebody. In this case, the new shareholder would pay the founders (not the company) for the shares.

And of course a company can always sell its treasury shares to a new shareholder. In this case, the new shareholder would pay the company. However, be careful! The investor must purchase them at a price using the current market value of the company, likely not the extremely low price the original founders paid for their shares,

When the original founder share price is paid for shares later in the company’s life, the new investor may be subject to a taxable event by the IRS.  Only in the case where nothing happened in the company between its founding and the time of the new investment would the potential exist for this to not be a taxable event.

So, the answer to the question Can you have a second “founders round” after the founding of the company? is  “Yes, sort of.” The new investor would purchase his/her shares in an “investment round”, which you can call whatever you want.

In summary

When you start a company – whether it is a corporation, a partnership, or an LLC – make sure that the founders/partners purchase their shares of the company. That establishes a basis for the security and will make tax filing a lot easier in the future. When shares are sold later on, make sure they are sold at the fair market price at that time.

 

Alan DavisAl Davis is a serial entrepreneur currently in his fifth startup. He is also an angel investor and the author of six books. He is not a CPA or an attorney, so the above is just his opinion!