If you finally found the right cofounder for your startup and are excited to get the ball rolling and have them sign a contract, one of the things that’s most important for you right now is figuring out how you’re going to pay your cofounder.
This may seem to be secondary to more immediate issues, after all, there’s product to sell, or coding to conceive, angel investors to court and all manner of fundraising to be done. You’re ready to hit the ground running with your new cofounder. But for the sake of you and your startup’s future, take the time to consider the safest and most effective way to compensate your cofounder for their contributions.
People often make the mistake of being too generous with their offer, just glad someone else is there to help them row the boat through the storm but taking the most pragmatic and conservative approach could save you potentially large sums of money in losses as well as years in court.
A caveat to consider- though it’s best to start out with a conservative payment offer in line with best practices, that doesn’t mean that the contract can’t be updated in the future, as long as both cofounders agree and it’s in the company’s best interest.
Here are some factors to consider when deciding how to pay a cofounder:
Equity allocation – Founder shares (share issued specifically to founders as opposed to common stock) is included as a form of payment with cofounders. The question is how much equity your cofounder should have. When determining the amount of equity for each cofounder, there are several factors to consider:
Idea generation - Generally, the person who generated the startup’s principal idea is usually the one who owns the larger share of equity.
Sweat equity - However, this may not always be the case and it’s important to consider things like sweat equity, where one cofounder may have had the original idea, but the other cofounder has the experience, technical knowledge, equipment, network and/or is willing and able to put in more time to bring the idea to fruition.
Equal partners - If both cofounders are expected to contribute the same amount or same value to the company, whether through initial investment or value generation, then the equity split may be approximately equal (as much as 49% or 51%)
Weighing the importance of these factors in the company’s future success is key to determining the right amount of equity split between cofounders.
Equity buy back - It’s highly recommended for a cofounder contract to permit the company to buy back a cofounder’s equity if they exit the company after only a short time. This means that they cannot come back years in the future when the company’s value has multiplied and demand compensation for the shares they were given in the initial stages, cashing in the success of a company they didn’t work to build. Events like this are completely legal and unfortunately common if you haven’t included a clause that stipulates otherwise, and it is a bitter pill to swallow for everyone involved, including investors, employees and partners who joined later who may now see the value of their company cut in half.
Cliffs - A cliff is a way to ensure the security of the company’s equity for a set period of time in order to prevent employees or cofounders from selling off their shares of the company before they’ve worked for a stipulated term.
Your contract should state what percentage and when a cofounder’s shares can be sold. Note that allowing a cofounder to sell off a high percentage of their shares in the short-term sends the message that you’re giving them permission to cash out early. You are essentially encouraging them to invest in the company short-term, without providing incentive to invest in the company’s long-term success.
A typical vesting structure stipulates a four-year employment term with one year of cliff. That means that a cofounder must work for one year before receiving the first 25% of their equity. If they leave before the first year, they receive 0% of their equity. If they continue working, they receive 25% of their equity for each year of involvement.
You may also consider including a clause that shares can only be sold after M&A or IPO. In this case, the startup’s value has a chance to increase and attract acquirers and your cofounder has the incentive to generate value in the company so that they can reap the long-term benefits of its success.
Single trigger and double trigger acceleration – In the event of M&A or IPO before your cofounder is vested, there are two different ways for the vesting period to accelerate. Single trigger acceleration occurs when 25-100% of your cofounder’s shares become vested. Investors tend to dislike this option as it may result in a cofounder who added value to the company and drew the attention of an acquirer to leave after cashing out. Double trigger acceleration occurs when two specific issues cause vesting acceleration which are typically: 1) M&A, and 2) termination of a cofounder or employee without cause. Investors tend to favor this route as it provides them with the benefit of maintaining the company’s employees and team members who generate value and at the same time allow them to replace them with their own team members.
Salaries - Paying too high a salary to a cofounder sends the wrong message to employees who are often working long hours on small salaries in the spirit of entrepreneurship, making a sacrifice now to reap rewards later. If one or both of the founders are receiving high salaries while the company hasn’t even taken off yet, it sends the message that resources aren’t being put into the business, where they should be. Also, employees likely don’t have the same equity incentive that founders do and making small salaries while the founders are earned fluffed up salaries can damage morale. Peter Thiel, PayPal and Palantir founder advises that, “the CEO’s salary sets a cap for everyone else. If it is set at a high level, you end up burning a whole lot more money. It aligns his interests with the equity holders. But, it goes to whether the mission of the company is to build something new or just collect paychecks.”
If your startup is in its very initial stages and you are working with limited capital, you may choose to offer a salary replacement or low salary in exchange for shares. Tread carefully when offering this type of salary exchange. Besides running into potential legal issues with wage law violation in some states, deferring salary or offering salary for equity creates the expectation that the founder will be compensated when the startup gets funding. The problem here is that this works against the concept of funding. When you get funding, you want to be putting that money into the business to help see it to its next stage of growth, not using it to make up for months of unpaid salary to your cofounder.
Finding the right salary for your cofounder is important to creating an atmosphere of fair wages and expectations as well as demonstrating your value for your company’s equity.
The most important issue when determining how to pay a cofounder is protecting your company’s equity. In the end, if the cofounder hesitates to a standard contract that includes cliffs or wants a high salary, this may be a sign that their interest is in short-term compensation and not the company’s long-term success. Consult your attorney to avoid making having any regrets in the future and, once all things are set in place, sign that contract, shake your cofounder’s hand and get ready to build your startup.
28th August 2020