Week Two of Y Combinator’s Startup School focused on “Startup Mechanics.” These are the things that often get overlooked in the rush to build and sell a product. Founder agreements, company incorporation, fundraising due diligence, and employee policies.
One of the most often talked-about topics is founder agreements. How do you decide who gets what of the company? In movies like The Social Network (below) and TV shows like Silicon Valley, we see founders fight over equity assignment. Some agreements leave people feeling burned and resentful. Is there a way to mitigate that risk?
When founding agreements and equity go poorly
I’ve thought a lot about this since the time that I started learning to program. One resource that affected my view was a founder’s talk by Greg Pollock, Founder of Code School. In it, Greg explains how splitting company equity in the early stages can lead to resentment.
What if you split the ownership of the company 50-50, only to find that one person contributes 80% of the work? This is bad for both people. Instead, Greg recommends a dynamic equity split, based on the book Slicing Pie.
Slicing Pie
The way that it works is simple, and this is worth knowing. Whatever your hourly wage would be as a professional, double it. That is your hourly rate as a founder. If you work with a co-founder, follow the same rule. As you work on the startup, keep track of the work that you contribute in a spreadsheet. You equity is equal to:
hours of work * hourly rate / total of all hours of work * respective hourly rate
This is a very simple formula. You might argue, “but all work isn’t equal!” That may be true, but this is as close that you will get to a dynamic equity split that incentivizes everyone. One week, suppose I work more and gain more equity. Next week, my co-founder picks up the slack and it evens out. When I’m working harder than my partner, I’m not resentful that my extra work isn’t compensated.
Now, a caveat. This strategy works well for part-time ventures. I used this agreement with my partner Nick when we made a mobile development tutorial and sold it online. For full-time ventures, you want to follow what the people at YC say, and split equity among founders as a C-Corp.
Equity Agreements
You should understand the different terms of a founder agreement that you will sign as a C-Corp. Many of the terms may be confusing if you have no legal experience. It’s still important to learn about what they mean. Conditions such as a 4-year vesting schedule and a 1-year cliff are pretty standard, but they may be new to you.
Kirsty Nathoo makes a great point — if you don’t understand how your company’s shares work, then you won’t be able to explain it to your employees. And transparency with your future employees is very important.
I know a software engineer who worked for a small startup. He started as a part-time employee and they offered him a full-time contract. Part of the contract stipulated that the employee would have 5,000 shares as part of their options plan.
Let’s break that down. 5,000 shares. What does that even mean? This contract didn’t explain what the total number of shares were. When he asked his employer, they told him that the 5,000 shares represented 1% of the equity. OK, that makes sense, but a total number of shares was still not provided.
After a year of working at this company, the employee finally decided to clarify his position. He asked the employer about the 1%, and how many total shares in the company there were. The employer told him that he meant 1% of the employee pool, which is only 10% of the company equity. This meant that his “internal” valuation went from 1% to 0.1%.
Transparency
This is why it’s so important to be transparent as an employer, to understand how options and equity work. It’s also important as an employee to know the total number of shares.
Options can be great for employees, but it’s also important to understand how they work. I’ve talked to many software engineers who think that options mean that the company grants equity. When I explain that you have to buy the equity, albeit, at a discounted rate, I see the surprise sink in.
When I explain that you may have as little as 90 days to buy the equity and that doing so imposes a big tax, I see the color leave their face. Yes, employees should try to understand this better. But employers should also make the process as understandable as possible.
When it comes to founder and employee agreements, the main thing to not lose sight of is fairness. Kirsty is spot on when she says that fairness (both perceived and actual) is an important idea.
Fundraising
The last subject of this week’s class was raising money. Luckily, Y Combinator has simplified the early part of this process with the SAFE agreement. SAFE here stands for “Simple Agreement for Future Equity,” and it is simple. In the very early stages, this should be enough. Later on, as you pursue further funding rounds (Seed, Series A), you will need legal help.
Conclusion
This week is the most concrete of the instructional classes. Instead of generalized ideas, “Startup Mechanics” is a checklist of startup essentials. I’ve tried to provide any alternative insight I have (dynamic equity splits, etc.), but in general the advice is spot on. YC has been doing this for so long, that in the majority of cases, it’s not worth recreating the wheel.
Tom Goldenberg is CTO and Co-Founder of Commandiv, a personal investing platform. If you enjoyed the article, please like and share it!