Co-Founder Equity Mistakes to Avoid | Startup School

[Music] hello I'm Michael cybal and today I'm going to talk about co-founder Equity splits and co-founder breakups to be clear we want people who are building tech software startups that they expect to be VC funded you know this is advice for you I can't really comment on other types of businesses there are many types of businesses that have that have equity and and to be clear this is not really about them also this is really focused on conversations that Founders are having in the beginning of a company for pre-product Market fit companies you're really talking

about the beginning of companies all kinds of interesting and crazy things happen later on and I it would be a misuse of this video and this advice to apply to companies that are later on or to apply to companies that are not tech companies so here's the tldr the core advice we want to give is be generous with co-founder Equity what you're trying to do is motivate your founding team to work extremely hard when it looks for many of the first couple years like things are not working the biggest mistake is to be stingy on

Equity during this very very very delicate time in the beginning of a startup causing people to leave while it's still possible you might make something big so the Jedi found founder and the dumb founder they're both generous with co-founder Equity the uh midwit oh they're thinking about skill sets and contributions and time commitments and the network and futurals and D thinking about all of these things and trying to do a really complicated calculation I'm going to argue today that's not required let's go over what we're talking about first co-funder Equity spits then co-founder breakups bad

reasons for very unequal Equity splits bad advice and then some final thoughts all right co-founder Equity um in my experience the mistake that Founders make is they don't think about how to motivate their team their founder co-founders today and tomorrow typically you're giving people Equity over that they're going to earn over the course of four years and you don't want them to be thinking in year 2 year three year four I don't have enough equity I'm not motivated or or I have this amount of equity and the CEO has four times more but I'm grinding

every day and I've been here since the beginning which would create resentment so the job of a CEO when Distributing co-founder Equity is to not just think about what's going to convince your co-founder to work on your company today is to think about what's going to keep them motivated over the course of all four years and hopefully much longer in that situation our typical advice is to go for close to equal Equity splits don't have to be exactly equal but the more generous you are the more you can expect a strong founder to stay motivated

next vesting and cliffs most often when you're giving Founders Equity that Equity vests over a period of time which means it's earned over a period of time and if you leave during that period of time you don't get all of the equity in addition a cliff is essentially designed to say if you don't make it to this moment in the company's history if you don't make it through year one you don't get any of your Equity Grant both of those tools are extremely valuable and they should apply to all founders I have to be honest

sometimes Founders ask me why are we doing this like we all like each other we're not going to break up nothing's going to go wrong I would just say this giving away founder Equity is not something that you should be innovating on and the best practice is that all of equity comes with vesting and cliffs when it's given to Founders life happens crazy happens sometimes people have to leave and they don't even want to leave sometimes family circumstances change sometimes people get sick sometimes people don't perform so by having vesting and having a cliff that

gives Founders the ability to let other Founders go or for those Founders to leave without destroying the cap table so you should be using vesting in Cliffs what's extremely typical is four-year vesting you earn your stock over four years and a one-year Cliff you don't earn any stock until you've hit one year of working at the company NeXT your co-founders must be essential to your founding team one of the things I think about with a founding team is like it's the smallest number of people who can get an MVP built get it in the hands

of customers and start learning one of the reasons why we tell people one of the other reasons why we tell people to be generous with their Equity is it helps them remove quote unquote co-founders who are not essential who really shouldn't be on the team or perhaps should be employees instead of Founders you should understand that like the co-founder title is not something that should just be given out willy-nilly you know teams that come into YC with you know five six seven co-founders clearly there's something weird some conversation hasn't happened it's almost always the case

seven people are not essential to getting a product up and out in the hands of customers next always remember that once again in almost every case when you're giving out co-founder Equity most of the work in your company hasn't been completed so this kind of comes back to the first point Equity is about motivating people for work they have not yet done as opposed to rewarding people for work they have done last things which are kind of negative one the CEO should have have the ability to fire Founders who are not performing and so however

you set up the equity split the CEO should Reserve this right and honestly there has to be a captain of the ship there has to be someone who's ultimately held accountable and they need to be given the responsibility to let people go who aren't performing if you're not willing to join a team under these circumstances that's tricky I would say that you're you're not understanding the seriousness of a company or maybe you should go start a company and be the CEO um but the CEO should have this responsibility they should um regardless of the equity

split and then finally what's most responsible is if co-founders have a conversation about what will happen if things don't work out now let me give you some guidelines at least YC's thoughts on how that should go if you have a co-founder breakup and you are pre-product Market fit here are some guidelines that YC has seen work over the years and these are things that perhaps you should consider talking amongst the co-founders so first if a co-founder leaves or is fired before their one-year Cliff it's extremely typical for them to get just a token amount of

equity 5% to 2% remember this is pre-product Market fit so there's no evidence that the company is going to work and the vast majority of work still has has to be done after the onee near Cliff but pre-product Market fit we recommend that if a Founder leaves or is fired they leave with no more than 5% of the company which often means they have to give back some Equity now this can be a tricky conversation but when a company's pre-product market fit once again so much work is left to be done and you want to

motivate the people who are remaining at the company to distribute that Equity to people who can actually help continue to increase the value of the company employees and Founders the founder who's leaving can't help increase the value of the company anymore so if they're holding a whole bunch of equity they're basically reducing the chances of the company being successful and therefore reducing the value of their Equity so that's why I recommend if a Founder is leaving or is fired after their one-year Cliff they should retain no more than 5% of the company NeXT if a

Founder is fired it's extremely reasonable for them to give in a small Severance you know 1 to three months but if a founder leaves that's not typical um you can do it but it's not typical and finally every founder regardless of whether they leave or they're fired should be expected to resign from the board sign a release um and often give proxy voting rights to the founders that are remaining basically allowing the founders that are remaining to vote their shares more often than not it is the non is a Founder that's not the CEO who

is going to either leave or be fired but I will say this um sometimes it's the CEO right life happens and so if that's the case whoever the new CEO is has to kind of arrange this breakup accordingly and even the CEO the previous CEO should understand these expectations because you know like I said sometimes CEOs screw up and they or sometimes CEOs choose to leave so with the expectations on how equ Equity should be distributed and um what happens with the breakup let's talk about um some cases where we see unequal Equity splits that

uh let's just say don't make any sense the first and most common bad reason for a massively unequal Equity split is well my co-founder agreed you know I own 90% of the company I asked my co-founder if they're willing to own 10 they said yes so everything's good right I would say as a CEO this is a perfect example of optimizing for today and not optimizing for tomorrow you should be thinking not what is your co-founder going to be happy with today you should be thinking about what's your co-founder going to be excited with when

it's year three of the company and everything sucks what's going to keep them motivated to stay and work extremely hard then and as CEO you always have to be thinking about tomorrow regardless of whether your co-founder does and you probably should be more generous with your Equity to compensate for when those bad times are happening how do you keep keep that co-founder motivated next well I came up with the idea so I deserve more Equity right it was my idea they're just building it we get almost 30,000 companies apply to YC every six months and

we see every idea that exists it's extremely obvious that ideas are a dime a dozen and execution is the game here and that co-founder is going to be essential in executing the company and if they're not they shouldn't be a co-founder so I come with an idea is not a great reason for a 99010 equity but next I started working 6 months before my co-founders so I deserve a lot more Equity they weren't there at the beginning well you still have to ask yourself how much work is left to be done if this is a

traditional tech software startup then 99% of the work is left to be done this could be a 10 20 30y year Journey if it's really successful and a difference in starting date of 6 months probably is not that significant when it comes to it next my co-founder needs a salary and I don't I would argue that you should be thinking about salary and Equity differently salary is the money that someone needs to live to pay their rent to buy food to literally give themselves the ability to work in your company Equity is what's going to

motivate them to work extremely hard and do extremely well and often get a below Market salary so I never like to think about reducing someone's Equity because they need more salary I always like thinking about giving every person on the founding team the salary they need so they can live for some people that might be zero if they come in with some money and then giving people the equity they need to be motivated to work extremely hard all right next I'm older and much more experienced than my co-founder you know this is a tricky one

um certainly people who are more experienced can contribute to the company can help fund raise often there are many things they can do that a younger less experienced co-founder can't but if you're making this person a co-founder that means that they're going to have to be a key contributor to the team that should mean you couldn't do it without them so you should be very careful about how motivated that person's going to be you should be generous with Equity as a result next well I hired my co-founder after raising some money well once again you

know fundraising I think people are surprised that fundraising doesn't massively change your chances of being successful there lots and lots and lots of startups that raise money and very few that go on to generate a billion dollars in Revenue so I would argue that even if you have $100,000 $500,000 in um in investment 99% of the work is still left to be done then finally I hired my co-founder post launch same thing that first launch of MVP is just the beginning of the journey so to sum up I think that all of these answers are

a flavor of the same thing it's a flavor of short-term thinking the best founders are long-term thinkers the best Founders are not only thinking about today but they're thinking about tomorrow and the best Founders are thinking about their co-founders needs even if those co-founders are not thinking about them it's the best Founders the best CEOs understand that this small team has to accomplish a lot or else the whole Endeavor isn't going to work the best Founders is using Equity to try their best to motivate people to work extremely hard they're not thinking about Equity as

something that should be hoarded they're thinking about Equity as a tool that can produce maximum motivation for a small number of people so let's move on to some common uh let's say bad advice that I see right so if our advice ISS hey you should be generous with your co-founder Equity um you want to motivate people for the long term and you should protect yourself by have investing in Cliffs some bad advice that I see is like oh we should have performance-based Equity um you know if my CTO writes this number of lines of code

or if my you know if the founder that's doing sales like generates a million dollars in Revenue will set their Equity based on that needless to say at the beginning of the Journey of a tech startup it's really unclear how to set those types of goals um and those goals change we see companies pivoting and thinking that you can kind of measure things so precisely at the start is a really big fallacy furthermore uh this is probably not an area that you should be innovating should innovating on your product and how you interact with your

customers um Distributing Equity there are best practices that tend to work so that's why Performance Based Equity is not something I would consider well what about part-time Founders um I would argue that a part-time founder isn't a founder and shouldn't really be considered in this equation I know there are some edge cases where there are some part-time Founders or like you know people who swop in and swop out and y y y but I think if you look at the most viable companies in the world you don't see a lot of prevalence of part-time Founders

so I just don't think they should be considered if you want to be a Founder you should be working full-time and then like what about other kinds of like Dynamic Equity agreements like oh if the company accomplishes this or if y y happens and like the equity is not really set if you're trying to motivate people it's really nice for them to know what they have and especially Founders they're going to be a lot lot more motivated if they know what they have when they're starting versus some weird kind of thing that's like hard to

Define in the rules might change Etc so I think you know these options are too fancy and oral advised often times they're created because people don't understand the value of vesting in a cliff if founder relationship isn't working out that founder should leave or be fired and that should happen before the cliff that's your protection that's your protection if things aren't working out not fancy formulas and weird kind of madeup stuff and to be honest if you don't have the wherewithal to ask a co-founder to leave if they're not performing or as a co-founder if

you realize that you're not able to perform if you don't have the wherewithal to leave on your own accord you shouldn't be doing this like you're not respecting how hard this is and how much work your co-founders are putting into it that's why vesting Cliffs work that's your downside protection and that gives you the ability to be generous with your Equity um as opposed to create fancy schemes so to wrap up um one common thing that you see among successful companies is that over the long term over 10 over 15 years um one founder will

often stick with the company a lot longer be more responsible uh for a lot longer and you could argue was more valuable to the company right you know you see these famous companies like Amazon and Jeff Bezos or uh Mark Zuckerberg at Facebook etc etc that's true and you would think that that means that those people should deserve vastly more Equity than their co-founders who might not have stuck around for you know a decade Etc here's the tricky bit about that it turns out with tech startups the beginning is extremely important those first four to

six years is where a lot of value is being created and those first four to six years is when most companies die so I would argue that even if you're in this lucky situation of your company being massively successful and you know you being the one who stays around the longest you still want to be extremely generous with co-founder Equity because those co-founders actually got you the energy of activation your company needed to even be in the game and without them maybe you're not in the game at all and you don't get to see this

company scale to something great you should really understand how important the early years are and the co-founders are and co-founder motivation is to making successful products happen and you should use your co-founder Equity to give yourself the best chance of building something that people want after that hey man you're Off to the Races you're doing better than 99% of other startups and of course the rules change [Music]