Dynamic Founder Agreements
In my role at Fresco Capital and as an advisor to several startups, I’ve seen it all with founders: disputes over shares, disputes over money, disputes over a new laptop, founders break up, a founder falling ill, founders get married, founders get divorced, founders get into physical arguments. Often this leads to one founder completely disengaged from the business and still holding a significant amount of equity or even a board seat. We’ve seen this at large companies such as Microsoft and more recently at ZipCar. Typically you need this equity to hire executives or attract investors. Worse, if the company is being acquired, you now have one founder who can hold up the deal if they are on the board and disengaged. That of course is a problem, but one that can be solved with a dynamic founder agreement.
Most founders settle the division of equity question with a static founders agreement. It usually goes something like this:
Founder 1: 50%, vested over 4 years, 1 year cliff
Founder 2: 50%, vested over 4 years, 1 year cliff
This solves a lot of problems, such as if a founder leaves after two years, they will still have 25% of the company but give up the second half of their equity. What happens if one founder is not “pulling their own weight” or contributing enough to earn the vesting (in the other founder’s eyes) but did not leave the company? What happens if they have to leave due to illness or personal emergency? What happens if there is misaligned expectations as what skills a founder brings and what role a founder will play?
I’ve seen this happen at one of my own startups. One of our founders was a lawyer and at the time we sold the company, he could not represent us due to it being a clear conflict of interest. While the legal fees were not all that bad (maybe $50k), to this day, almost ten years later, my other co-founders are still mad at the lawyer co-founder. This was clearly misaligned expectations.
This is what Norm Wasserman calls the Founder’s Dilemma, or the unexpected consequences of not spelling out the roles and expectations of the founders early on combined with the unintended complications of a founder leaving early or disengaging. He suggests a dynamic founders agreement.
The Dynamic Founders Agreement
The dynamic founders agreement is a way to mitigate the risk of an underperforming founder by changing the equity based on pre-set parameters. For example say I am starting a company with my friend Sam. Sam and I agree to a 50-50 split with Sam being the “business guy” and me being the “tech guy”. The assumption is that I will be the coder of V1 and lead the development team after we get funding. But what if I need to leave the company due to family emergency? What about if I decide that I don’t want to code anymore, before we can afford to hire a developer? What if I only give 30 hours a week and consult on the side?
A dynamic founders agreement is a big IF THEN ELSE statement that spells all of this out. IF Steve works as expected, his equity is 50%, if Steve has to leave the company, if he becomes disengaged, here is the pre-negotiated equity and if we have to buy Steve out, here are the terms. For example:
Steve works full time as CTO performing all the coding and technical duties of V1, his equity is 50%, vested over 4 years, 1 year cliff.
Steve works part time, is disengaged, or we need to hire developers sooner than expected, his vested equity is reduced by half and he forfeits his unvested equity. Loses board seat.
If Steve has to leave the company because he needs a job or a family emergency: if Steve built V1 then the buyout is a one time payout of $50,000 USD cash or 2% vested equity, if Steve did not build V1, the buyout is 0.5% vested equity. Loses board seat.
Having a dynamic founders agreement won’t solve all of your problems, however, it will make the the process of removing a founder much less stressful. Sure some of the language in the dynamic founders agreement will be subject to interpretation, but the “spirit of the agreement” is much easier to follow or even if you have to litigate, more robust. If you never need to use the dynamic founders agreement, but built one anyway, it will force a frank and open conversation about roles and commitment among the founders. This only strengthens the relationship between founders, increasing the chances of success.