The greatest tragedy to hit any start-up

A good friend and serial entrepreneur once described entrepreneurial ventures as “a lot of ifs in a row”. This has certainly been my experience – there are many things that must go right (and must not go wrong) in any venture and one of the skills that the best entrepreneurs learn is to anticipate anything that might derail an otherwise promising venture.

In my view, the greatest tragedy that can befall any venture is an irreversible falling out between its founders. The venture may have huge potential but if the team falls out then all is lost. This value destruction can occur in a trice. As an EMBA in the 1980’s (!) I was a member of a team which won the school’s Business Plan competition with a whizz-y new publishing venture. The very next day – as we planned on next steps – a ‘team’ member said that he did not trust a fellow with money. Sadly, that was that. I do not think that they ever spoke to each other thereafter. The team fractured and the dream disappeared in a puff.

Most team disintegrations occur more slowly as resentments build and relationships crumble. As unofficial advisor to dozens of student start-ups I am often faced with a co-founder (usually one) approaching me to ask what to do about the other co-founder who has not been pulling his or her weight – indeed the reason why I am putting pen to paper tonight is that I have had three such meetings (on three unconnected ventures) since lunchtime. In all cases, the issue has been the same: how to divide equity between the co-founders. Or rather, how to re-divide equity between co-founders when one party appears to be free-riding on the efforts of others.

Double meaning

The word ‘equity’ has two meanings. The first and most common relates to numbers of shares - mere rectangles of cold paper granted to any investor in consideration of their input. But equity also means fairness or justice - words brimming with the emotion that I observe welling in the eyes of so many an aggrieved co-founder. They are unable to bear that someone else is not pulling their weight and yet still owns a chunk of shares, particularly when it is not as to what was agreed at the outset. It is not the money that matters to them – I have seen the same fractures occur in social enterprises (where shares are worthless). It is the principle of the matter.

Many different currencies

One of the problems with splitting equity in consideration for contribution is that contributions come in many different currencies with no objective exchange rate.  This is inevitable - the very strength of a venture is that its members bring a diversity of talents, and assets to a venture: hard work, intellectual property, connections, credibility, scarce specialist knowledge, cash, and the original idea! How on earth do you divide common stock (shares) between these various inputs in a way that everyone regards as fair?

Another problem is that some of the contributions (like the idea and cash) are contributed at the time of formation whilst other inputs (principally pure grind) come later as an unenforceable promissory note.  The trouble is that equity is often rigidly agreed at the time that the company is incorporated – which is fine if all co-founders proceed to perform as advertised but can result in terminal resentment when one co-founder feels that another is reneging in their commitment.

Often founders finesse the first (exchange rate) issue by agreeing a 50-50 split up-front. This unlikely equality of lifetime contribution is common because it easy and obviates the need for wearisome, awkward discussions over ‘who owns what’, or, ‘whose contribution was greater’. Another reason is that equity means control and a 50-50 split suggests equal say in the direction of the business – thereby conflating control with upside.

Options

So, how can founders avoid fractures? I have found three points that help.

First, do not simply agree to a 50-50 split without talking through assumptions that each founder may have about their counterpart’s future input and commitment to the venture. We are often quite reluctant to broach the subject in the event that it may be misinterpreted as lack of trust. Whilst perfectly understandable, this is bonkers in my opinion. Separate the people from the problem, as they say. Place the blame on me even by referring to this paragraph! Consult a few other ‘happily married’ founder teams.  Review a few founder agreements to set the agenda and sense some solutions. John Kay, who taught me strategy at LBS, said that agreements had two purposes, the first to enable you to sue the other party downstream, and the other to force parties to obtain clear understanding before either has invested too much. I am talking about the second. You may well end up at 50-50 but at least you will know why your co-founder(s) think you are worth the 50.

Second, separate the past from the future. The past is ‘sunk’ and everything created to that point is probably owned jointly. The future is fundamentally different. Like any other input future stakes are earned and the currency of choice being equity (in part because you have no cash anyway, but also because equity aligns incentives).  Ideally every founder would be paid monthly in shares at some agreed, risk-adjusted exchange rate. Of course, issues of control, ownership and power mean that it is not that simple, but the principle stands.

Third, do not allow resentments to fester. Address them openly and quickly. De-politicise by making it a standing agenda item on periodic member meetings. This is made much easier if you have some kind of pre-nuptial benchmark. It will be emotional since the non-performing party will feel that they are being dumped. Those with low emotional intelligence should read Daniel Coleman’s book, aptly titled Emotional Intelligence in which he sets out strategies for diffusing highly-charged conflicts. Issues rarely resolve on their own, rather they fester and become gangrenous. Nevertheless, if it does become too personal, then agree to find an independent and trusted sage who can help resolve the dispute.

When all fails

Disputes end in stalemate far more often than in the courts. Early stage ventures are inherently consensual and one party can easily block any decision. Who would invest in a business where a disgruntled, eponymous co-founder has an option on throwing a grenade into the ring?  It is far more likely that the venture - bereft of the goodwill that was once its strongest asset - is simply abandoned.