Beware the “Accidental” Ownership Model

As a Founder, You are the Master of Your Domain

Over the past 20 years, I’ve participated in many start-ups, both bootstrapped and venture-backed.  During that time, I’ve seen many approaches to start-up employee ownership across a broad spectrum of philosophies – from radically low/no employee ownership (beyond the founder/founders) to ultra-high employee ownership (where many or all employees are treated as owners).  At Infinity, we referred to this broad form of ownership as “Citizen Ownership.”

I’ve also experienced the best and worst of how ownership can change over time in early- stage companies: from too few people owning too much of a company, all the way to people who contributed little or nothing to the company’s success owning a large stake.  In between, of course, is a broad spectrum of ownership, which is where most companies end up.  

I believe that it’s very important for founders to (1) consciously and proactively decide up front their aspirational ownership model and (2) plan how to achieve that model using specific corporate and legal mechanisms to execute it.  Don’t let your ownership model happen accidentally. This happens – and more often than you would think.

Part of your responsibility as a founder is to protect the interest of early-stage common shareholders from the nature of capitalistic individuals who are not capable of starting companies themselves and/or are just trying to make a $ and don’t care about your mission.  If you as a founder aren’t looking out for the interest of the common shareholders, it’s possible that the people who put in the hard work, sacrifice and commitment to start the company from scratch may be pushed aside by investors or late-comers who desire to capitalize on others’ hard work.  

Just to be clear: I’m not advocating that founders be greedy and not share ownership with employees (or investors) who come in at later stages when new skill sets are required.  Quite the opposite: I believe sharing ownership with those who come in later in your company’s life-cycle is essential for most entrepreneurs to be successful – I’ve done this consistently in companies that I’ve helped start and it has often worked well.  It’s critical to embrace the reality that few people are wired like Bill Gates or Steve Jobs and have the skills to lead a company from founding all the way through world domination. 

However, I amadvocating that founders be VERY disciplined in ensuring that they protect their own interests and the interests of other early-stage employees, particularly engineers.  If you are successful in your start-up’s mission, many people will come along who want to capitalize on your hard work. Sharing your ownership with the right people can create a lot more value as you grow.

So, what’s the best ownership model?

Over the past 20 years, I’ve concluded that there is no single ownership model that works broadly across all different types of companies. Founders must match their companies’ ownership models to their management philosophies, as well as their business goals and their expectations for their companies.   

There are as many ways to successfully configure a cap table as there are entrepreneurs. But the end-game configuration that hurts the most is the one where you feel like you’ve given too much ownership to people who don’t deserve or appreciate their ownership in an entity that you started from scratch and that you believed in when no one else did. 

Unfortunately, all too often I see first-time founders accept outmoded or antiquated ownership practices and beliefs that may or may not have worked in another situation/project/company: “In our companies, Founders get X%, Investors get Y%, post-founding employees get Z%.”  Often these ownership practices are driven by investors’ “models” for how they would like to run their funds: essentially as a series of relatively homogeneous ownership structures that minimize cost and complexity for the fund and help them reduce risk.

I’m not blaming the investors for trying to reduce cost, simplify their businesses and minimize risk.  However, I’ve observed that often, the most successful companies – those that venture investors strive to fund (call them “The Fundable” 😉 )   have strong founders who are deliberate in terms of the ownership models that work for them and their new companies. 

The impending Facebook IPO is a strong reminder that founders can and should pursue ownership models that work for them and their companies, regardless of how different it might be from current venture capital ownership dogma.  No matter what investors say, they make all kinds of exceptions to most of their “rules,” all the time.  As a founder, you may or may not have the leverage required to trigger their exceptions. If potential investors say “We never do X,” what they usually mean is “You don’t have enough leverage to make us do X.”

One interesting example of ownership innovation is the “Founder Preferred” model, which has become accepted in Silicon Valley.  Unfortunately, this model has yet to become broadly used in smaller, more provincial markets such as Boston/Cambridge, Seattle and Austin.  It’s hard to believe that such basic practices have not yet been widely adopted, but I hope we will begin to see this happen. 

The recent improvement in the economy has reinvigorated founder confidence, and increasingly founders have the benefit of improved transparency from sources such as “The Funded” and publicly available templates that enable founders to compare deal structures and terms proposed by their potential investors to those of other founders. Let’s hope that a successful Facebook IPO will help validate the benefits and integrity of some of these innovative mechanisms that benefit entrepreneurs and thus further encourage even more entrepreneurship/start-ups.  

In my next post, I’ll talk about one very important facet of ownership when starting your company: how to optimally structure options grants for early employees.

 

This entry was posted in Founders, Start-Ups, Venture Funding. Bookmark the permalink.

One Response to Beware the “Accidental” Ownership Model

  1. Corey Rosen says:

    Good article. In my work as the founder of the non-profit National Center for Employee Ownership, I have talked with hundreds of entrepreneurs trying to make these decisions and, sad to say, you are absolutely right that the most typical model is that the employee pool will be x% (almost always 10!).We recommend instead that companies think more dynamically. Set corporate critical number targets for the year. If achieved, give out a percentage of the value meeting those targets adds as an equity pool based on what numbers will be enough to attract, reward, and motivate people. Then allocate equity based on an internal fairness model that looks at the relative contributions of all the team members. Research on this issue strongly shows that it is better for corporate performance to share equity broadly with most or all employees–an unhappy receptionist can spoil to sale of the best product, and many great ideas can come from employees at all levels.More details on these issues can be found no our book The Decision-Makers Guide to Equity Compensation.

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