Five Common Mistakes with Co-Foundersby Scott Edward Walker on November 2nd, 2010
This post was originally part of my weekly “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs). Below is a longer, more comprehensive version. Please shoot me any questions you may have in the comments section – or feel free to call me directly at 415-979-9998.
I’m a first-time entrepreneur, and I’ve been working on a new e-commerce site for about six months. I outsourced the development work, but now I’m thinking it would be better to bring on a technical co-founder to handle that work. What are some of the mistakes you’ve seen a sole founder like me make hiring a co-founder. Any advice would be appreciated. Thanks!
Here are five common mistakes that I’ve seen:
Mistake #1 — Adding a Co-Founder You Don’t Know or Trust. Choosing a co-founder is probably the most important decision you will make in connection with your venture. Ideally, it should be someone that you know really well and whom you trust (like a close friend) – i.e., someone you are confident will be in the trenches with you fighting and clawing when the going gets tough (and believe me it will).
Some first-time entrepreneurs make the mistake of hiring a co-founder whom they have just met (e.g., at a conference) or who is a total stranger. Simply put, that makes no business sense. You have to treat hiring a co-founder like you’re getting married – and obviously you don’t marry someone unless you know him/her very well and trust and respect them.
Mistake #2 — Issuing Too Much Equity. Some entrepreneurs make the mistake of giving their co-founder too much equity — sometimes as much as 50%. Indeed, splitting the equity equally between co-founders is usually not the right business decision — particularly where it’s your idea and you’ve already spent six months on the venture.
The splitting of equity is a significant business decision which must be negotiated between co-founders based upon their respective contributions to date and their expectations going forward. In this context, you should probably be thinking in the 20-25% range, assuming the co-founder will be adding significant value. I discuss this issue in detail in my blog post “Ask the Attorney – Splitting Equity.”
Mistake #3 — Not Imposing Vesting Restrictions. Some entrepreneurs make the mistake of issuing stock to their co-founder without imposing vesting restrictions. This becomes a huge problem if the co-founder leaves shortly thereafter. Indeed, it would be inherently unfair if your co-founder quit in six months and kept all of his equity.
To prevent this, you must make sure that your co-founder executes a restricted stock purchase agreement, with a vesting schedule which grants him ownership of his stock over a four-year period (typically on a monthly basis). If you don’t know your co-founder very well, you should also think about a “one-year cliff” – meaning he would not be entitled to his first 25% tranche until he has worked for the company for at least one year. I discuss this issue in detail in my blog post “Founder Vesting: Five Tips for Entrepreneurs.”
Mistake #4 — Not Requiring the Execution of Employment Documents. Some entrepreneurs make the mistake of hiring a co-founder, but not requiring him or her to execute (i) an offer letter agreement and/or (ii) a confidentiality and invention assignment agreement. The offer letter will set forth all of the co-founder’s rights and obligations, including that the relationship is “at will.” The confidentiality and invention assignment agreement is designed to prevent disclosure of the company’s trade secrets and other confidential information and to ensure that any IP developed by your co-founder is legally owned by the company.
Non-competition provisions may also be appropriate in certain circumstances; however, such provisions are unenforceable in California other than in the context of the sale of a business — though California courts may enforce contractual provisions that prohibit employees from soliciting the company’s employees, provided that such provisions are reasonable in scope and duration.
Mistake #5 – Not Complying with Applicable Securities Laws. Some entrepreneurs make the mistake of not complying with applicable securities laws in connection with the issuance of stock to a co-founder. The bottom line is any time a company issues securities it must comply with both state and federal securities laws; non-compliance could cause severe consequences, including a right of rescission for the co-founder, injunctive relief, fines and penalties, and possible criminal prosecution. Complying with securities laws with respect to issuing stock to a co-founder is generally not onerous (particularly in California); however, you definitely need to get a lawyer involved – particularly if the co-founder will be paying more than a nominal amount for his stock.