I met with a talented young entrepreneur last week with early traction on a very interesting idea. After getting to know him a bit and learning about the business, I asked him about his co-founders.
“Well”, he said, “there are four of us, but I’m the only one working on the business full-time.”
“Hmm,” I replied, “tell me more about that.”
“Well, these guys have a ton of connections in the industry and have been really helpful in getting it started.”
“OK,” I replied, “so tell me about the cap table, and specifically about how the founder equity is divided among the four of you.”
“Well,” he said, “the three of them own around 70%, there’s a pool for early hires and I own the rest.”
“So let me get this straight,” I replied, “you’re the CEO and the guy on the hook to build this company for however long it takes, but you’ve got a set of non-operating co-founders who own the majority of the business?”
“Well, yes but…”, he started to reply, but before he could get to the end of his explanation I interrupted him. “You’re clearly a really smart guy,” I said, “and this might be a great business. But your cap table is already broken and you haven’t even gotten started. You may be able to raise an angel round, but no serious investor is going to touch this deal because the incentives for the guys who are actually going to be doing the work for the next five to ten years are all fucked up, and it’s only going to get worse if the business actually works.”
I wish this was the first time I’ve had a conversation like this, but I see it all the time and it always breaks my heart and pisses me off in equal measure.
It breaks my heart because I love to see super-talented founders swing big, and to see a strong entrepreneur with a good idea be set up for failure is a tragic waste of talent and time.
It pisses me off because I’ve seen this behavior among experienced guys who should know better too many times to count. Sometimes they’re well-intentioned and just haven’t thought it all the way through; more often they know exactly what they’re up to and are using their personal reputations and superior knowledge of how the game is played to try to put one over on a naive young founder.
The rap goes like this: “I know a ton about this industry and have relationships and knowledge that will be the difference between success and failure for you. We’re going to be partners; I’ll be Chairman and take (fill in the blank: 20%, 50%, 80%); you’ll be CEO and take the rest, and off we go.” (A less-egregious but equally-damaging version of the same thing happens with the shitty end of the “startup advisor” pool, guys who dangle access or intros but demand big chunks of equity for their “help” — see my post on Angels with Sticky Fingers for more on that subject).
I’m a huge believer in the importance of mentorship for startup founders (and think the way Techstars has turned that into a service is absolutely amazing), but mentors and advisors aren’t the guys putting their careers on the line, and if they become owners of the business at all, the scale of their stake should reflect the fundamental difference between being involved and being committed. (As just one data point, multi-year advisor grants in the 0.25% range are common in our portfolio at Founders’ Co-op, and they come with vesting and performance expectations that must be met to be earned).
Whenever I see a cap table that has a “non-operating co-founder” ownership stake in double-digits, alarm bells go off in my head because I know the founder has gotten — and taken — bad advice about how great companies are built. If the company hasn’t raised a ton of money yet this can be fixable — usually by having a direct conversation with the owner(s) of the passive block about the need to revisit. But if the passive block is too big or too hard to refactor the shortest path for the investor is just to pass on the deal rather than starting their journey with a time bomb already on board the plane.
In my worldview, there are only three legitimate ways to become a material owner of a startup: commit your life to it as a founder; commit your capital to it as an investor; or commit your professional opportunity cost to it as an early hire. Any meaningful chunks of the cap table that aren’t accounted for by one of these three scenarios are a flag on the field, and if the chunk is big enough or the story behind it damning enough it ends the conversation before it even has a chance to get started.