I have seen many good businesses ruined by co-founder misunderstandings about two key things:
- control of the business
- the economics of the business.
Discuss these two things before the business makes money. Make decisions on the important, specific issues raised by this post.
It's often not worth the expense to hire a lawyer or form a legal entity when you're just starting out. So write these decisions down in an informal way, like in an email. Just enough detail to set a baseline understanding between you and your co-founder. When the inevitable question comes up months or years later, having a clear idea about what you decided will be crucial to the long-term success of the company.
This post assumes you only have one other co-founder. If you have more, some of the recommendations will not be applicable.
This post also assumes that when the company is profitable, some portion of those profits will be distributed to the founders rather than reinvested in growth. This means that this article won't be helpful to companies that either are, or aspire to be, venture-backed. Rather, it is most helpful for companies with the goal of profitability and sustainability with minimal outside capital. Think Nugget or Indiehackers, not Y Combinator.
Control of the Business
If there are only two founders, you should require the consent of both founders to move forward with any "material" decision.
Examples of decisions that are material for a young company:
- raising money;
- distributing money from the company to the founders;
- compensation decisions for founders;
- bringing on an additional founder;
- hiring or firing employees;
- entering into any material contract with customers or suppliers;
- spending company money above a certain threshold; and
- decisions on business strategy.
There may be more for your specific company.
For non-material decisions, like taking a client out for a meal or signing up for a cloud service that only requires a monthly commitment, the two co-founders could be empowered to make decisions on their own within their areas of responsibility.
Economics of the Business
Economics can encompass a lot of issues. But there are two critical ones that should be answered upfront.
- Profit Sharing. When and how are profits split?
- Capital Contributions. What money is used to start the company?
A 50%/50% split of profits is not uncommon.1 But it should depend on what each founder is bringing to the table in terms of time, effort, expertise and connections. The remaining key questions are when do you split and what do you split?
When. The question of when you split dovetails with the above discussion of control. If the two founders decide to take money out of the company as profit, then they'd split that profit in the percentage they agreed on (e.g., 50%/50%). But they must first decide to distribute the cash out of the company. If they don't, the default is to leave the cash in the company bank account and reinvest it in the business. Make sure you've decided who decides when to take profits out of the company. When there are only two founders, I recommend that both have to consent for money to be taken.
What. The question of what you split is an inquiry into what "profit" means. In principle, this is just revenue minus expenses. As accountants know, however, things are rarely that simple. Someone will need to make a decision about what profit is actually available for distribution. I recommend that either both founders make this decision together, or if you are working with an accountant, have his or her determination be final.
What can make this more complex is if one founder is putting more initial capital (cash) into the business upfront than the other founder.
When your company is brand new, it won't be making any money yet. How do you pay expenses?
Before you open a company bank account, a common way for new founders to do this is for one founder to Venmo the other founder for half of the expense. This ad-hoc, 50%/50% split of expenses amounts to both founders contributing equal amounts of cash to the nascent company. And if two founders are contributing equal amounts of cash, there isn't really an issue. You could safely skip the rest of this section. Just decide that both founders are expected to put in the same amount of capital to get things going and move on.
The issue arises if one person is putting in more money than the other. Imagine Founder 1 and Founder 2 are putting in equal amounts of time and effort, but Founder 1 puts in $10,000 to get things started. Founder 2 puts no money in. If Founder 1 and Founder 2 have exactly 50%/50% interest in the company, Founder 1 gets a little screwed, right? Founder 1 puts in more than Founder 2 but gets exactly the same ownership.
You can address this by giving Founder 1 a little bit more of the company to compensate him or her, so instead of 50%/50%, you split the company, say 60%/40%. This can work, but it can be unfair to both founders in different scenarios:
Upside. If the company is a breakout success. Founder 1 will always have 20% more of the company than Founder 2, even years or decades later and even though they both put in years of their life, just because Founder 1 put in $10,000 in the beginning.
Downside. If the company shuts down the day after Founder 1 puts in the $10,000, Founder 2 ends up being entitled to $4,000 (40%) of what is really Founder 1's money, even though the company never operated and no business was ever transacted.
To avoid this problem, the startup world has handled this with something called a liquidation preference.
Liquidation Preference. A liquidation preference tweaks the profit sharing formula to make sure the founder contributing more capital upfront is compensated for this extra contribution, without giving them a permanent advantage over the other founder. One permutation of such a liquidation preference could be if the company makes any distributions of cash, that cash might be split 100%/0% until Founder 1's initial contribution is totally paid back. Once Founder 1 is paid back their original investment (or a multiple of their original investment), then distributed profits would be split 50%/50%.
That's just a crude concept example to give you a sense of what liquidation preference means. If you decide to go the liquidation preference route, make sure you agree on two things:
What multiple of their contribution Founder 1 gets, with 100% (1x) of their contribution being typical and 200% (2x) being the upper limit I would recommend before things start to feel unfair to Founder 2;
What the profit split is (e.g., 100%/0%) until the liquidation preference is extinguished and the normal split (e.g. 50%/50%) takes over.
Leaving the Business
What happens if someone wants out? Can they sell their interest in the company to someone else? Can they take their 50% share of the company's assets and just bounce? What say should the other co-founder have in those decisions?
Typically for a two-person business, it would be unusual to allow one of the co-founders to just sell their interest or take half of the assets and leave without the others' consent.
If both founders think they're done with the business, it's easy: just split the assets of the company at the profit split 50%/50% (subject to any liquidation preference if someone put in more cash than the other).
But if only one person wants out, you should decide how you want to handle it. If the company or the other founder has the cash, the exiting founder can just be bought out at a fair valuation. If there is not enough cash on hand, the situation is a little tricky, but one common approach is to convert the exiting founder's equity into debt or a debt-like security that is paid back over time.
In summary, decisions on economics and control are important to make early on in the company's life. When the time is right,2 a lawyer can assist with more detailed decision-making and you will form a legal entity. Until then, having made these key decisions will give you and your partner peace of mind that there is a framework for the economics and control of the company.
- Some people think a 50%/50% split runs the risk of deadlocks if the founders don't agree on a decision. This risk is mostly theoretical since material decisions should require both founders' consent. And non-material decisions are unlikely to be put to a formal vote where a 51% founder will force his or her view of which coffeemaker to get on the 49% founder. If that's happening, it's time to part ways with your co-founder.↩
- When is the time right? The timing of forming a entity will be the subject of another blog post.↩