What does it mean to be a shareholder?
Part 1 of a series on ownership
Ask any entrepreneur and they’ll tell you they feel immense pride in owning something. It’s a prime motivator.
What does it actually mean to be a shareholder?
It’s an innocent question that I doubt founders spend time contemplating.
Maybe they should. Because in my workshops I’m constantly asked about technicalities of stacked SAFEs, multiple liquidation prefs or cap table math.
Over time I’ve realized that there’s a gap in knowledge that’s driving those questions. Founders are struggling to understand why a term sheet is structured that way or why a VC is behaving a certain way.
I don’t recommend going deep into securities law. But not knowing the dynamics behind owning shares puts founders at a disadvantage, especially if they are raising money.
So for the next few posts I’m going to talk about ownership from the ground up, from the perspective of a founder-shareholder.
I’ll start with issuing founder stock, which I cover in this post, then walk through the important ownership concepts at each stage in a startup’s life. Doing it by stage will allow founders to skip to the stage that’s relevant to them or to see what lies ahead.
How early is early? How about 4000 years ago?
Did Assyrians invent carried interest?
Modern companies (and funds) are based on principles that were developed in ancient times.
Here's an example of a fund that existed in ancient Assyria 4000 years ago:
You’ll recognize many concepts that are the same today:
a separation of investors and managers
the idea of pooling risk
profit sharing
a set timeframe
wanting entrepreneurs to have skin in the game
The point is the structure of this “joint stock company” satisfies a very human need to invest in and build potentially risky enterprises by a system of incentives and shared risk.
If you’re interested in the history of the company, pick up “The Company” by John Micklethwait and Adrian Wooldridge.
In the beginning there was founder stock
You just started a company with 2 friends. Hopefully you quickly reviewed my last post on founder equity splits. You divide up the initial allotment of shares.
When you receive those shares you’re now playing two roles: the investor (principal) and the manager (agent).
You’re an investor in the sense that you did something to earn that founder stock. You came up with an idea, invested money, or just signed up for a decade of hard work.
Once those shares are issued, ignoring vesting, you switch over to another role, that of the manager who does the work.
Those two roles (principal and agent) are almost perfectly aligned at the beginning of the company. Trusting management to do their job is trusting yourself.
Agency risk does not mean hiring a bad design firm
Imagine if one co-founder needs to get paid a salary but the other two can afford not to:
Already there are slightly different perspectives.
Imagine 6 months later progress in the company has not gone as expected.
The founder getting paid might be more patient because they are getting a salary
The other two founders might have a greater sense of urgency because they are using up their savings
This is a very basic example of agency risk. That means the potential conflict between the interests of managers (agents) and investors (principals). In this example, the founder getting a salary might have a greater interest to take things slowly while the other founders have an interest to speed up progress (to get sales or raise money).
There’s still very close alignment since all investors are also managers at this point. But the point is it’s not perfect alignment.
How to deal with this situation:
Issue, or vest, more shares, even a small number, to the unpaid co-founders. That re-balances their risk so if it takes longer to get to a revenue or funding milestones, it was worth the wait.
Rowing in the same direction
Anyone who canoes knows what happens when one paddler is not in synch. Even now I keep a mental checklist of people I will not canoe with.
Everyone talks about how important alignment is when you’re assembling a co-founding team. That’s true. But it’s true in the sense that everyone should aspire to that.
In reality, how do you know that the aspirational alignment that exists at the beginning will last years or a decade or more?
You don’t.
Fair does not mean equal
The idea of being intentional with the founding equity split is to have a fair, transparent process that survives reality.
Most co-founders believe they are equally committed and bring roughly the same stuff to the table. I question that assumption and strongly suggest you go through my template to find out.
The other thing to remember is that 99% of what builds the value of those founder shares happens in the future. The template I created is a framework for talking about what those important, risk-reducing future milestones are. Then assigning some weight to them in the form of granting shares or vesting them.
The biggest negative event, from a shareholder perspective, is a co-founder leaving early. Without a vesting schedule the remaining founders will definitely feel unfairly treated. This will also be a turn-off for future investors, but we’ll cover that in more detail when we talk about outside investors.
Basic shareholder rights
Even with only three shareholders and very few shares, there is already a basic structure you should be aware of. This is fairly standardized in startups but depends on your shareholder agreement, by-laws, initial charter etc.
Note that I am not a lawyer and nothing I write is legal advice.
Here are some basics:
Issuing new shares - When you first start the company you can issue an arbitrary number of shares. It could be three. Or three million. Later, shareholders will need to approve the creation of new shares, eg issuing new shares to be sold to outsiders.
Selling founder shares - Imagine one of your co-founders selling their shares to someone you don’t like, eg a family member. You didn’t sign up for that. There are usually rules that say you can’t sell shares to a third-party without approval or at least the other shareholders have a right of first refusal to buy those shares.
Buying back founder shares - If a co-founder died, was disabled or could not do their job it would desirable for those shares to be re-acquired. This is easier said than done because establishing the market value of a private company is difficult. Luckily, shotgun clauses, where a shareholder can force a buyback, are rare in startups.
Shareholder votes - Many things require shareholders to vote including electing the board of directors. In the early days there are rarely formal votes when three people can just decide over beers. But later there will be increasing tension between majority shareholders, particularly institutional investors, and minority shareholders who don’t want to be walked all over.
There are lots more terms and I still turn to Venture Deals by Brad Feld and Jason Mendelson as the best overview of VC deal terms and concepts. Chapter 6 “Other terms of the term sheet” covers many shareholder terms, even if it’s from the perspective of a VC term sheet. Just read the book.
Tip: standardization is always beneficial
Your mindset when creating a shareholder agreement, investor rights agreement etc. should be to be standard. You’ll rarely gain by having non-standard terms, even if they’re beneficial to you. But those will make future negotiations with investors difficult.
A good places to start: NVCA model legal documents (CVCA version for Canadians)
Wearing two hats
Even at the very start of your company, be aware that as a founder-shareholder you wear two hats.
One as principal/investor interested in generating a large return on those initial founder shares. And the other as an agent/manager who has the information, skills and resources to do the work.
Most of the time there is near perfect alignment between those two roles and among the shareholders. Negotiations between the two sides is negotiating with yourself.
But that will change over time. What’s more important than learning all the legal terms is to understand your dual roles as shareholders and managers. This colors every negotiation you will have in the future with your co-founders and outside investors.
In the next post I’ll cover raising money from outsiders for the first time and what it means for shareholders.