Equity to active and non-active co-founders

A remarkable number of startups have conflicts between co-founders because they assume that the equity situation will simply get sorted out as they proceed. The magnitude of this challenge how its impact is reflected by the fact that this topic has been covered in earlier posts, but there is need to elaborate on this further.

Here, we discuss the challenges of active and non-active founders. Non-active founders, by definition, are involved in the founding of a startup due to their involvement in the evolution of the technology. They are often researchers, having achieved technology excellence in the area that the startup considers commercialising. It’s important to know advantages and disadvantages of majority interest in a startup by non-active co-founders. (Yes, as a matter of fact, there are disadvantages to having too much equity).

Advantages:

The perception of advantage of significant equity (over 40% t0 50%) is that as the startup commercialises, there can be a significant payback to the co-founders. The assumption is that 50% will give you a greater payback compared to, say, 30%. However, if the startup succeeds, your lifestyle as a co-founder may not be dramatically different if you exit with $75 m, compared to, say, $150m. The threshold for a comfortable lifestyle is considered to be significantly less.

Another perception of advantage of higher equity is control. But control over other co-founders is disingenuous. In fact, it’s imperative that the co-founders have a joint front, since as soon as investors enter the fray, the latter will in any case have veto rights. Thus, the perception of control over other co-founders only lasts till the investors come in, and if this an any way creates uncertainty in the minds of prospective investors, the startup simply does not get funding.

Disadvantages:

A higher percentage of equity to non-active co-founders comes at a significant cost. The more the equity of the non-active co-founder, the less remains for distribution to the other co-founders or key employees who will be required to drive the idea towards commercialisation realisation.

Since the percentage of equity also impacts the decisions of the startup, co-founders and employees eventually perceive that the non-active co-founder is doing back-seat driving. This is because unlike them, the non-active co-founder is not solely dependent on the startup and the salary therefrom to sustain himself, and to that extent, his actions or decisions pertaining to the startup do not have any meaningful impact on him.

Investors expect exclusivity for all technology being developed by the core team, since they invest in the team and its capability to execute on the idea, rather than the technology itself. When non-active co-founders hold significant equity, they are perceived to be part of the core team, and investors expect them to cumulate all technologies they’re involved in into the startup. Since non-active co-founders often are researchers with technology excellence in multiple areas, this undermines the future commercial opportunities of other technologies for the non-active co-founders. Beyond this, investors expect non-compete for the core team. Since the researchers often have joint projects funded by governments with collaborations with global industry players, this can also be put in jeopardy due to the non-compete clause.

Non-active co-founders like to have a high degree of control on their startups, reflected by the higher equity percentage. However, the tighter the control, the stronger the exclusivity that prospective investors expect. And once you’re seen to be a key driver (even as a non-active co-founder), exclusivity kicks in.

How this can be mitigated:

This risk to non-active co-founders can be mitigated by having equity in buckets. Each bucket has an agreed-upon equity proportion to be shared between the various co-founders, based on their ongoing engagement with the startup. Thus, if the non-active co-founders recede into the background, their equity can be distributed among others. If not, they still get equity in the agreed proportion, but without having to give up their rights on other technologies.

If the non-active co-founders actively give up control, investors do not see them as part of the core team but simply the basis for the origination of the technology, so long as they provide exclusivity to the startup to licence or transfer the technology in question. They still get the equity, but by virtue of not being in the board or taking a management position, they don’t risk being seen as the drivers. It’s important to note that this in no way diminishes their equity holding. Additionally, they still have the option to commercialise other technologies without strings.

However it’s done, it is critical to define equity between co-founders, specially non-active co-founders, since this equity and obligations pertaining thereto, risks becoming an albatross not only for the in-active co-founders, but also for the startup.